October 28, 2019
Multifamily development continues to be a darling of the commercial real estate world as limited new supply throughout the cycle has driven higher rental rates and pushed vacancies to all-time lows. Multifamily real estate offers developers a unique value proposition with low retenanting costs, cheap debt, and limited cash flow volatility relative to other property types. As the top target for investors ‑ one that often offers the best risk-adjusted returns – multifamily construction has experienced significant investment over the past decade. Yet more recently, even with investors seeing multifamily housing as a safe choice, the outsized returns previously associated with ground-up development have fallen. At George Smith Partners, we have noticed that investors and lenders have reacted by shifting from construction to reposition strategies. This is the result of the narrowing gap between the return on cost (developers profit) and today’s cap rates for stabilized properties.
While cap rates for existing product have remained constant, construction projects have realized steady cost growth. Part of the cost increases were caused by oil and energy prices increasing in near lockstep with transportation expenses. Construction has been further hindered by unemployment reaching a record low, increasing the asking wages of skilled labor[i]. Furthermore, while ongoing trade tensions may be leading to lower global interest rates, the corresponding tariffs are making it more expensive to source building materials.
Investors are also facing changes in land values. Land which previously presented excellent return opportunities for developers with entitlement expertise now forward price to maximize entitlement value. This results in a lower degree of pricing differential between by-right, entitled, and permit ready projects. These price differences are disproportional to the degree of difficulty required for completion.
One consideration is that real estate cycles tend to have lengthy periods of supply and demand imbalances. Ground up developments characteristically require a time frame of several years, often misaligned with initial market conditions by lease-up. Buy side funds may be looking to hedge against a possible market downturn and are increasingly concerned about the risks associated with weaker future rents. This speculative activity, along with declining interest rates, appears like a leading indicator of a directional change in business cycle activity.
With the aggregation of increased physical good prices, shortage of labor, and high land prices, the return on cost (ROC) metric for apartments based on un-trended rents is often sitting within 50-100 basis points of today’s cap rates. Previously these same projects would mandate a spread of 150 – 200 bps between return on cost and cap rates. This has a major impact on markets that are in need of ground-up development projects. Los Angeles, for example, is currently experiencing a void of institutionally equity partners. In 2019’s California Department of Housing (HCD) review, California “should be building about 180,000 units per year to keep up with demand,” however according to Public Policy Institute of California, “construction permits for only about 93,000 residential units were issued over the last 12 months.”[ii] As the discrepancy widens, public policy may play a role. More affordable housing will flip to market rate and force the housing department to find ways to preserve the covenants protecting affordable multifamily rentals. Landlords are required to notify tenants three years before policy changes go into effect, but push back could challenge the timeline. If repositioning products become limited in their ability to displace or evict below-market-rate tenants, the risk for developers might galvanize ground-up again.
For now, favorable socioeconomics continue to drive needs for multifamily rentals. As costs for construction remain high, investors will continue to reach for the most easily achieved gains by seeking lucrative reposition products instead of risky ground up projects.