Our Perspective 8/ 31/ 2022

Northmarq featured in DDC Journal: Apartment developers work harder to fill capital stacks

MINNEAPOLIS, MINNESOTA (August 31, 2022) – Multifamily developers feeling the squeeze from rising costs are sharpening their pencils and looking for creative solutions to get projects off the drawing board.

Despite the overwhelming demand for all types of housing, developers have been recalculating costs due to a triple whammy of rising interest rates, inflation and supply chain pressures. In some cases, developers are seeing revised cost estimates that are between 20 and 30% higher than what they had originally estimated.

That large delta is forcing some developers to push pause, while others are able to power through by raising rents, adjusting return expectations, modifying designs and value-engineering their capital stack.

Developers continue to find good liquidity in the market on both the debt and equity side, but underwriting is more challenging for both developers and lenders. One question everyone is grappling with is how much of the higher costs can be passed on to renters before it starts to impact lease-up. The answer to that varies depending on the location. Developers building in markets with more robust rent growth are better able to adapt to increases on the cost side.

Although the Sun Belt is attracting a lot of attention for its double-digit rent growth, there are pockets of opportunities all around the country. Some submarkets are experiencing razor thin vacancies of 2-3%. St. Louis, for example, is seeing strong demand for rental housing, including pent-up demand for new builds. Those market dynamics have spurred a surge in development activity over the last four years. Northmarq recently closed on a $46 million construction loan for the 266-unit Flats of Wildhorse Village in Chesterfield, Mo. In this case, the borrower thought rates were likely to rise and chose to do a 5-year fixed-rate loan with a local bank, locking in an attractive rate and taking interest rate risk off the table.

Rising rates impact loan size
Although interest rates are still low by historical standards, financing costs have moved higher along with Fed rate increases. SOFR has increased from about 0.1% in January to 0.9% in late May, while the 10-year treasury has increased from 1.65% to 2.85%. Construction lenders recognize potential risks developers face in this higher cost environment, and they are starting to dig a little deeper on loan underwriting. Some are asking how current the general contractor bids are to confirm the costs reflect the current market.

Another challenge of rising rates is that borrowers will need to bring more money to the deal to layer on top of their construction loan. Rising rates creates a de-levering effect. If a lender underwrites a loan at a rate of 3.75% and then the rate moves to 4.25%, simple math means the loan amount will go down in order to maintain the lender’s target debt service coverage ratio (DSCR). What that means for borrowers is that they may need to work harder to fill the capital stack and limit exposure to interest rate risk.

Value engineering capital stacks
Despite cost hurdles, deals are still getting done, and lenders are willing to be creative and flexible to win business and originate loans. Some lenders are willing to offer a “stretch” senior loan with an oversized first mortgage that is internally tranched into a separate A and B note within one structure. It’s an engineered structure that helps the lender get a little more yield, and it also helps the borrower get higher leverage at a blended rate. Life insurance companies also are willing to do a participating mortgage where they will do up to 90% of the cost and then they share in half of the profit or upside of the deal.

Banks are typically offering up to 65% loan-to-cost on non-recourse loans or up to 75% on recourse financing. Borrowers can still get 80% leverage on a non-recourse loan from Northmarq’s HUD team if they are able to be patient with the longer lead times to get those deals done. Northmarq’s correspondent life insurance companies represent an attractive option as they offer construction to permanent financing. Borrowers can lock in a fixed rate today for a 2-year interest-only construction period, which then converts to a 10-year amortizing non-recourse loan.

Borrowers can find a variety of solutions to help fill any gaps that occur in that capital stack, including mezzanine debt, preferred equity and higher leverage bridge loans. Now more than ever, it’s important to have a very diverse base of financing options. Working with a debt and equity professional will give developers access to a broad base of lenders and financing options, including institutions, banks, debt funds and agency lenders in order to structure the best capital solution as things change in a very fluid market.