There’s no disputing the growth in the multifamily market over the past few years. Cranes have been visible in big and small cities across the country and 2016 was the first year in a decade that more than 300,000 units were delivered, according to the National Multifamily Housing Council (NMHC), which says 300,000 to 400,000 units are needed each year to keep up with demand.

The level of demand varies from market to market, naturally, but multifamily developers everywhere are still looking to do what they do best: develop. The trouble for some, though, is these projects cost (a lot of) money, and before cranes and crews can get to work, the proper financing needs to be secured.

Lately, that has become a sticking point.

“It’s certainly as difficult an environment as we’ve seen on this end of the cycle,” says John Gray, head of investments at Lennar’s LMC, of the current construction lending market. “It’s interesting where the market has gone because, traditionally, you look at real estate cycles and you see construction lending pulling back because there’s a reduction in the strength of the fundamentals of the business. That really hasn’t been the case this go-around. The pullback has been due to regulation.”

“Regulation” isn’t a word uttered with much enthusiasm in many business circles, including multifamily construction lending. Since the Great Recession, there have been several laws enacted that require businesses to alter the way they lend or borrow money, which are beginning to impact developers’ pipelines.

According to RealPage, roughly 282,700 units were started in 2016, down from about 350,000 units in 2015. The firm is expecting another decline, between 20% and 30%, in 2017, with around 200,000 to 220,000 unit starts.

Burdensome Regulations
Problems obtaining a construction loan begin with the High Volatility Commercial Real Estate (HVCRE) regulation under the Basel III capital requirements, which went into effect in 2015. Each loan that’s designated as HVCRE in a bank’s portfolio is assigned a 150% risk weight under the rule. To avoid the HVCRE designation, borrowers must contribute at least 15% of the real estate’s “appraised as completed” value prior to the advancement of funds by the bank.

“The effort was to get banks to do development loans on a more conservative basis,” says John Isakson, chief capital officer at Atlanta-based Preferred Apartment Communities. “The problem is, the definition of leverage and the definition of equity were so limiting that it actually went way overboard, which is why you’ve seen banks being so cautious.”

That cautiousness has increased costs for developers, Gray says. “All these banks are being forced to reduce their multifamily construction lending exposure,” he says, “and what that’s causing is you get developers like us that are paying back two projects that have been successful and sold, and you wind up with maybe one more project at capacity, and, obviously, with a lack of lenders in the market today with available capital. What that does is drive construction lending pricing.”

According to Dave Borsos, vice president of capital markets for the NMHC, loan-to-cost limits started dropping and spreads to LIBOR began widening last year. In 2008, he says, borrowers could get 85% to 90% loan-to-cost and sub-100 spreads over LIBOR. “Banks were aggressive,” he says. “And even up through 2015, they were distinctly more cautious in not going down that same path that they had tread before the downturn.”

In 2015, Borsos estimates, up to 70% loan-to-cost and about 200 over LIBOR spreads could be had. In the first quarter of 2017, though, loan-to-cost expectations were cut to around 55% to 60%, and spreads widened to north of 300 over LIBOR, on average, he says.

“It’s taking more time and effort to identify terms that work for the deal that they’re trying to get financing for,” Borsos says of developers. “It is a little less straightforward. I think the market has adjusted, but, in general … the constraints still exist in the market and those constraints are translating into a bit more effort to identify somebody to finance your project and at the terms that can make the transaction work.”

A project’s location and a company’s existing relationship with a lender play a big role in getting a deal financed, Borsos adds. “It is much more selective geographically, client-based, depository-based in terms of what people are willing to do,” he says.

Mind the Gap
With banks more conservative, some developers have turned to other sources to fill in the gap. Traditionally, Isakson says, a borrower would go and get 70% or 80% loan-to-cost and be left with 20% or 30% equity. From there, they would typically fund it themselves or take part in a joint venture. But when the loan-to-cost drops down to 55%, it’s more than they’re willing or able to raise in many instances, he adds.

