Developers - how are you justifying taking projects off the ground with construction loan interest rates sharply rising?
To anyone who has a development project in the early stages or in the pipeline, what strategies are you implementing to make sure you don’t go over budget in todays environment?
[{"id": "icl8d66", "text": "Rents are through the roof. Land was virtually free since we're building on the back half of a rent stabilized mixed use building.", "replies": [], "depth": 1}, {"id": "iclaljq", "text": "If enough projects get postponed, there will be better availability, so costs should stabilize and suppliers and trades *should* sharpen their pencils.\nIts a bit of a gamble so if someone has deep pockets and the area has high barriers to entry, higher rents and cheap debt free land, it might make sense.", "replies": [], "depth": 1}, {"id": "icli2bw", "text": "Higher rents have made it work and then some.", "replies": [{"id": "icmc51u", "text": "What about your interest carry? That\u2019s the thing", "replies": [{"id": "ico6rq1", "text": "I build in more interest carry. Not that hard.\n\nI promise you, the thing that keeps me up isn\u2019t interest rates \u2014 it\u2019s construction increases. And honestly, rising rates probably help construction prices stabilize.", "replies": [], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "iclqjge", "text": "One of my clients said costs of construction materials are going down in some markets which hopefully will spread nationally.", "replies": [{"id": "icmi1ht", "text": "They are. Look at the chart for lumber futures.", "replies": [{"id": "ico6y3v", "text": "Lumber yes, but labor needs to come with it before there is a big decrease. Our electrician sub just quoted our captive GC $6/SF increase (!) on the exact same building (!) in the exact same location (!) for the second phase of a project, two years later. It\u2019s just wild.", "replies": [], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "iclz7w3", "text": "Inflation means higher rent. Higher rates increase back end cap rate, meaning lower valuation. Higher rents help to offset this. We already see record rents in existing properties and are underwriting last year\u2019s rent on jobs starting now. We will be in very good shape as rents continue to climb.", "replies": [{"id": "icmc6bh", "text": "Good luck on your debt though. Construction loan rates are high", "replies": [{"id": "icmnquy", "text": "Your post was / is about rising rates, and his answer fully covered your question.", "replies": [{"id": "icmpegj", "text": "Not fully. He\u2019s making an assumption that there will be strong rent growth. Rents can easily trend back down to pre Covid levels and now you\u2019re left with a building with a much higher capitalized  interest reserve", "replies": [{"id": "icmq6mi", "text": "&gt;He\u2019s making an assumption that there will be strong rent growth.\n\nHe was answering your question.\n\n*(Fully).*", "replies": [{"id": "icms9bt", "text": "He made a post to argue", "replies": [{"id": "icmsgh9", "text": "I sensed that almost immediately.\n\n*\"Hi, how am I?\"*", "replies": [], "depth": 7}], "depth": 6}, {"id": "icmw087", "text": "How is that fully answering my question? That\u2019s one aspect of it.", "replies": [{"id": "icn789b", "text": "What the hell are you talking about? You want someone to draw you a proof? How are developers dealing with higher interest rates? The same way they always deal with them. Factor the interest rate in and see if the deal makes sense.", "replies": [{"id": "icn7xa0", "text": "You\u2019re an idiot. That\u2019s not my question. Rates are rapidly increasing and are uncertain. What\u2019s so hard to understand. Stop acting like a Jack ass", "replies": [{"id": "icp92wr", "text": "You can't figure out how developers are dealing with normal changes in business cycles...and *he's* an idiot.\n\nDude...you need a different career.\n\nWendy's is hiring.\n\n*(Don't get your hopes up son...in fact, I'd offer a discount to their standard offer if I was you).*", "replies": [{"id": "icpe1ks", "text": "What are talking about. I\u2019m posing a question on the feasibility of development with rising costs. If that\u2019s not a concern for you find a new career because you\u2019ll be bankrupt soon. Also One building in My portfolio is worth more than your entire life. I need to hire a super. Let me know if you need a job. Never mind you\u2019re too dumb to even be a super. Your reading comprehension is worse than my 7 year old cousin.", "replies": [], "depth": 10}], "depth": 9}], "depth": 8}], "depth": 7}, {"id": "idfy1sd", "text": "*\"Hi, how am I?