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How Capital Stack Dynamics Contribute to Today’s Challenges to Multifamily Developers

While almost anyone investing in apartments prospered during the recent boom, the players that will succeed during this cycle shift will be experienced teams.

The apartments sector has undoubtedly taken a shift. With a record bullish run of almost 10 years, multifamily is now hitting a slower stride. Developers and investors alike are faced with challenges. While investor dollars are still available for well-located deals, land for new development is more difficult to source, particularly opportunities that are well-located, with a predictable entitlement path and timeline. The sites that do exist are now challenging to complete and overall project costs are much higher.

While almost anyone investing in apartments prospered during the recent boom, the players that will succeed during this cycle shift will be experienced teams, with the strongest relationships with capital partners, lenders and brokers.

Rental rates are slowing

Over the past decade as the multifamily sector has flourished, we have witnessed pronounced rent increases in most major metropolitan markets across the country. Spurred in part by job growth and the notable demand for units coming from would-be buyers choosing instead to rent, all of our projects in Los Angeles and Chicago have continuously exceeded proforma rent growth, along with showing absorption rates in excess of 30 units per month. However, several submarkets with multiple new buildings are beginning to increase concessions—resulting in what we believe will be a pause in the growth of effective rent over the next couple of years.

Development costs are higher

Due to a shortage in available building trades, construction costs in Los Angeles have increased 75 percent over the past seven years and in Chicago about 50 percent. Development budgets are being stressed from other sources as well. As politicians have taken note of so many new projects built in recent years, they have increased fees, plus requirements for income-restricted (affordable) units have been introduced in many major markets. This has inevitably driven up developer costs and decreased achievable yields.

Regulators have also exacerbated the situation. In restricting the amounts that banks can lend developers for new construction, banking regulations have forced developers to secure more equity. This has also opened the door for non-traditional lenders and debt vehicles like mezzanine debt and preferred equity to compete for borrowers. While helping developers somewhat by filling the notable gap in available debt, these options come at higher rates and thus, as is the case with construction costs, drive down project yield. These capital stack variables make many of the deals that we evaluate ultimately infeasible.

Demand to continue despite slowdown in construction

With this confluence of factors, the pace of construction of new apartment units is understandably expected to decline over the next few years. This decline will become more pronounced as we close out the year and move through 2018. However, demand for rental units likely won’t wane, especially in major metros with large employment centers. Some cities, such as Los Angeles, San Diego, Chicago and Austin, Texas, to name a few, will continue to experience high rental apartment demand.

And, in perhaps one of the most interesting trends of the current cycle, demand is also projected to come in strong among the substantial number of young adults currently still living with their parents. This “echo-boomer” demographic is historically high in number, and it is expected that many of them will enter the rental pool in the next few years. With a slowdown in new unit construction, this demographic is expected to lead us into a rental unit shortage in the years to come and, as an industry, we need to be ready for that.

Therefore, even as the apartment sector tightens up and new deals pencil to lower yields, patient investors with a longer term view will be rewarded.

Kevin Farrell serves as chief operating officer for Century West Partners, a Los Angeles-based developer of luxury, transit-oriented multifamily communities, and as president and chief operating officer of Fifield Realty Corp., a Chicago-based commercial real estate development firm.

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