How are developers still building?
For you development monkeys- please help me understand how there are still developers getting deals done in several markets right now?
I’ve been a development manager/director for 7 years. I was recently laid off because our firm couldn’t keep funding payroll without any capital events happening or new development fees coming in the door. They’re basically winding down and about to close their doors.
At today’s interest rates, cost inflation, and flattening rents, how are there still large projects being started in 2024?
I get that some firms have massive balance sheets, access to lower-cost capital, and their mega projects may take 10 years to complete, so ok, they’re playing a slightly different game. But for the small to medium sized shops doing 100-400 unit MF deals, they’re all subjected to the same rules/reality we’re all facing. Yet, I still see some of them building throughout the Midwest, South and Southeast. And it’s not just garden apartments which tend to make the most sense right now- I’m seeing even 4-5-6 story apartment over retail deals being started.
Obviously nothing compared to activity we’re used to seeing a few years ago, but i can’t understand how there is ANY activity today. Who is funding it? What returns are they projecting? Seems incredibly risky.
How is this possible? What am I missing?
I mainly work on retail, multifamily, and plain jain combinations of the two, and I can only talk about the Southeast. Retail deals are happening in tertiary markets with tenant demand being so strong. Ground leases and improved land sales are transferring the development cost to the tenants, and the tenants accept so they don’t lose sites to competitors. Cap rates for investment grade credit are tight enough for us to do site work and pour concrete. Grocer tenants have been growing consistently for the last several years, and the outparcel business is still fairly active which is juicing IRR. Multi tenant buildings aren’t really working, but that looks to be changing. On the multifamily side, the vanilla garden style deals breaking ground in my neck of the woods are good sites in stable markets. It’s really telling now to see which firms are willing to be aggressive in the underwriting—not naming names, but there are firms winning deals today simply because they’re forcing the proforma (as it’s always been). You underwrite $2.50 rents, I underwrite $2.00 rents, and you win the deal. Can’t think of a ground up mixed use deal right now that seems economically legit, but a few major value add sites (nearly ground up development type or stuff) traded recently which are 2-3 years out from breaking ground. I’m excited to watch those play out because they appear to be one of those situations where the duration of the business plan gives them a shot to float through the current environment, commit to the deal now if they want to, take it step by step and potentially tee it up for another developer, or just cut bait. One of them is a regional mall that’s 40% occupied. They got the deal at an uber low land basis after lender foreclosed and are replacing the retail entitlements with multifamily, essentially keeping T1/T2 and building apartments next to it.
Agreed re: the gamblers being the only ones winning deals and actually building today. Any sane shop (read: ones with skin in the game) is not building today because you're basically gambling on outsized rent growth or underbudgeting significantly.
There are plenty of markets around the country where the fundamentals just require more development. At the end of the day that is all that really drives this. The population grows, you need to build more. Also I the biggest change I have seen from developers pitching me is their deal term. Many are now talking hold periods that are 2 - 3 years longer than they were previously. This doesn't really entice me however, because most of them are dog shit operators. I have zero confidence that holding a deal longer will really help them grow NOI. I can think of a handful of developers around the country where this would be beneficial for their business model, mostly because this is what they have always done and they are now just on time parity with the churn and burn developers.
I think the big homebuilders are the ones who are actually fucked. Their products are terrible, half of them need extensive rework, and if it wasn't for their ability to bully customers and bend regulations to their benefit most of them would be bankrupt now with how terrible their product quality has gotten.
Care to elaborate on the shit quality home builds? I'm shopping for my first one, so curious
If you buy a new built home from one of the big builders you have to be very careful because their contracts and warranties are basically worthless. They hire the cheapest bidders for everything and half of their contractors don't know shit about what they are doing. Every home will have some touch ups or minor things that need correcting. But I can't tell you how many pre move in inspections that I have seen where major structural issues are discovered, doors and windows that are falling apart, and drainage control that was supposed to be installed is just not even there.
These companies in my humble opinion are just outright scams selling substandard products as "custom" homes.
$1000/Sellable SF - $400 Hard Cost/SF - $65 Land Cost/SF - $50 Soft Cost/SF = $485 Profit/SF
Yeah but what are you building that only costs $400/sf and sells for $1000/sf that isn't life science (which is totally dead lol)?
Condos and the actual $/SF amount is ~$1200. I used $1000 to account for affordable housing and cost of sale
Those are super low soft costs for my market - does that include sales/marketing, commissions, contingency? What about financing costs? Development management fees? What kind of entitlement and construction timelines are you looking at in your market?
