The Pursuit, The Purchase and The Pause

We often get questions regarding the elevated levels of multifamily permits when we send out the snapshots. The fact that permits have stayed elevated through a time when exit values and lack of available financing have rendered many projects unbuildable can seem confusing. To better understand at least some of what is happening, a fictional story might be the easiest way to paint the picture…

Once Upon a Time…

Let’s follow a fictitious company called J&R Development, who is a developer of multifamily in the metro Phoenix market. It’s January 2021. The development market has seen a jump from the Covid trough, and the principals of J&R have just read this article saying the Fed doesn’t plan to raise rates anytime soon (as long as inflation stays low), which is great because they have a couple of sites on their radar that they are pursuing.

The Pursuit

The market has gotten very competitive and construction costs have been increasing at a seemingly unsustainable rate. But exit cap rates are compressing (exit values increasing) and Phoenix is seeing unprecedented rental rate growth that is overcoming the margin lost to increased costs. J&R’s underwriting still works and works so well that they’re actually able to increase what they’re offering for land parcels.

J&R is aggressive in making offers but keeps missing out to others who are paying bigger numbers and at times even offering to close more quickly. They would love to get through construction drawings and close their construction loan with the land, but their competitors are closing at site plan approval and taking the financing risk. Construction debt is plentiful and inexpensive, so the risk seems minimal.

Halfway through the year J&R finally gets a letter of intent accepted but it takes forever to get the PSA agreed to because everyone is so busy. They’re finally under contract in Q3 of 2021. Inflation has started to kick up a little bit, but everyone is calling it ‘transitory’. Plus, the Fed hasn’t started raising rates, so J&R proceeds with their due diligence.

The Purchase

By Q1 2022, J&R has worked through their due diligence period and their earnest money goes non-refundable, subject to receiving final site plan approval from the city. It’s an uncomfortable amount of earnest money but it was necessary to get the deal in this competitive environment. On top of inflation creeping up, the 10-year treasury is starting to climb, and the Fed raises rates for the first time in March.

J&R is concerned about where things are headed but if they bail now, they lose that uncomfortably high earnest money deposit. That loss aversion propels them through the pursuit of their entitlements and their equity partner agrees to close on the land in Q3 of 2022.

J&R is uncertain if they will be able to get a construction loan but are too heavily invested in the project to walk away. They are growing evermore concerned as the Fed has continued to raise but inflation has stayed stubbornly high and the 10-year continues to climb.

The Pause

By Q4 of 2022 J&R has their site plan approval and is working through construction drawings when they get word their preferred lender is no longer funding new projects. They have other relationships and try to leverage those but find the answer is the same everywhere they turn. “We’re pencils down…”

At this point, given how much time and money they’ve invested in the project, J&R figures the only option moving forward is to continue to pursue approvals of their construction drawings, so they’ll be permit ready when financing becomes more readily available. They do so and their approved (but not pulled) permits show up in some broker’s multifamily permit snapshot in Q2 2023 buried under some goofy poll about the 10-year treasury.

J&R looks for some optimism but terms like “higher for longer” are being batted around and now they start to see some new construction multifamily sales come through at prices that are lower than what it’s going to cost them to build their units, let alone make any sort of profit.

The Fed finally has mercy and stops raising in July of 2023. J&R has a committed equity partner who knows they’ve gotten wrapped up in the most aggressive rate hike in four decades. They agree that they’re all in this together and will work with J&R to pursue whatever avenue is necessary to get to a profitable exit.

The Solution (?)

We see reasons for optimism on the horizon, but whether that translates to projects becoming viable again can only be addressed on a case-by-case basis. Some basic checkpoints we run through when consulting with clients who find themselves in this situation are:

• Reevaluate and Adjust the Project Scope: Can the development be scaled back or modified to reduce costs and improve financial viability? This might involve phasing the project, modifying the number of units, or altering the mix of commercial and residential spaces.

• Explore Alternative Financing Options: To many, traditional financing routes are no longer feasible under current market conditions. Consider other options that might offer more flexibility and better terms in a higher-interest-rate environment.

• Renegotiate Terms with Stakeholders: Open communication with the landowner (if the land is still in escrow), lenders, investors, and contractors is crucial. Often, a renegotiated price from a developer still provides the highest price for the landowner in a shorter time than taking the property back out to the market and starting all over.

• Capitalize on Government Incentives and Programs: This is particularly useful if the property falls within the boundaries of a Qualified Census Tract or Difficult Development Area. These programs take time to implement but groups who can navigate them are getting projects off the ground in this environment.

• Pivot to a Different Use or Strategy: The property’s zoning may allow for another use that is more appropriate for today’s market conditions. It’s worth exploring alternative uses or product types, particularly those that can gain approval without a rezoning case.

• Consider Strategic Partnerships or Joint Ventures: Partnering with another developer, investor, or entity can spread the risk and bring additional expertise and resources to the table. A joint venture might open new avenues for financing, marketing, and execution that were not previously available.

• Hold and Wait for Better Market Conditions: If the ownership structure allows, holding the land without immediate development might be the best option. This approach requires patience and a long-term perspective, but it can pay off when market conditions improve in the future.

• Selling the Land: If the land was purchased at an attractive basis or the interests of the equity partner have changed, selling the land might be the most prudent decision. This could provide an opportunity to recoup the investment and potentially realize a profit, which can then be redirected towards more feasible projects or to strengthen your overall financial position.

We understand these scenarios are often easier said than done, but these possibilities are some of the initial ones we consider when evaluating a planned project that is no longer feasible.

If you find yourself stuck with your current project or have any questions in general about the market, please do not hesitate to reach out to us!

Thanks for reading,

John and Ramey