There is no shortage of capital available to seasoned multifamily developers and investors because the property sector’s underlying real estate fundamentals remain so strong. That was one of the key takeaways of the ninth annual InterFace Multifamily Southeast, a real estate conference hosted by InterFace Conference Group and Southeast Real Estate Business. The event drew more than 400 multifamily professionals to The Whitley hotel in Atlanta on Nov. 27.
Speakers during the development panel said that multifamily real estate has plenty options on both the debt and equity sides, but underwriting financing for new construction can still be a strenuous process because they aren’t seeing as high of returns as years past.
“Our return thresholds are lower, that’s a fact,” said Chad DuBeau, senior managing director of Mill Creek Residential Trust. “Construction costs are high and land prices are high. The cost of capital is very reasonable, but when you put all those factors together, underwriting is just difficult.”
Panel moderator Ron Cameron, senior vice president and principal of Colliers International, asked his fellow panelists a pointed question about the state of the industry. If the multifamily cycle were a game of golf, what hole is the sector currently on?
Colin Cavill, managing principal of St. Clair Holdings, said that the apartment industry is currently playing the 16th hole, indicating it’s late in the cycle.
“We’re starting to see hesitancy of capital sources to truly chase the deal,” said Cavill. “Lenders have dramatically pulled back in terms of leverage, which really affects entrepreneurs’ ability to get a development deal over the line.”
The developers said that similar to lenders, their equity investors are also more cautious because of the lower internal rates of return (IRR) they’re getting compared with the recent past. Cavill said that sovereign wealth funds will do deals at a 11 to 14 percent IRR, but that most domestic equity groups are still expecting IRRs in the high teens to low 20s. As a result, developers are adjusting their leverage during underwriting.
“The struggle we have in underwriting is getting our equity investors their returns and keeping leverage at a level that we’re comfortable with,” said Kyle Brock, managing director of Crescent Communities. “It’s tough to hit those equity returns without juicing the leverage. That’s a constant challenge we have.”
Bennett Sands, managing director of Atlanta-based Wood Partners, said his firm has accepted the lower leverage environment in the underwriting process in order to get deals done. The highest he said Wood Partners will underwrite now for construction financing is 60 percent loan-to-cost.
“As a result, we’re having to convince our capital sources that it’s no longer an 18 to 20 percent IRR, it’s in the mid-teens,” said Sands. “The equity groups getting deals done are the ones that are accepting lower returns.”
The developers on the panel said that even after underwriting is in place, their returns could still take a hit if variables outside of their control go sideways, including rising construction costs and zoning or entitlement miscues that could delay construction times.
“It’s taken four to six months longer than we anticipate for municipalities to approve plans, and that’s if we know people in the city,” said Cavill. “I’m expanding the time it takes before we really start construction, which impacts the returns, but I’m doing so as a backup so we have flexibility.”
Facing these potential disruptors, developers are safeguarding their projects by building in contingencies on the front end of their underwriting to mitigate their risk.
“We’ve had a few too many challenges at the end of a deal trying to get costs in line, so we add a little more cushion upfront,” said Brock. “It does make those projects more difficult to underwrite, but capital out there has adjusted its return expectations so we’re able to make things work.”
In the face of lower returns, some developers have opted to change their corporate philosophy. DuBeau said that Mill Creek Residential has pivoted to become a long-term holder of the assets they develop because they’re not making as high a profit selling. DuBeau said his firm is confident in the sea change in strategy because he believes that multifamily’s demand drivers will be in place for the foreseeable future.
“Our view is that we’re finding opportunities that are good investments in the long term and investing not from a merchant-build strategy but rather a long-term one,” said DuBeau.
Mill Creek Residential’s focus in 2019 will be on finding the best development sites, emphasized DuBeau. “We’re a strong believer in site selection. We’ll make that bet, but in a disciplined fashion.”
— John Nelson