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Digging for Dollars (Multifamily Development)

Despite the continuing vice grip on construction financing, multifamily developers—bolstered by low construction costs and a coming wave of demand—are breaking ground again. But will they reap the financial rewards of building in the downturn?

From “Apartment Finance Today”

By Jerry Ascierto

Developers are, inherently, eternally optimistic. Where there is dirt, they see potential. Where vacant lots stand, they imagine thriving communities and bustling streets. Those who lack vision need not apply.

Over the past few years, that outlook was clouded by the Great Recession. But today, with rumblings of a recovery emerging, optimism is back in vogue. Despite a capital markets environment that’s dim at best, many developers are looking past today’s still-lingering storminess, and all they see is sun.

Consider Encore Multifamily, a division of Dallas-based Encore Enterprises. Though just a few years old, the firm now has 1,760 units in its pipeline, all of which are expected to start by year’s end. In a sign of the times, all of those units will be financed through the Federal Housing Administration’s (FHA) Sec. 221(d)(4) program.

To a large degree, however, smaller firms such as Encore are not the frontrunners in today’s development marathon. Instead, it’s the larger companies that are leading the charge, wielding balance sheets and cash on hand that can help them bypass the need for traditional debt. AvalonBay Communities had nine developments underway in mid-June, and the REIT hopes to break ground on another eight this year, with an increasingly bullish perspective on the market. Earlier this year, it announced $400 million in total developments planned to start in 2010; by the end of the second quarter, the company had upped that projection to $600 million.

“We don’t think we’ll see construction costs any lower in the near future,” says Rick Morris, senior vice president of construction for Alexandria, Va.-based AvalonBay. “And we’ll be delivering when the economy is strong, and there’s no other new product coming into the marketplace.”

Apartment developers scale down design.

WHENEVER DAN MARKSON goes to a party, the senior vice president at The NRP Group asks younger people where they want to live when they get their own apartment.

“Invariably, the buzzwords are walkability, entertainment, public transportation, green features,” Markson says. “Bigger really isn’t better to them.”

As the industry begins to break ground again, it has modified its approach to unit design to reflect the next generation of renters. Many of the communities being built now feature smaller, more efficient unit sizes, with more robust amenity areas.

“Renters are willing to sacrifice a little bit in square footage to get that rental check a little lower every month,” says Mark Wallis, a senior executive vice president with Highlands Ranch, Colo.-based REIT UDR. “It’s the MINI Cooper concept: a way-cool car, but it’s smaller, so it’s cheaper than a BMW.”

And it’s not just smaller units. While many of the nation’s largest developers have favored ever-larger communities, the next generation may be more cautious. After all, the smaller the project, the smaller the lease-up risk.

“We in the industry have said for years that you’ve got to build at least 200 units to achieve operating efficiencies,” says Brad Miller, president of Encore Multifamily, a division of Dallas-based Encore Enterprises. “But building a 100- unit project is not a bad idea. It would lessen the pressure on your equity requirements, and you can operate those units more efficiently.”

Even the nation’s largest apartment owners have noticed that the less sexy garden communities weathered the current downturn a little better than their trophy peers.

“We’re seeing that the actual value lost was a little bit higher on the high-density, higher-dollar construction, and less so on traditional garden-style communities,” says Dennis Steen, CFO of Houstonbased REIT Camden Property Trust.

Indeed, while construction debt continues to be limited, construction costs have come down so much that deals are penciling out once more. And after three years of virtually no new construction, developers see a not-too-distant future where rents and values will soar due to undersupply.

“In two years, there may be a housing shortage like I’ve not seen in my 35-year career,” says Brad Miller, president of Encore Multifamily. “If you can deliver units toward early 2012, that’s the absolute most optimum time to maximize rents.”

Capital from the Capitol

But first things first. Everything depends on finding capital, and right now, all roads in the search for construction debt lead to the FHA. For its part, the FHA isn’t used to being so popular, and conversely, many developers aren’t used to dealing with the agency. Both sides are still struggling to understand one another.

Only a few years ago, most developers avoided the FHA like a traffic jam, mocking the “lender of last resort” for its bureaucratic ways and molasses-slow pace. Since the credit markets collapsed in late 2008, there really have been no other resorts, and the agency quickly became a beacon to which all developers were drawn.