If you read my comment above, I used $1000 net of commissions and affordable housing requirement. Sale prices can range from $1000/SF-$3000/SF depending on which submarket. I came up with those numbers off the cuff from an actual development happening in my neighborhood (250 unit, 250k SF building) and didn't build a model for the comment. The figures i'm providing are big picture. The main point is developers in my market are still building and they are primarily building condos for sale. The numbers I provided above is also rough figures of my costs for my developments, so I'm speaking from first hand experience. Furthermore I just pulled up the model for the institutional shop that I used to work for and the soft cost/interest cost is $100/SF, so you can adjust the profit/SF to $435. Timeline for entitlement is 1-3 years depending on size and impact and 1-2years construction.
What I can tell you is in my market (northeast multi), no one is lol. Anyone who is currently under construction had financing already locked up, but no one has started anything in the last 6 months, architects and GCs are getting hungry. I'm moving forward on a few projects but that's because the place I'm at is extremely long term capital and they just have different priorities (and even then, we're still a year out on construction). I heard an anecdote of a group that has a 6% yield deal ready to go and can't find LP financing. The interesting part is if you *can* get financing and start construction 2024/2025 you basically won't have any new product competing with you.
seeing the same in the Mid-Atlantic, needs to be a 6.5 untrended yield to get an LP on board. Very few of those truly exist, know of a number of deals that are around a 6 that can't get started. We have gotten a couple LP commitments over the last 6 months on deals achieving a 6.5+, now we just need to get to the closing table as fast as we can. Debt is available but costly, we haven't had to drop anything because of debt, it is all about the equity.
We've been seeing lenders get back up to 60% LTC at like S+350, which honestly isn't too bad, it was more like 55% with S+375/400 not too long ago.
There's something to be said about things usually working out when you can make RE deals happen when others are having trouble. Just the same as where everything "made sense" to develop in 2021 so everyone broke ground at the same time and now they're probably mostly getting burned. You sometimes have to think about it in supply and demand being in your favor instead of just your proforma underwriting to the IRR you want using today's assumptions. Today's assumptions will change and as history shows, they tend to move into the favor of those that can get deals done in tough times and they tend to move out of favor for those that do all their deals when the markets hot and it's easy to underwrite. Enough operators / developers / capital think this way which is how they're still getting deals done and just UW more aggressively to make the numbers "work". The crappy operators and markets will probably end up getting burned this way, but great operators in markets with strong demand drivers over the next 10 years have a good shot at coming out ahead this way.
You say it seems "incredibly risky" to break ground today which I keep hearing. I never heard that in 2021 (although I'm sure there were great minds thinking / acting like it was). Yet here we are with developers delivering left and right into over supplied markets, higher rates, needing pref equity to do a cash-in refi so they don't lose the keys. Why wasn't everyone saying "it's incredibly risky to break ground today" back in 2021? It's because people have a tendency to think in a vacuum and assume that today's assumptions won't deviate much over time.
I've had this sentiment in real estate for a while, but I feel that it's become less of an "investment" business and more of a fee driven commodity skillset. The arbitrage you're able to get because of the amount of information available is much, much lower than before, and your ability to crush on deals is so much lower since everyone's got CoStar & very sophisticated nationwide market research as well as a much more common skillset than ever before with widespread education of the subject matter and the internet. I know we as developers like to pretend that we're better than brokers, but at this point I feel like we're only justifying fee with co-investments so we can raise capital. I think that we're basically getting the same risk-adjusted returns as before, but the risk is significantly lower than it was pre-internet.
I feel like a lot of developments just get started in order to bring in fees in order to feed the machine and keep people employed rather than strictly on disciplined DD and good investments, and this has also been my sentiment with acquisitions as well. We've had so much news recently about acq shops blowing up because they're syndicating capital into bad deals and clipping fat fees, but even major shops I feel like incentivize deal flow with acq fees as part of the bonus structure rather than strictly carry encourages this.
Not saying that there's only deals getting done because of this, but I do feel like a lot of it has to do with straight up pressure for deals because people want to keep staff busy and make a profit when there's none to be made. If you're taking a 3-5% dev fee on a deal you're still making money even after DPE, and if you've got a 5% equity stake and a 5% dev fee you're essentially guaranteed a 1.5 EMx before you think about actual deal returns, and as long as you're hitting your internal cost of capital returns on a deal (maybe like 5-10% these days considering a lot of people aren't making money unless you're taking a massive YOLO), you're still essentially getting 50% IRR on your "human" capital as long as you make full fee and don't hit any project delays.
Agree that there's less and less "edge" to real estate as time goes on, but it still exists, and I would not underestimate how poorly a lot of operators / developers manage properties or development processes, meaning there is still edge from being an excellent operator or being able to develop something and actually hit your budget and timing while delivering a great product.
