The joint effects of heavy supply additions, rising construction costs and the possibility of an looming recession have multifamily lenders in Dallas-Fort Worth (DFW) exercising caution and restraint on new construction financing, even as jobs and people continue to flow into the metroplex and fuel demand for housing.
The sector’s fundamentals are very encouraging. According to data from CoStar Group, the metroplex has added approximately 23,000 new units over the past 12 months. At just over 25,000 units, absorption during that period has more than adequate. Vacancy currently sits at 7.5 percent.
In addition to the market adding 80,000-plus jobs and 100,000-plus people for several consecutive years, strong demand for Class B properties with value-add potential has kept rent growth moving forward.
Concessions have begun to sprout up in a handful of submarkets that have seen particularly concentrated levels of new supply, but the metroplex still posted overall rent growth of 2.9 percent over the last 12 months, according to CoStar.
In addition, lenders are keenly aware of the construction industry’s ongoing challenge to add skilled labor. Labor stress is creating longer construction timelines and stabilization periods.
“Two years ago, we had subcontractors walking off our job sites because they had better offers,” says Phillip Huffines, founder and co-owner of Dallas-based development firm Huffines Communities. “That’s not happening today, which suggests the labor supply and skill is catching up to demand. But construction costs continue to increase at least 2 percent annually, which means that for Class A product, rents really need to be close to $1.65 per square foot for suburban communities.“
“Costs are always a concern for developers, and the uncertainty from the trade war and tariffs has created a tough environment for general contractors to lock in pricing,” adds Bobby Weinberg, senior vice president at NorthMarq’s Dallas office. “However, construction loans have been made more viable by the availability of multiple exit scenarios, as the sales market has been robust with recently completed projects selling at competitive cap rates.”
Bobby Weinberg, NorthMarq
CoStar notes that heightened investor interest in DFW apartment assets has driven prices up and cap rates down over the last couple years. Properties in core urban submarkets are trading at cap rates in the mid-4 to low-5 percent range.
The average cap rate across all properties in the metroplex has compressed in 2019 as well, currently clocking in at 5.8 percent after closing 2018 at 6.1 percent. Cap rates on Class A assets are lower at 5.2 percent, per CoStar.
Given that many construction loans are provided to developers that intend to sell the property or secure permanent financing, a lengthier stabilization period means that lenders face longer exposure when it comes to getting those loans off their books.
Weinberg says that in addition to strong investment demand for new multifamily properties, construction debt origination has been bolstered by lenders’ willingness to refinance construction loans during lease-up/pre-stabilization periods. This provides developers with the means to own their projects for the long-term and in certain instances return portions of their equity.
Paired with uncertainty about the macro-economy’s long-term health, the micro-level factors of heavy supply and escalating construction costs are keeping multifamily lenders on their toes. While capital generally continues to be available, leverage for new projects has generally held steady at 60 to 65 percent among senior debt providers, sources say. New construction may occasionally be financed at 70 percent loan-to-cost for the most proven and qualified borrowers.
“Demand for housing is holding and construction continues to take off, but banks are being more judicious to make sure they don’t overbuild, especially in the Class A space,” says Phil Melton, national director of Federal Housing Administration (FHA) production at Bellwether Enterprise. “By going to 60 or 65 percent advance rates, they’re ensuring they have a lot of equity deals in front of them in case there’s a correction down the road.”
Phil Melton, Bellwether Enterprise
Tariffs on certain China-made products, such as commonly used kitchen appliances, are also adding to development costs. For all of these reasons, debt providers continue to offer the most favorable terms to established developers that have the equity, resources and relationships to withstand longer construction timelines and ever-increasing budgets.
“The biggest players will always be able to find capital and push pricing down,” says Melton. “There’s competition among lenders to execute deals with top-tier developers, but middle-tier developers often have to scramble to get the leverage and pricing they need.”
Steady Capital Flows
Yield curves may be inverting, stock markets may be see-sawing and trade wars may be slogging on, but none of those geopolitical factors have stunted the burgeoning amount of capital that continues to target the DFW multifamily market — and from a variety of lending and investment institutions.
Sources note that the majority of DFW’s multifamily developers are merchant builders that follow a four-step business model: build, lease, stabilize and sell. Successful execution of that model requires a steady amount of incoming capital so different stages of different projects can be financed simultaneously. Merchant developers at any given time need funds for construction, marketing and prior debt repayment, hence the importance of a healthy volume of capital in the space.
Coupled with the steadfast forces of strong job and population growth, the robust flow of capital into the market provides ample reason for lenders to have some optimism in their cautious approaches to financing new construction.
Heavy capital flows not only bolster liquidity in the marketplace, they also foster competition among debt and equity providers. Both functions are critical in ensuring that deals continue to get done. And with capital widely available, factors such as flexible debt structure and certainty of execution take on greater importance.
“Builders need to build and capital funds need to deploy capital, otherwise they die,” says Steve Forson, managing director at Dallas-based Churchill Capital. “The primary difference between this point in the cycle and others is that both borrowers and lenders are more conscious about their exit strategies. Flexibility and speed of execution are both key, not just for securing debt but for getting projects leased, stabilized and sold.”
Rate Impacts
At its most recent meeting in July, the Federal Reserve elected to cut the federal funds rate for the first time in more than a decade, settling on a benchmark figure of 2.25 percent for the overnight lending rate between financial institutions.
The Fed’s move lowers lenders’ threshold for profitability, which is usually passed on to customers in the form of lower borrowing costs. But in another display of discipline, leverage ratios on new construction loans (which are typically priced against LIBOR to begin with) will likely remain the same, says Chris Harris, senior vice president in Walker & Dunlop’s Dallas office.
“The Fed’s move shouldn’t really impact multifamily construction financing,” says Harris. “While some lenders are limiting their new loan capacities to existing customers and new borrowers with strong credit and track records, the lending community also recognizes that multifamily is performing very well and absorbing most of the new supply.”
At an even more fundamental level, sources note, the need to provide an overall lower cost of capital is not the impetus behind the Fed’s decision to lower rates, which still remain quite low by historical standards.
Demand for permanent financing, however, is much more susceptible to fiscal policy changes, sources agree. For instance, lower rates on single-family loans, which most commonly carry fixed interest rates on 30-year terms, equate to a more affordable cost of owning a home, which can lead to higher turnover in the multifamily arena.
“About 25 to 30 percent of our residents don’t renew because they’re buying homes,” says Huffines. “While lower interest rates can make constructing new apartments less expensive, it really impacts permanent financing. Rates on those loans are usually fixed for 10 years, and if 10-year money is coming down in cost, that makes multifamily communities much more profitable because interest expense is by far the largest expense associated with ownership.”
Phillip Huffines, Huffines Communities
Melton of Bellwether says that his firm experienced a surge in demand for permanent loan applications following the Fed’s decision to slash the rate. The steady decline in the 10-year Treasury yield, which has slid by more than 100 basis points from 2.66 percent at the beginning of the year to 1.54 percent at the time of this writing, has compounded this effect.
“Construction leverage ratios are still consistent with where they’ve been for established sponsors,” he says. “But we’ve seen a flurry of activity in the permanent financing market and volume is moving quickly in that space. The rate cut is really geared toward 10-year money, but we’re also seeing more borrowers target our construction-perm combination program within our FHA platform.”
Melton adds that borrowers looking for construction-to-perm loans can currently secure a sub-4 percent all-in rate on a 40-year, nonrecourse, fully amortizing loan.
— By Taylor Williams. This article first appeared in the September 2019 issue of Texas Real Estate Business magazine.