“Most developers going through HUD today have not been through it before,” says James Pyle, president and CEO of Jacksonville Beach, Fla.-based LandSouth Construction. “But in a lot of ways, you have to go through the process to understand it.”

The FHA’s specific requirements have subsequently forced many developers to adjust their game plans. Encore, for instance, has an in-house construction group, but chose to outsource the work on its Sec. 221(d)(4) deals. That’s because the program requires the general contractor to put up a 100 percent performance and payment bond—a guarantee equal to the full estimated construction costs—or a letter of credit equal to between 15 percent and 25 percent of total construction costs.

In other words, a developer working on a $20 million deal would have to put up at least $3 million in a letter of credit. And that $3 million can be better spent elsewhere. “That is restricted cash. Since I co-invest $300,000 in every one of our deals, that restricted cash is worth 10 co-investments,” says Jay Graham, vice president of Encore Construction, Encore’s in-house construction group. “When you look at all the investments you can’t make, versus laying that risk off to a third-party general contractor, it’s not a difficult equation.”

While all-in rates for 221(d)(4) loans continue to remain low—Encore locked in a 6.25 percent rate last November and a 5.25 percent rate in May—the terms are becoming stricter. The FHA was set to unveil sweeping underwriting changes, lower leverage levels, and higher debt service coverage ratio requirements to the program in July.

That tightening of credit standards can be seen in Encore’s last two 221(d)(4) loans. The November deal, for a development in Corpus Christi, Texas, featured a loan-tocost (LTC) ratio of 88 percent. The May deal, for a project in Burleson, south of Fort Worth, Texas, was at 83 percent LTC.

“I’ve only seen a 5.25 percent rate once in my lifetime, and that was last week,” Miller said at the time. “But going forward, after the new HUD guidelines come out, that world changes substantially. And that’s going to close out a lot of small guys.”

Banks Begin to Step Out

Encore, for one, remains pessimistic about the swift return of conventional financing. But national banks such as U.S. Bank, PNC, and JPMorgan Chase, as well as the healthier regional banks, are dipping their toes back in the water again. These lenders are targeting only the best-in-class sponsors with whom they have long-standing relationships.

“We’re starting to see the traditional lenders coming back into the market,” says Mike Kavanau, senior managing director at Holliday Fenoglio Fowler’s Chicago office. “If it were six months ago, even if the best-in-class sponsor applied, the bank would probably say no. But access to debt capital has clearly opened up.”

Bank pricing is being quoted these days at LIBOR plus as low as 300 basis points (bps) and as high as 500 bps, resulting in all-in rates between 5 percent and 6 percent. But the next generation of construction debt and terms will be largely relationship-based.

THE FATALITY RATE OF new Sec. 221(d)(4) applications is now about 50 percent, so managing your expectations as you begin the process is key. Here are five things to keep in mind as you search for a 221(d)(4) loan.


Even though new construction is inherently forward-looking, the FHA doesn’t see it that way. Many borrowers don’t realize that the FHA is only concerned with the here and now when it comes to a project’s feasibility.

“Many borrowers will say that two years from now, the market is going to come back,” says Phil Melton, who runs the FHA division of Charlotte, N.C.-based Grandbridge Real Estate Capital. “But HUD wants to make sure there’s a market there today, not projecting that there will be demand two years from now.”


Many borrowers assume an invitation letter from the FHA is a slam-dunk that they’ll win eventual approval. But just getting to this stage is more akin to entering a race where the odds are about even. HUD will often invite numerous projects in the same market, though it is unable or unwilling to fund them all. At that point, whichever deal gets its final application in first will usually get the nod.


This is a chicken-or-the-egg issue. While the (d)(4) program goes up to 90 percent loan-tocost, you still need to make up that remaining 10 percent in the capital stack. But many borrowers want to make sure they have a loan quote before going out and raising equity. In HUD’s estimation, this will not do: You really need to have the equity on hand.

The same goes for having all your plans and specs in order. Some borrowers are reluctant to shell out $10,000 to do their plans and specs without knowing whether the loan will go through. But lining up all your ducks in a row will help accelerate the deal cycle time.


Sometimes, there’s a gap between what borrowers request in proceeds and what the FHA is willing to do. But the FHA doesn’t think like a private lender. If you ask for a $20 million loan, and the FHA comes back with an offer of $19 million, it is what it is.

Simply remember that there’s no room for negotiation. This includes the possibility of speeding up the deal processing timeline. FHA lenders will do their best to push an application to the finish line, but always remember that the FHA runs on its own clock.