Do you think this 'commoditization' of development is a threat to people who are just starting out their career? I've heard about this issue and the fact that dev is getting more and more institutionalized.
A former colleague had an interesting comment about this, he basically said as a higher-up employee at a large company you have two types of risk: deal risk and career risk. Deal risk is if one of your deals blows up or doesn't perform as underwritten, which can jeopardize your job at that company, but it isn't discovered until years later. Career risk is not sourcing and getting deals done, which has the same risk of getting fired, but the discovery process is in real time. There are definitely people who primarily think about career risk and just keep their fingers crossed on deal risk.
Plus, it's easy to find a thousand excuses why your underwriting didn't work out, it's hard to justify your 18 month dry spell.
Move to a market that has much more restrictive zoning laws. You will have plenty of edge if you know what you are doing lol. You could also get fucked if you don't.
Let's not even get started on acquisitions. These fly-by-night syndicators feeing the hell out of clients. A 1% acquisition fee (on top of the principal buying the property and selling it to the fund at a profit), a 1% disposition fee, a 1% asset management fee (oh and they hire a 3rd party leasing company too). Then they sell it to the next syndicator within 17 months to juice the IRR and collect the disposition fee faster (although the equity multiple probably sucks).
At least a developer does bring some value.
Work for developer on West Coast - CA, NV, AZ.
Not much of anything has been started in the last 12 months, deals that are breaking ground now were likely locked in ~12 months ago.
Apart from the costs/underwriting dynamics others have mentioned, another issue is that the greater capital markets - speaking about existing assets - have been dead the last 12-18 months, so no one knows where pricing should be...in effect there isn't even a playing field established to play on. If XYZ allocator knows in-place cap rates are a 5.0% today, then they can probably get comfortable building to a 6.5%, but since virtually no existing assets have sold, then no one knows what the spread (YOC to residual) should be.
We're starting to see some existing deals trade, which certainly helps to establish the playing field which is a nice first step. Having said that, if you're buying an existing deal at a 5-5.5% where you can get to a low/mid 6% with relatively little lift, then why the hell would you build to a 6.5%?
Current theory we're hearing is that Step 1 is for the institutions to start buying existing assets again, at which point they will gradually bleed out on the risk spectrum towards development.
DeFi
We're still building even though interest rates (permanent financing and construction financing) are significantly elevated.
We recently just took out a construction loan with permanent financing @5.99% interest and still had funds left afterward (not much). We were a little worried last week especially with all the significant movement in the 10 year. A couple times we were worried that we might have to show up with funds to close the gap (although we have said funds). Kind of sucks that interest rates have gone up some 250 basis points since we broke ground, however I know there are firms much worse off than us.
I would say a lot of the developers having trouble building projects are those that were happy to have a GC do the project for them, collect their development fee, and repeat. In the times of easy money, you could do that and be fine. You lose a lot of cost control by doing that and in these times you need to cut as much fat as possible.
just curious, but how many starts have you had in the last ~12 months?
5 starts. 4 starts last 6 months.
The firm I work for builds both luxury and affordable (LIHTC) rental housing on the west coast as separate business lines. The luxury deals have all slowed down or been put on hold, while affordable is very active with several projects under construction or closing. Affordable is still exposed to high construction interest carry and cost escalation, but it's a different game altogether as it relies on securing public subsidy to pay for it. I guess it's a good hedge.
Three months ago, closed a construction loan for a single-tenant BTS industrial deal. Secondary market. 65% LTC, SOFR+325, recourse, credit tenant.
This month, closed a construction loan for a second phase of a garden-style MF deal. 50 unit add-on to 150-unit Phase I. Tertiary market. Land and sitework costs all front-loaded to Phase I which helps Phase II. Phase I rents also leasing at $200+/mo above original proforma which helps everything. 70% LTC, S+300, recourse.
Same sponsor for both deals. Yield on cost of like 8% for both. Sponsor will probably refi the MF deal by end of year with Fannie or Freddie.
Working in the Mid-Atlantic as a master developer. We are going after redevelopment/brownfield sites, 50+ acres that are in sun-tertiary markets (think Richmond, VA or DC suburbs). We self-develop retail/multifamily but will sell off unfinished lots to townhome builders for more than the price of the land allowing us to get the land for free and most of the master infrastructure. Pair that with either a TIF or tax credits and a premier grocer and you can still solve for a satisfactory return. MF only works if you have the grocer to get that premium, otherwise standalone MF is struggling. I would also note trying to utilize as much of the existing infrastructure as possible has been saving us - we’re doing a project in the SE where we’re reusing an existing parking garage, keeping the roads in place and building around that instead of ripping up all of the utilities.