*\" is pretty much ***all*** aspects of your posts.", "replies": [], "depth": 7}], "depth": 6}], "depth": 5}, {"id": "icnzew3", "text": "Rents have never decreased in the history of the US.", "replies": [], "depth": 5}], "depth": 4}], "depth": 3}, {"id": "icn2dzz", "text": "Can you elaborate on this? How are construction loan rates higher?", "replies": [{"id": "icn32oh", "text": "Are you not following the rate hikes", "replies": [{"id": "icn7gwe", "text": "That doesn\u2019t answer my question. Do you want to try again?", "replies": [{"id": "icn7tgj", "text": "That exactly answers your question. Re read", "replies": [{"id": "icn8cbv", "text": "Your post said that construction loans are high. What makes them higher than any other loan right now?", "replies": [{"id": "icn8eqv", "text": "CL are Tied to short term interest rates. Fed raised them yesterday by .75. Direct effect", "replies": [{"id": "icndzrf", "text": "Most construction loans use SOFR as the index and that hasn't been moving. It's been hanging around 75bps before and after the fed move. I can't explain why it's not moving, but I watch it and it's been staying low - hasn't been moving like the 10-yr. So to answer your original question, construction loans haven't been impacted (yet), although spreads have widened some.  There are ways to structure a cap on that index, then you underwrite and see if you still like the deal.", "replies": [{"id": "icngxq2", "text": "Great explanation and thanks for taking time to write that. \n\nI just closed on a property purchase and had a construction loan tied to it, but it\u2019s renovation of existing structures. Assuming this is why we did not see a major difference in the rate.", "replies": [{"id": "icnif7h", "text": "My construction loan are tied to the prime rate so direct effect", "replies": [], "depth": 11}], "depth": 10}], "depth": 9}], "depth": 8}], "depth": 7}], "depth": 6}], "depth": 5}], "depth": 4}], "depth": 3}, {"id": "icn3phk", "text": "Yes I know what construction loan rates are. One of the many variables of development. One thing we look at is (gasp) taking less debt when it\u2019s expensive. There are a lot of ways to do the math. My comment on rising rents really doesn\u2019t matter for construction debt; that\u2019s how we offset more expensive debt at stabilization of a new development.", "replies": [], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "icmbqdu", "text": "By underwriting the deal and realizing you can make more than what you\u2019ve put in", "replies": [{"id": "icn40uj", "text": "This is the only answer. Yeesh. Every deal is different and we've negotiated land prices/ acq prices down, etc. It's just an equation. We only do the deal if it works anyway.", "replies": [], "depth": 2}], "depth": 1}, {"id": "icmefqn", "text": "It's all based on the assumption that rental rates will continue to climb. Everything will work out for developers if that happens. If it doesn't that means we're fully in a tanking economy and everyone else is losing their shirt as well.", "replies": [], "depth": 1}, {"id": "icmgiqo", "text": "If you are a developer you are, by nature, an eternal optimist.", "replies": [{"id": "icmiam9", "text": "Can\u2019t make it if you\u2019re not", "replies": [{"id": "icmwknl", "text": "That sounded pessimistic.", "replies": [], "depth": 3}], "depth": 2}, {"id": "icn3jid", "text": "Or a masochist", "replies": [{"id": "ico6jo3", "text": "I am a developer. I am both", "replies": [{"id": "icopjha", "text": "Ooooo", "replies": [], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "icmz6bs", "text": "Also just make sure your deal is good enough \n\nI know it\u2019s overly simplistic but I\u2019m super cautious when get a property and make sure there\u2019s lots of room for overages. \n\nGotta remember the basics\n\nFurther overall I still feel like there aren\u2019t enough homes or rentals for people. I don\u2019t think it will be a problem immediately solved (in Canada for reference).", "replies": [], "depth": 1}, {"id": "icn5x14", "text": "This environment eliminates your competition or creates a huge barrier to their entry, if everyone is afraid to build then there is scarcity resulting in higher prices when yours completes. But you have to be bullseye accurate with site selection and market/submarket knowledge. And you better know exactly who your buyers in tenants are before you break ground.", "replies": [], "depth": 1}, {"id": "icn7a0j", "text": "The real threat isn't interest expenses during a 2-4 year build, even if you assume your WACD over the term of the project is going to be double where rates are currently sitting. Interest costs are a fairly marginal piece of your overall cost base in development. If your project was so skinny it couldn't deliver low end acceptable profitability with your overall costs going up by 5%, it probably wasn't a good project to start with.