Will Developers Build Out of a Tumultuous Cycle…Again?

Developers are essentially eternal optimists at heart. It’s almost a requirement to be a project visionary. But even that level of positivity can be tested during in a market like we’ve experienced post COVID. That’s when it is most relevant to look to history for encouragement. Cycle shifts begin with pain and uncertainty but almost always end in opportunity as we gain clarity. Yes. Viable projects are still on hold, with many currently economically unfeasible. This will change.

Budgets are finally stabilizing as costs are becoming less volatile. The industry worked through the period of post-COVID shortages. Now the supply chain is normalizing after pandemic disruption brought chaos. Pricing has reset, albeit sticking higher into the foreseeable future. According to a recent CBRE report, overall construction costs for industrial property are up 40 percent since 2019. Lumber is stable. Concrete and other source materials are also stabilizing. All at higher pricing, but once again predictable. Steel and concrete costs are up 55 percent and 54 percent respectively according to CBRE calculations. And while rising costs in a tight labor market have not cooled yet, we might be getting closer to that time. The bid pipeline is now low enough for a cooling to begin here. As retail, industrial, multifamily, and hotels continue to perform and absorb vacancy, we will see demand momentum for new construction again. So as current project costs and potential values are now better understood in context with the new rate climate, developers have become more confident in their planning.

However, the pullback from banks as the dominant force in construction financing as they face their own challenges in the current cycle has sidelined them right when conditions seem poised to track positive for new development out of 2024 into 2025. So where do we look for optimism on the financing side? Alternative capital sources have emerged to backfill this position.

Liquid market

Capital is accessible to the development space from traditional, established, and new sources. Debt funds, family offices, and new private lending platforms cannot entirely backfill the absence of banks, but they sense opportunity and are active and available in the construction space as a result. Insurance companies are still a resource for construction-to-permanent loans for larger projects, especially developments with a Credit Tenant Lease in place. And yes, some banks continue to take on new loans for longstanding relationships or qualified borrowers offering a significant depositor relationship.

Unlike the Great Financial Crisis, liquidity is abundant in the system when lenders can underwrite to their target returns. Here are some insights into the dynamics of today’s capital mindset.

Land Carry Costs: We are seeing debt funds, private lenders, and family offices step into the development space to fund bridge loans for land carry costs up through entitlement. The delay cycle for viable projects really peaked in October/November of 2023. A lot of people held on and are now eying summer or fall 2024 for their starts. Pricing isn’t ideal, but it is workable. For viable projects fine tuning budget and programming to current market realities, refinancing can provide bandwidth for soft costs and entitlements as they finalize schedules and align financing.

Equity: In the development world, the returns equity desires haven’t dramatically changed. Equity costs are steady, not rising or declining, although the debt costs are much higher than they once were. The math for the return for the equity needs to shift. Currently, the desired return is in the 7 percent to 7.25 percent return on costs as they weigh risk against alternative investments. Most developers would prefer engaging at a 6.75 percent return on costs, so they have been forced to shave a budget or accept a decrease in the available debt. This will shift as…

Distress Pivot: It’s coming. Equity markets have bifurcated, with the splitting point being rates. Many have raised money for distress, looking for debt investments thinking this shift would feel like 2009. But that hasn’t been the case. If rates ultimately drop back to the mid-6 to mid-5 percent range, we will see very little distress. If this equity doesn’t deploy it will move back to development. This could push desired returns back down to 6.75 percent from the current 7-plus percent. We will have to wait and see. If expectations for debt costs to drop later this year hold true, there are a lot of projects waiting to pounce and break ground.

Banks: These lenders have supplied most of the construction debt for many years. In this cycle, they are hurting the most. Developers and banks are each facing their own challenges. Banks need deposits to enhance their liquidity. They are pricing with a risk adverse mindset and previously common exceptions are much harder to impossible to obtain. They used to be a debt resource at 70-75% Loan-to-Cost (LTC) but are now more likely to fund at 60% LTC with a depositor relationship of 10-20% of loan. Ultimately this can make the loan feel like it’s at 50% LTC or lower. For borrowers that can do it, great. Otherwise, alternatives are required.

Debt Funds: These opportunistic lenders are doing their best to fill the gap in bank funding. Yes, their pricing is higher. They are also hyper focused on their exit risk. Pretty soon more will be willing to take the risk, especially once the much-anticipated rate cuts arrive as predicted for later this year. From a capital perspective, the debt funds are really the significant player and will be for a couple of years as banks work through their adjustments to new market norms.

Private Lenders: These are the family offices and wealth management platforms, functioning much in the same space as institutional and structured debt funds. They have a desire for higher returns through real estate allocations. They are pairing their equity to experienced sponsors with a story to tell and, when feasible, taking first position in the capital stack.

Insurance Companies: These ever-consistent and well-capitalized lenders have construction-to-permanent money allocated that they are eager to put out to market. They function best in the large footprint, CTL, or Build-to-Suit space. By and large they are pursuing a small piece of the pie with long term holders but are ready and able to compete for deals that meet their targets.

Credit Unions: Development deals for credit unions are few and far between and tend to focus on smaller deals in markets they have familiarity with. That can range from $1 to $10 million. They are the quintessential relationship-based lender. Relationship with sponsor. Relationship with product type. Relationship with community. The tend to keep local.

Ultimatel,y people are ready and would love to move forward. Funding options exists, and active developers should be looking closely at all sources and structures. If they have land and have carried it for any extended period, at this point the decision to build or sell is compelling. For those which have taken the time to prepare, if rate conditions improve or even hold, many are ready to go in next 12 months and the capital is there to execute.

Jeff Matlock is senior director, Gantry.

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