Construction costs are still high but we’re seeing subs starting get aggressive now bc the market is slowing. Heard concrete subs were quoting a pre-cast garage in the high teens per stall.
Good info. Im in the NoVa market myself. What are you seeing for hard cost PSF for something like a small retail multi tenant retail center? Or do you only do mixed use and multifamily?
Don't do a ton of small multi-tenant retail but I'm seeing hard costs around $250psf (site+hard costs) based on 100,000 sf - grocery anchored at 40,000 sf so a little skewed.
Multifamily I got quoted hard costs $185k/unit for type 3 (5 stories), $180k for type 5 (4 stories) - not including general conditions, fee or insurance. Both properties are +300 units, Class A.
How much do you sell the unfinished pads off for to townhome builders?
Depends on the sub-market. Some current comps (national/regional builders): Richmond = ~$65K/lot; D.C. = ~$80K/lot. We allow them to get unappealable approvals, but not a grading/building permit. So there is some risk that they don't close but we get their engineering plans in that situation so we can flip it quickly.
Markets good again
Sincerely,
UK
I'd say many deals that get done is because of assumed exit cap compression so you can get somewhere around 200-250bps of dev spread.
Why are you assuming cap rate compression? So I get say YOC is 7% and your exit cap is 5.5%, is that assuming cap rate compression at exit? I thought it would be a different term and in general would you assume cap rate expansion if you decided to hold it for 10+ years if you're not a fund and looking to hold on to a long term asset?
The deals I work on tend to be merchant builds. So as soon as the property is stabilized we are trying to sell, capital markets permitting (which they haven't been). I say assuming cap rate compression, because more often than not a dev spread of 150bps 7% YOC -5.5% exit cap which is a reasonable exit cap assumption, will often yield an IRR that is less than what investors want. This means we have to assume lower exit caps to meet the IRR that we target.
All that being said, assuming cap rate compression is rather aggressive and a product of investors hoping rate cuts are coming and the CRE market will improve. Typically, cap rate expansion is the norm and what investment committees and LPs expect to see.
If you're underwriting cap rate compression, you are essentially saying that the market consensus on long-term borrowing rates is wrong. So you are making an interest rate bet, and you are using a real estate development project to do it. I may think that you are going to be right but seems pretty dang risky to me.
I’ll put this one way: if rates come down, it’s not because commercial real estate is in a “better” place than it is today. It will only get way worse before it even remotely appears to get better. Especially when you realize that “good” today has to literally be tied directly to a “bad” for someone else. Especially in development, no one on the market rate side is exploring new land/builds today regardless. Even in Los Angeles, a half acre lot to build 85-125 units (5 vs 8 floors) in a prime westla submarket has literally zero interest for any of the major sponsor/family offices (tishman, laterra, CEI, HNW/family offices, etc). No one.
someone on here find me some sponsors who are noticing these big guys on the sideline and land starting to come down to reality and want to chase stuff, willing to put up some money to chase/pursue deals. We’ll option the contract to close on (ministerial) approvals and have pricing well below recent trades from 2020-2022, and will have time for capital markets and especially construction costs to come down and stabilize (2-3 years for entitlements and get to RTI once taken down). Cap rates where they are today pencil to in (6-6.25% uROC and a) 4.5-5% cap rate, prime LA markets. Big bifurcation between 1970’s assets and new assets today too, especially when 70’s product were trading at the same or lesser cap rates than new product. Wild times but seems like the math is starting to make more sense, it’s just finding the people with juevos big enough or enough cash to pounce when others are looking away for their own reasons.
I don’t think it even matters if fed lowers rates. 10yrT been inverted for 2 years. It’s staying in the low 4s. Cap rates will be in the 5s. Which is totally manageable. But YOCs need to be in the 7s. Not happening at these cost bases. Relief not happening there unless something truly 08 crazy happens which doesn’t seem likely.
I still like development IRRs vs acquisitions but it will be lower returning compared to the heroin of ‘17-‘21
Are you really building to a 7% YOC? How? Deals in Dallas no true underwriting are hard to get to even a 6%
What product type?
I get your frustration, especially with the current economic conditions. Despite the high interest rates, cost inflation, and flattening rents, some developers are still finding ways to move forward. One reason is access to creative financing options, like opportunity zone funds or public-private partnerships, which can offer tax breaks and subsidies. There's also a persistent demand for housing in certain areas, particularly in the Midwest, South, and Southeast, where population growth supports new developments. Additionally, some developers have strong relationships with local banks or private equity firms that provide favorable financing terms. Lastly, developers with a long-term outlook are betting on future market recoveries, even if the current returns seem risky. It's a complex mix of factors, but it explains why some projects are still getting off the ground.
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