THE MARKET FOR CONSTRUCTION debt will improve in 2012, but there are a bunch of developers who'll hardly know it.
Competition among construction lenders who want in on a wave of Renter Nation demand should get a little more stoked, as banks hunger again to place capital. Rates are likely to stay low, and underwriting will grow more borrower-friendly as leverage levels inch up and nonrecourse provisions become more common in low-leverage deals.
That's great news for developers who are itching to make up for lost time and deliver into the next great upturn. But not everybody will be invited to the party.
Banks continue to resolve troubled loans and increase their lending capacity, true, but those same troubled loans offer a cautionary tale. Even as competition returns, a sense of caution to a fault will underlay 2012—chastened lenders will shy impulsively from “extend and pretend” flight. In short, borrower scrutiny doesn't look to be loosening up any time soon.
“With the right signature, you can get construction done, but without it, you're not getting anything done,” says Gary Mozer, managing director of Los Angeles–based George Smith Partners. “That completion guarantee is so much more important now.”
Value-add deals are also expected to gather momentum as financiers get more comfortable with—though stopping short of trending rents—the prospect of rent growth.
“If you look back a year ago, we didn't have a lot of commercial banks and private funds that were going to do value-add transactions and take risk,” says Bill Hughes, managing director of Encino, Calif.–based Marcus and Millichap Capital Corp. “And now, we've got a plethora of highly structured products in the marketplace.”
The equity market jumped off the sidelines much more swiftly, and developers are still waiting for the debt to catch up. And in some ways, it has. Construction capital is now available from a greater array of organizations—including life insurance companies and pension funds—than it was a year ago. The good news is, the money is out there again. The bad news is, it's pretty damn selective.
Then again, many owners are grateful—in an abstract sense—for the conservatism of the banking sector. After all, developers develop; it's their MO, their raison d'être. And the fact that some markets are in danger of overheating is a true testament to just how far this industry has come in the past year. But the more overheated a market becomes, the less demand and, ultimately, rent growth you're going to see.
The brakes on an overheating sector can only be applied by financiers, in the end. “I just hope the banks don't lose their discipline— you have new developers entering the market, new equity, and what's holding back a complete overbuild across the nation is the banks,” says David Ravin, president and CEO of Charlotte, N.C.–based developer Northwood Ravin. “But if those guys decide they need to increase market share, there will be as many projects built as they're willing to loan the money on. We just went through this.”
Rising Spread
Pricing isn't expected to fluctuate much next year. The London Interbank Offered Rate (LIBOR)—the benchmark upon which most construction and renovation loans are based—has been low for some time. The one-month LIBOR was a minuscule 28 basis points (bps) in mid-December, just 2 bps higher than it was in December 2010.
Consider that during the apartment market's last boom, the onemonth LIBOR averaged around 500 bps in 2006 and 2007. While LIBOR is an internationally set benchmark, U.S. monetary policy exerts a strong influence, and many expect this “new normal” to continue.
“It's a very artificial situation and one that the Fed has explicitly said they're going to continue for some period of time,” says Ryan Krauch, principal at Los Angeles–based first mortgage lender Mesa West Capital. “There's a very good chance that LIBOR remains low for one, two, if not three years, until the Fed starts seeing some signifi- cant and sustained economic recovery.”
Still, the benchmark is only one part of an interest rate. The spread that lenders charge over the benchmark really tells the tale. And in that regard, borrowers may not see quite so much stability this year.
The cost of borrowing is ultimately determined by supply and demand, and the demand by hopeful developers clearly outpaces the supply of ready and willing banks.
“If there's so much demand for this capital and not enough sources, there's going to be an upward pressure on spreads,” says Mozer. “One of the major banks that was lending everything at 225 over—then it was 250, and in December was 275—is hinting that it might be at 300 over in 2012.”
But so much depends upon the global capital markets. The construction debt market was progressing nicely in 2011 until a summer of discontent brought a debt ceiling drama in Congress, a downgrade to our nation's credit rating, and the Greek debt implosion. Suddenly, construction debt got a little scarcer, before returning again in the fall.
Cautious Enterprise
The value-add trend started in the best markets and with the largest developers, but it's only a matter of time before secondary markets, and middle-market developers, can freely access capital to renovate. Today, it's a cautious enterprise—the per-unit dollar amounts being offered are still modest. In many ways, curing deferred maintenance has become the new value-add. The prospect of healing an underperforming property is a viable play.
“Property values have gone up in the top end of the market, and that bifurcation means there is still value to be had in properties that have been underinvested in,” says David Brickman, head of the multifamily division of McLean, Va.–based Freddie Mac.
In fact, Freddie Mac is hoping to roll out some enhancements to its existing adjustable-rate programs in 2012 to capture this expected wave of value-add deals. Specifically, the company is looking at how it might use its credit facility line of products to serve as a vehicle to transition floating-rate debt to longer-term fixed-rate mortgages.
Wells Fargo has been among the most active rehab lenders, and private lenders like BB&T Real Estate Funding grew more active this past year. An increasing amount of life insurance companies are offering bridge capital as well. But relative to demand, the supply of nonrecourse debt for value-add plays is limited.
“You have to have a very specific market to justify renovation or rehab dollars in multifamily right now,” says Krauch. “But of those of us who are active, we're small potatoes relative to the need of capital.”
The bridge-loan market certainly grew healthier in 2011. More bridge lenders are now offering longer-term loans, three years with two one-year extensions, and leverage usually tops out at 75 percent.
But the issue with bridge money today is that it's either cheap bank capital or expensive private-fund capital. All-in rates quickly go from around 3 percent to 6 percent, and there's not much middle ground.
And the way these deals are being underwritten has certainly changed from the last go-round—nobody is really trending rents anymore. Today, bridge lenders aren't as interested in investing in a deal based on the projected strength of a given submarket.
“They're going to do it based on a tried-and-true business plan, whether it's investing in improving the asset, burning off concessions, or leasing up the balance of the units,” says Kevin Smith, who leads the Alternative Capital Division of New York–based Centerline. “You have to show that there's a real exit for the bridge lender.”
Cycles vs. Memory
Of course, there's always the Federal Housing Administration (FHA)—if you have the patience.
The FHA has processed more than $6.8 billion in new construction/ substantial rehabilitation loans over the past two years, and its rates and terms are difficult to ignore. Sec. 221(d)(4) loans were pricing around 5 percent in early December, an incredible rate for 40-year nonrecourse money. The problem is, you may still be waiting for that loan to close a year after you start the process. And most developers just don't have the luxury of time.
Or do they? The multifamily industry came out of the recession so quickly that many developers feel like, if they don't get a product in the ground now, they've already missed this coming cycle.
But maybe the FHA's slowness, and the private sector's hesitancy, is a blessing in disguise. In the nation's strongest markets, talk has turned again to overheating, and the joke is that our industry has 10- year cycles but two-year memories.
So, maybe slow and steady really does win the race.
“We had two years of downtime—we don't need to build it all tomorrow,” says Joe Coyle, who runs the student housing division of the Marlton, N.J.–based Michaels Organization. “The fear of anybody who looks to do this long-term is that we backslide into pre-2008 days. But as banks get out from underneath existing projects, that money needs to be put back out on the street.”
FULL COFFERS: Capital One provided $44.07 million in construction and mezzanine loans for the Gallery at Cameron Village (right), a 282-unit community being built by Crescent Resources in Raleigh, N.C. Wells Fargo provided $53 million to a joint venture of Rockpoint Group, Jefferson Apartment Group, and Perseus Realty for the construction of the 231-unit 14W (left) in Washington, D.C., due to be completed in October.