\n\nThe real threat is your exit value eroding because of rate increases. Cap rates will rise generally in tandem (typically lagging 6 months) so if rate hikes and organic bond market sell offs continue, some developers will see their revenues drop steadily over the course of the build out. Even if you assume rents will rise due to inflation, because cap rates are a multiplier, they can create a net loss very quickly.", "replies": [{"id": "icn83c3", "text": "This is a great answer. Definitely agree and makes sense.but again your interest reserve can blowout fairly quickly in todays environment", "replies": [{"id": "icn8ogr", "text": "Sure it can, but unless the developer has very little liquidity, a bit of cash thrown in will refill it and carry the IR through to completion. To your point, it does get more challenging when you're syndicating and you have to put out a cash call to investors.", "replies": [{"id": "icn9mti", "text": "Yup. Someone people on this thread don\u2019t get it. But yes. Money coming either out of your pocket or investors.", "replies": [{"id": "icnail7", "text": "I've noticed a lot of responders are coming from a build-to-hold perspective which makes them less sensitive to exit value erosion. At worst they'll have to put more cash in to pay off the shortfall between their construction loan and the smaller than pro-forma term loan on completion.\n\nI work in debt &amp; equity brokerage mostly dealing with multi-family rental development and I can tell you all of my sophisticated merchant developer clients are nervous - even the well capitalized ones. Anyone who isn't concerned is either irrationally optimistic, incompetent, or is long a build and is talking their book.\n\nOn the bright side, most of the institutions and REITs I'm talking to are pretty excited to pick up a the completed projects at a discount in a year or two.", "replies": [{"id": "icnbavn", "text": "Interesting. Question for you. Since you\u2019re dealing with lenders all day during this rate environment - do lenders not see this as an opportunity to lend out at higher rates and make more money since net interest margin is key for them. What\u2019s up with lenders revoking term sheets If the DSCR is there and they can lend conservatively? Any true risk?", "replies": [{"id": "icncelo", "text": "Lenders are still sitting on a ton of liquidity and spreads have risen substantially in the past 6 months (from about 140 bps in Jan on AAA rated deals to about 190 today on 5 year term deals). So yes, most are taking this as an opportunity to take more profits and hedge against future cost of funds growth.\n\nWhere I've seen and heard about lenders revoking term sheets is where rate growth has put them beneath minimum DSCR and they therefore need to re-size the loan. So it's not that they're not still willing to lend in most cases, it's just that they need to restructure the loan offering.\n\nThe few deals I've seen lenders fully walk from were skinnier development projects that just don't have enough margin for a lender to roll the dice on. Keep in mind that most lenders don't want the hassle of foreclosure, even if they're relatively low LTC/LTV and therefore likely to get out whole. Some of the credit unions and regionals are also temporarily holding all new construction and land loans - they're too small to take on significant risk and want to wait and see what will happen to values.", "replies": [{"id": "icnil0d", "text": "Great write up!! Thanks so much. Funny question that now comes to mind. What index do you usually see construction loans tied to? Mine is the prime rate but is SOFR more common? Also have you ever seen a fixed rate for construction loans? How rare is this and why don\u2019t lenders do it?", "replies": [{"id": "icnjyxk", "text": "Fixed rates for construction loans are essentially unheard of outside of a few government insured programs. The reasons for this are varied but essentially boil down to they're short term instruments (generally less than 3 years), aren't tied to a fixed cash flow, and are generally revolving demand loans which means that:\n\na) lenders can call them with some notice to the borrower and;\n\n b) borrowers only pay interest on the amount they've drawn from the loan.