Many FHA lenders will tell you that the economics of making and servicing a (d)(4) loan preclude them from making smaller loans— anything under $2 million. The lenders basically have a threeyear window for every loan: nine months to a year to get a loan closed, another 12 to 14 months to get the deal built, and another year before stabilization.

“It’s a pretty costly execution from a corporate overhead perspective,” Melton of Grandbridge explains.

Balance-sheet lenders are already requiring a significant amount of “cross-selling.” That is, they want borrowers to do all their banking with them before they’ll make a balance-sheet loan. “Chasing a loan-only relationship, like what occurred in ’05, ’06, and ’07, is not going to be the way of the new world order,” says Clay Sublett, national production manager for Cleveland-based KeyBank Real Estate Capital. “Now, the overall relationship is key, and if you have that, you’re going to get a return phone call.”

This banking relationship is not just about deposits, either. Banks are taking a longer view of development now, to include permanent takeouts as a consideration in the construction loan process. A construction lender that also has Fannie Mae, Freddie Mac, and FHA executions would expect you to use them when it came time for a takeout.

“We have an array of permanent loans,” Sublett says. “But if somebody wants to use another agency lender, they’re not going to get my balance sheet.”

Full recourse is a de-facto standard now as well, and developers shouldn’t expect any loans above 75 percent LTC. “For every dollar below 75 percent, you probably make a better friend with the bank,” Kavanau says.

Soothing the Labor Pains

Let’s assume your banks love you, the backend financing works itself out, and you’re able to procure debt financing that enables you to break ground. At this point, you’ve got some great factors going for you, thanks (ironically) to the downturn. For one, construction costs are down so much that a developer building the same property today that they built in 2007 would find comparable, if not higher, yields.

“Construction pricing is down 15 percent to 20 percent across the board, but rents are the same,” says Brent Little, vice president of higher education at Indianapolis-based Buckingham Cos. “You’ve got a different leverage point now because you’re only getting 70 percent debt. But the decrease in construction costs more than covers that change.”

In fact, labor costs are so low, they’re practically giving it away. General contractors (GCs) and subcontractors are feeling the pinch, and many are quoting prices at breakeven, just to keep the lights on. Even large developers with in-house construction groups are outsourcing to take advantage of today’s low rates.

“We’re doing everything with third parties right now. We like the guaranteed price features we can get,” says Mark Wallis, a senior executive vice president with Highlands Ranch, Colo.-based REIT UDR. “We strategically felt like that was the best way to go—the capacity is out there, the prices are right, and it all flows a little bit of risk.” The company was wrapping up three new communities in early June and just broke ground on the second phase of Vitruvian Park in Addison, Texas, near Dallas.

LandSouth recently bid a job in North Carolina, along with 10 other GCs. “It was the cheapest pricing I’ve seen in more than 10 years. People are hungry,” Pyle of LandSouth says. “Even the strong subcontractors are down to their core people, and now they’ve just got to do some work.”

Some developers have lowered construction costs on the fly during the downturn by renegotiating or re-bidding labor contracts. But it’s a very fine line to cross: How much of a reduction is too much to ask? “We could’ve broken a lot of people’s backs, but we didn’t take advantage of our subcontractors,” says John Leonard, a vice president at Cleveland-based NRP Contractors, the construction arm of The NRP Group. “I wanted to assure that if we had a quick recovery and were left in a labor shortage, that we had the labor base necessary.”

Living in a Material World

Another advantage to building in the downturn is taking advantage of the low cost of materials. Across the board, materials prices have declined in the past couple of years, and although some prices have ticked upwards of late, they’ve just as quickly ticked down again.

Take lumber. In May 2006, framing lumber reached $377 per 1,000 board feet, but a year later it was $100 less, and by January 2009, the price had fallen to $190. There was an enormous overlap of supply on the market when the music stopped, and it took a couple of years to burn through that overhang.

In fact, the drop-off in demand was so steep that many mills throughout the country shut down. But now, as demand for lumber and drywall picks up—and there’s less product on the market—prices are starting to climb back up. So far this year, lumber prices peaked in April at $367 per 1,000 board feet—they hadn’t been that high since May 2006. But by late-June, the price was down again to $247.

“We’ve seen an extraordinary spike in lumber due to capacity issues and inventory becoming restricted,” says Encore Construction’s Graham. “As a little bit of capacity now begins to bleed back into the market, we’re seeing the price come down just about as fast as it went up.”

