In a previous article, we asked a question: how will development deals continue to get built in a high interest rate environment?
With construction and financing costs continuing to rise, along with a slow-down in rent, how will deals pencil?
Initially, three things will need to occur for deals to begin penciling again:
1) Land values will drop – on many asset classes and locations, the land represents a very large proportion of the total project cost. While land values have been sky high for years, they will come down to accommodate developers trying to get a deal to pencil.
Of course, there is nuance to this point. On many deals, the cost of land represents a minimal portion of the total budget. On other deals, the land could be upwards of half the total cost of the project. On those deals in which the land is not a significant portion of the cost, a drop in land values will not be meaningfully helpful in getting deals to work.
2) Construction costs will come down- I know a slew of developers who are excited about this. They are excited for an opportunity to develop a deal through a recession, because labor is easier to come by, and the lack of demand for raw materials translates to… lower prices.
One developer even told me that his most successful projects were built through recessions, when he was able to build for less.
That is something many people don’t take into account. We are accustomed to generalized inflation. Over the past 30 years, inflation has been a consistent part of our economy. But in the short term, both raw materials and labor do see fluctuations in cost. When raw materials are less in demand, and more laborers are looking for work, it is indeed possible to see overall construction costs deflate. This will need to happen for development starts to ramp up again.
3) Tenants may need to pay more in rent- this does not only apply to multifamily tenants. Commercial tenants may see upward pressure on rents as well, despite all that is going on.
(I personally don’t see this as likely. People are not doing well as they have in recent years. Retail sales will likely go down. I just don’t know how much more people and businesses could afford to pay in rent.)
When I posed this question to my LinkedIn network, a number of comments also proved to be insightful. Below is the one I found most relevant:
4) Lower leverage/Flexible construction financing: some banks and credit unions offer construction to mini perm loans, which are loans that start as a construction loan, but automatically convert to a permanent loan at the same loan basis. These loans typically have a five year total term, and could be an excellent product for a developer who wants to build a project without concern of a construction loan takeout at stabilization.
More obviously, using less debt could significantly de-risk a deal. If the main concern is that the cost of debt will be too high at the completion of the project, having less debt could give the developer more wiggle room to perform even when the takeout loan is expensive.