Banks Reign in Leverage in Effort to Curb Apartment Construction

By Charley Babb

My real estate career spans over three decades. Yet for the very first time, I have witnessed lenders exercise prudence and consequently slow down new construction supply. As the majority of local and national multifamily investors have realized, Denver has been one of the most robust and successful national markets to emerge after the Great Recession. It appears that the experience of the lending community in Denver is typical of most major markets across the United States.

Apartment absorption is keeping pace with new supply delivery.  The Denver vacancy rate of 5 percent suggests a quite stable market. This market could potentially accommodate the additional supply needed to meet the strong demand for multifamily units in the metropolitan area. Coupled with the expected growth in jobs to forty three thousand per year and population growth of fifty two thousand people per year indicates that demand will remain strong. Rents will continue to grow, albeit at a slower pace year after year. However concessions are still largely non-existent.

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Yet despite these encouraging trends, lenders are cautiously considering whether to fund new multifamily construction loans. While the door isn’t completely shut, many banks are reserving their balance sheet for their most reliable customers. Others have reduced loans to no more than 60-65 percent of the total approved cost of the project. In addition, non-recourse for any portion of the loan has become extremely rare.

Construction costs are on a upward climb but at a stable, steady pace. A relaxation in the commodities markets has further abetted the situation. However labor shortages remain and they are a challenging component of the equation.

Without a commensurate reduction in land and constructions costs, the obvious (and likely intended) outcome is that the lower leverage places exert pressure on and therefore constrain equity returns. Thus, the risk-reward dynamics will be put out of equilibrium, slowing down development. The slowing development will give the market a fighting chance to absorb the delivery of new units in the existing pipeline. This will preferably reduce the potential over supply. These so-called “soft landing” reaps benefits for both developers and lenders alike. However these have rarely happened in our economic history. Rather, developers continue to take on debt as long as banks are willing provide it and thus all contribute to their own loss.

So this time around, as we approach the likely end of this expansion cycle, businesses will exercise more prudence. But what does one do if their project really should be built due to the submarket metrics? We have been able to assist our clients by procuring a tranche of preferred equity to offset the reduction of loan proceeds from construction lenders in the overall capital stack.

For example, we recently closed a transaction where the total project cost was $40 million. The senior construction loan was limited to sixty five percent of the cost or $26 million. The sponsor was able to replace the $4 million reduction from their proforma debt level with preferred equity that carried a 12% coupon that accrues throughout the construction period and is repaid upon refinancing at stabilization. While the weighted cost of debt is somewhat higher, the resulting leverage can provide for an economically viable project and garner acceptable returns for the equity investors.

For more information on how Metropolitan Capital Advisors can assist you with capitalizing your next development project or property acquisition, contact Charley Babb in our Denver office at 303.647.1122 or e-mail Charley at cbabb@metcapital.com .

The Author, Charley Babb, is a Senior Director and Principal in the Denver office of Metropolitan Capital Advisors

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