Oriented strand board went up to about $17 a sheet in 2007, was as cheap as $5 in the fall of 2009, and in June was rising back up to around $9. And the price of concrete slabs has also fallen sharply in the past few years. At the height of the market, slabs were pricing at $100 per yard, but that cost has fallen to about $65, as of mid-June.

Smaller builders can band together to keep construction costs down.

THE APARTMENT INDUSTRY’S biggest builders have a big benefit going for them: scale. So when it comes to achieving discounts on building materials, they’re able to turn their purchasing power into great pricing. Unfortunately, smaller shops often can’t capture those same discounts.

One way smaller firms can increase their buying power is to band together with other regional developers to hit critical mass for price breaks. “It would make sense if smaller developers could [form] buying groups,” says John Leonard, a vice president at Cleveland-based NRP Contractors, the construction arm of The NRP Group. “That would go a long way to hold their costs. Then again, a lot of times, competitors don’t even talk to each other.”

Still, smaller developers face bigger challenges than capturing the lowest price of lumber. The competitive landscape of the industry has changed, as the Great Recession eliminated many smaller players from the market. And it may be some time again before smaller developers join the party: The financial requirements of banks and the FHA clearly favor the best-in-class sponsors.

“There’s been a winnowing. Family companies that are three or four generations old with great track records are having trouble,” says Dan Markson, who ran a smaller firm before joining The NRP Group. “Financial institutions want well-capitalized players— the bigger the better—and it doesn’t bode well for mom-and-pops.”

But as capital loosens up, there’s an opportunity for smaller firms. “Do predevelopment work now, and put a lot of sweat equity into entitlements,” says Brad Miller, president of Dallas-based Encore Multifamily. “Conventional financing won’t be gone forever.”

Given the fluctuating prices, knowing when to buy is a tricky business. When prices are depressed, many developers will strike, buying up large volumes and warehousing the materials. But one of the advantages of building during the downturn is waiting until the last minute as prices continue to fall.

In 2008, AvalonBay was building a 311- unit community in Norwalk, Conn., as lumber prices fell rapidly. The company started the project in January but did not need the wood framing until June. “Usually, in a lousy market, we buy things as quickly as we can,” says Morris of AvalonBay. “But at Norwalk, we waited until the last minute in May because we could see that the market was continuing to fall.”

In late May, with lumber prices coming back down to earth, the NRP Group also chose to employ an “as-needed” approach. “We won’t even buy a whole package right now because it’s so over-inflated,” Leonard says. “And that’s proven to be true the past few weeks, with prices going down. So that’s worked to our advantage.”

Knowing the Exit Plan

For the most part, the developers breaking ground today are taking a longterm view. The merchant building model of selling before the construction loan comes due has fallen by the wayside since the recession began. Instead, today’s developers are planning to hold for at least four or five years, betting that they can capture a wave of rent growth in a supply-constrained market as values ascend.

This year, about 97,000 units will hit the market, and that figure shrinks to just around 56,000 in 2011, far below the 116,350 units that came online annually from 2007 to 2009, according to New York-based research firm Reis. And while rent growth will be mostly flat this year, Reis forecasts 1.6 percent growth in 2011, 2.4 percent in 2012, and 3 percent in 2013.

For example, as Encore builds its portfolio, the company plans to hold for five to seven years. “At that time, we may look at a number of exit options, including the formation of a real estate investment trust, or a portfolio sale,” Miller says.

And while the (d)(4) program, with its 40-year amortization, works well for long-term holders, it also creates a very valuable financial asset in a disposition. “You can imagine how advantaged we’ll be in five years when we sell a property that is fully assumable with no penalty or interest-rate risk,” Miller adds.

As banks start to lend again (albeit only to the alpha dogs) and construction costs fall to more manageable levels (although still in flux), development activity will continue to increase. The gates are finally opening, and if history’s any indication, it’s only a matter of time before cautious optimism gives way to full-bore optimism, and smaller developers are once again able to join the party.

In fact, multifamily starts increased 9 percent in May, the fourth-straight monthly increase, according to McGraw- Hill Construction. “It really comes down to taking advantage of where construction costs are and the opportunities that are presented to us, such as on new land deals,” Morris says. “We think now is a great opportunity to utilize our capital in a smart way for the future.”

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