Core Hard Cash

By Brad Donnell

It had been a while since we ha d seen much in the way of new development deals around here.  Like prairie dogs hiding in their holes, Core-Hard-Cashonly momentarily popping their wily heads out to see if the coast is clear, bankers have generally steered clear of new development deals for the past 3 years.   On the other hand, equity sources were equally averse to new development, instead running giddily around the apple tree with their aprons out waiting for pennies on the dollar AAA credit properties to rain down.  While a few apples fell, there really was no one around to shake the tree very hard like there was back in the late 1980s.  As a result, there has been a dramatic drop off in transactions of any sort during this period and everyone has seemed to forget that some development deals make sense to do right now.

Lately, we have seen a number of new development deals come through our shop.  It feels as though many real estate entrepreneurs have finally given up on chasing the “steals” and are shifting focus back to a more normalized development mindset.  Leading the way, naturally, are apartment projects.  Given the inability of most of the population to qualify for a home loan these days, rental properties such as multifamily are seeing dramatic increases in occupancy and rental rates to the point that it begins to make economic sense to build new.  There is no scarcity of developers with their hands in their pockets looking for something to do so.  Bidding up “distressed” deals to above market has started to become boring, sort of like betting soccer games while you wait for the NFL season to kick.  It may still be pre-season, but the rush seems to be on.

While marketing an equity raise for a to-be-built multifamily project recently, we received the usual chorus of “no, we are looking for distress” but out of the 50 or so equity sources we approached, the resonating refrain was “we want core and we want infill”.  It became clear very quickly that suburban multifamily has scant little chance of getting done right now regardless of the yield.  With cap rates crawling back down into the 4s and 5s on core properties, it is no surprise that equity is focused on these sorts of assets.  Going from a 9 yield to a 6 yield on a suburban deal is not nearly as fun as going from a 7.5 to a 4.5 in the middle of town.  While the capitalization rate arbitrage is attractive on suburban projects, equity providers are clearly more interested in the Class A infill assets for the simple reason that they believe there is a much more hungry pool of low yield requiring institutional buyers out there than more entrepreneurial ones who might transact at a 6 cap.   Indeed, at a recent panel discussion in Austin, sellers remarked that there were probably 30 buyers for each CBD deal that was up for grabs.  The idea that the pool of buyers at higher cap rates for suburban deals is not active or as deep seems ill conceived.  People actually do buy these sorts of things and often prefer not to be at the top of the market.  During the marketing of this equity raise, I fully anticipated the discussions to hinge around the proposed yield and how real it was.  I thought I would be discussing absorption rate forecasts and the costs of the project relative to whether or not proposed pet rent and pool view premiums were truly attainable or not.  Instead, the discussion started and ended with whether or not this particular site was considered infill or suburban.  Yield seemed secondary to the capital provider’s consideration of the transaction which was a break from previous pre-economic meltdown equity raises.

Right now, the economics of new construction are beginning to make sense on a number of deals.  Under normal circumstances, most of these deals would be getting done.  A 300 basis point spread on a Class A multifamily project in the suburbs that would lease up and perform just fine is oddly unattractive today which speaks volumes about the availability of equity in the market.  The prevailing notion that the market is flush with cash looking for deals seems to look a little outdated.  If indeed the market was highly liquid, a rational market would also gravitate to the yield provided by these suburban deals and not only to the lower yielding core/infill projects.

What seems even more counterintuitive is that the “build in the core” argument similarly parallels the argument to build condos.  The bet is “we believe there are a lot more people who will pay a lot more to be located centrally than those who would pay less and live somewhere else”.  The number of renters able to pay high rents is estimated to be higher than those that can pay less.  As seen with the condo boom, there is actually a finite supply of people willing to pay $800,000 for a glorified apartment that is difficult to get to during rush hour let alone scratching around like a chicken looking for a cricket over where to park once you get there.  In fact, there are several condo deals near downtown Dallas where you either have “lots of airy space” by virtue of the fact there are no walls, only shell, or where you and your buddy might be the only owners in an 80 unit building.   It seems counterintuitive but that is the market for to be built apartments today.  Those seeking equity for multifamily projects need to pass on those sites that are not considered infill for the time being.  Eventually, suburban deals will start to attract equity once some of these high-end infill deals run out of renters.  In the interim, if you are looking to capitalize a suburban project that makes great economic sense, be prepared for a long and likely unfruitful search.

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