If there is a gap between the amount a lender is willing to give a borrower and the amount of equity the borrower is willing and able to put into a deal, a third party may be the only way to secure sufficient financing.

Mezzanine lenders are reemerging to fill that gap.

Mitch Paskover, president of West Hollywood, Calif.–based Continental Partners, says he has noticed more mezzanine lenders coming into the multifamily space recently. “If you have a construction loan that has only 50% of cost or 60% of cost, a lot of developers don’t have that much cash lying around, so mezzanine guys are stepping in to fill that void,” he says.

One of those “mezzanine guys” is Isakson at Preferred Apartment Communities, which has a mezzanine program that helps fund development deals. What sets the company’s program apart, Isakson says, is its willingness to go deeper in the capital stack than its competitors.

“A lot of borrowers have come to us that normally wouldn’t because their lenders have said, ‘We won’t do 75% [loan-to-cost] anymore; we’ll do 50% or 60%,’ ” he says. “And they need somebody to bridge that gap in the capital stack, which can be pretty substantial, and we are willing and able to do that.”

Balance Sheets
For LMC, one of the nation’s major developers—it completed about 6,200 units in 2016, according to Gray—mezzanine lending isn’t something it worries about. “We’ve always been a 35% to 40% equity investor, so it really hasn’t changed our business plan,” Gray says. “It’s just made our cost of borrowing more expensive.”

Despite the rising costs and tighter lending market, LMC’s business hasn’t been slowed down. The company’s balance sheet is huge in more ways than one, Gray says. “We’re a 50% to 60% [loan-to-cost] borrower, so if you’re a bank and you have a finite number of dollars to put out for the year, it’s a fairly easy decision to choose a bigger balance sheet for your sponsor and a lower loan-to-cost deal,” he explains.

The NMHC’s Borsos says most deals are taking longer and require more effort to finish. So some developers are seeking outside help.

Shahin Yazdi, principal at Los Angeles–based George Smith Partners, says he’s noticed more borrowers seeking a broker to provide financing options these days. “Their lender may not be lending in construction anymore, and, also, a lot of lenders, if you haven’t done a construction loan with them [before], they’re all doing loans [only] with repeat customers,” he says.

Banks are more focused on client relationships today, Borsos says, which encourages selectivity. “If a bank, from a credit perspective, feels that their exposure in a particular market is hitting levels where they’re uncomfortable lending more … they’re going to look towards clients with which they have a deeper relationship,” he says.

But other developers have had to scrap deals altogether. Los Angeles–based Olive Hill Group was looking for construction financing for a 200-unit building in downtown Los Angeles last year, but early on in its search, Tim Lee, vice president of corporate development and legal affairs says, it became apparent that lenders weren’t willing to offer enough funding.

Olive Hill typically looks for around 65% loan-to-cost and, Lee adds, has had no trouble securing sufficient financing in less-competitive areas in California. But this time, the loan-to-cost would have been around 55%.

“It could’ve been done if we wanted to push the limit a little, but we just didn’t feel comfortable going after financing that would put restrictive covenants on us that we just didn’t feel were within our risk assessment,” he says.

Looking Ahead
Although it’s more difficult to find financing, multifamily construction deals are still getting done, Borsos notes. “The number of units under construction right now would tell you there’s still broad availability and people are figuring out ways to get deals financed,” he says. “I’ve not heard of anybody who hasn’t been able to access construction financing at all.”

Whether the lending landscape will change in the near future remains to be seen. Yazdi contends it’s going to get tougher before a possible letup. “We’re not seeing too much loosening in regulations today, but I think by the end of this year and next year, you’ll find that banks will get a little more aggressive, especially if President Donald Trump follows through on his promises and really eases up the Dodd–Frank laws and HVCRE regulations,” he says.

Borsos is expecting the current lending conditions to persist through at least the end of the year. “I think we’re at a steady state where banks are comfortable where they are,” he says. “Banks will continue to have and manage exposure depending on the market and client, which therefore has some impact on the … depth of availability of capital. [There are] fewer bidders on a construction loan, but there are still some.”