Apartments have been the darling of the real estate industry for almost a decade. Even this deep into a long, bullish run, investment dollars are still available to be placed into the sector. However, the tide has shifted, making it harder for less-savvy investors and developers to keep up their streak of profitability, or even to remain in the game. Those left—undoubtedly, those more seasoned—are dealing with the challenges of the day, including land sourcing, rising construction costs, and less aggressive financing from construction lenders.
This confluence of factors is affecting the capital stack in four especially noteworthy ways.
1. Rising Developer Costs Are Lowering Project Yields and Making Debt More Difficult to Obtain
Politicians have been witness to so many apartments being built over the past decade that they’ve seized the opportunity to increase fees to developers. Additionally, they now often demand a larger component of affordable housing from the developers who want their projects to be green-lighted. These actions have, unfortunately, driven up the overall cost of projects to developers and, in turn, lowered their achievable yield.
In response, lenders have started to pull back or reduce the amount they’ll lend, making it much harder for developers to obtain equity financing. While there is still debt available, there’s definitely less of it to go around.
2. Regulations Are Driving Down Loan Amounts
While the Dodd-Frank regulations of 2010 were primarily well intentioned, they’ve produced some negative consequences to the multifamily sector. Just as with rising developer costs, regulators have restricted the available dollar value of construction loans. As a result, returns to equity investors are lower and more equity is now required to get deals done. Capital is essentially slowing down.
3. Value-Add Deals Are Getting Priced Too High
Those active in the value-add space are facing their own set of challenges. Existing deals, such as rehab and reposition property opportunities, are getting priced higher. There’s so much capital chasing existing acquisitions that value-add buyers are experiencing feeding frenzies whenever opportunities come to market. Most of these deals offer yields of 0.5% or less below those of brand-new core assets.
We’re starting to see a lot of the active investors in this niche slow down their activity. These players are trying to figure out what to do with the cash in the system.
4. New Investment Vehicles Are Cropping Up
With regulators prompting the slowdown in bank lending, nonbank lenders and new debt-investment vehicles are flooding the marketplace and helping fill the finance gap. These players have the advantage of much lighter regulation, giving them greater flexibility in managing and evaluating the risk of their loans. They’re thus able to provide debt considered far too speculative for traditional bank lenders and are freer to operate in a space that banks, for the time being, can’t. Their interest rates, however, are somewhat or substantially higher than bank rates. You might borrow (55% to 65% of cost) from your bank at 4.25%, but to get a higher level of financing (65% to 75%), you might pay as much as 7% to 8%.
While these exotic debt instruments are available for the increased number of borrowers in need of financing, their higher rates constrain some acquisition companies and developers from utilizing them.
In total, these capital trends are key indicators that we’re nearing the end of the apartment boom—specifically, the boom in new construction. After 2017, expect the number of new units starting construction to decline quite dramatically. Take note, however, that this decline in new construction won’t necessarily be due to a lack of demand, which will, very likely, remain high, especially in major metropolitan centers, as well as among the historically high number of young adults currently living with their parents who will eventually enter the rental marketplace.
These demand projections, coupled with less (expected) new product, are proof positive that we as an industry need to be prepared for a potential apartment-unit shortage in the coming years.