\n\nThe second point is the most important because lenders can't just hold funds for a borrower without charging interest on those funds - and charging borrowers for funds they haven't borrowed yet is unacceptable to borrowers. So every draw from the construction loan can be thought of as a new loan, and therefore subject to whatever the rate is at that time, hence making the whole loan variable. \n\nGenerally if you're a small to mid-market borrower, your rate will be tied to prime, and larger loans can be benchmarked to LIBOR (CIDOR in Canada), Banker's Acceptance Rates, or other similar market benchmarks.", "replies": [{"id": "icnocp1", "text": "You\u2019re a genius. I will DM you to remember you if I ever need a loan", "replies": [{"id": "icnowuy", "text": "Definitely not a genius but I've been in the capital markets for a while. I appreciate it!", "replies": [], "depth": 11}], "depth": 10}], "depth": 9}], "depth": 8}], "depth": 7}], "depth": 6}, {"id": "icswv9p", "text": "Great comment. My question is, don\u2019t they have a lot of capital in their stack they are forced to use? I feel like the nervousness may also be partly due to the fact that investors are looking over their shoulder for similar rate returns. It\u2019s less about their ability to actually find something and complete it, but there\u2019s more pressure. For privately funded individuals I feel like they don\u2019t have that hanging over them.", "replies": [], "depth": 6}], "depth": 5}, {"id": "icp0c9q", "text": "Either that or default on your debt which a lot of people who over leveraged may unfortunately do.", "replies": [], "depth": 5}], "depth": 4}], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "icny1rh", "text": "Revenue covers cost. Lol too easy next question.", "replies": [], "depth": 1}, {"id": "ico2uto", "text": "If you know what you\u2019re doing, you\u2019re underwriting debt using the forward yield curve- this means your interest reserve will be sized off the anticipated interest rates, not just todays. On top of that, many loans require interest caps, though they\u2019re getting pricey now", "replies": [], "depth": 1}, {"id": "ico74bh", "text": "I pick sites that support higher rates in a sensitivity analysis. Honestly rates are the easy part to manage \u2014 construction costs are the hard part.", "replies": [], "depth": 1}, {"id": "icp5tup", "text": "Rent indexations. That\u2019s the only thing that can make it works.", "replies": [], "depth": 1}, {"id": "icpkr8q", "text": "I'm doing a project aimed at an industry that's exploding due to changes in Illinois tax code. Basically the industry is exploding here because the government has recently changed the laws to be ultra favorable. So I can get way higher rent than market from these guys and have more demand than I can satiate.", "replies": [], "depth": 1}, {"id": "icpn27s", "text": "I am not a developer but I work with some and I study many others. The #1 thing I see with all of them is their time horizons are around 20 years or more. They have also been more focused on luxury developments, whether that be homes or condos or apartment buildings. I am in South Florida and Developers here have been doing extremely well since 2015.", "replies": [], "depth": 1}, {"id": "id5f9fj", "text": "For the most part, higher rates are starting to alleviate overheated labour markets and stratospheric increases in construction costs. The relief on these ends vastly offsets increases in our cost of capital. Therefore, we find our position strengthened with respect to existing pre-sold projects. \n\nThe long term picture is more complicated because higher rates are reducing demand by limiting mortgage affordability. Furthermore, higher rates apply upward pressure to cap rates as yields rise. Our thesis is that there will be an adjustment to a new equilibrium wherein sale volumes are lower than current. That being said, we are of the opinion that there will be upward pressure on the rental market as more would be purchasers are forced to rent. This in turn will make it easier for developers to achieve the higher cap rates necessitated by increases in interest rates. \n\nAs with any adjustment, there will be winners and losers along the way. Ultimately, we expect to find ourselves in a world with less leverage but higher base returns.", "replies": [], "depth": 1}]