Unraveling Lag Time in Real Estate Development

Something that at times is difficult to understand, or at least conceptualize, is lag time. Recently, a client asked us who the groups were that were selling newly built multifamily assets. If prices are down and they’re selling at or below replacement cost, why sell? Are they distressed? Crazy? Smart? This led to a rabbit hole of thoughts which ultimately led us to lay out some rough timeframes to consider.

We decided to take a look at merchant-build sales in 2023 and tie them back to when the developer closed on the land to determine the lag time. For this exercise, a merchant-build sale simply means the asset was sold to an investor from the group who developed it.

Of the 22 transactions we looked at, the average time between the land closing and the completed asset closing was 3.61 years. When accounting for what was likely an extended land escrow period of 12-18 months, we’re looking at roughly 5 years from when the land went into escrow until it was sold as a completed project.

These are averages, so there will be variance amongst the numbers. The quickest sale was 2.79 years post land closing and the longest was 5.71 years. We can debate whether 5+ years should be considered a merchant build but to avoid applying too much objectivity (and brain power), we included those in our set if they were purchased from the developer (there were only two, so they didn’t skew the numbers too much).

Working backwards 5 years from 2023, we surmise the land sites for many of these projects were likely put in escrow sometime in 2018. Think about that. Did anything disruptive happen in the market between 2018 & 2023? Just a pandemic, nearly free-to-borrow money, massive rental rate growth, supply chain delays, relentless construction cost increases and cap rate compression (amongst other things we’ve failed to mention).

Some benchmarks from 2018 (average for the year):

• Fed Funds Rate:

• 1.83% (range: 1.41% - 2.27%)

• Low: 0.05% (May ’20, stayed 0.1% or less until Mar. ‘22)

• Current: 5.33%

• 10-Year Treasury Yield:

• 2.91% (range: 2.58% - 3.15%)

• Low: 0.66% (April ’20)

• Current: 4.15%

• 30-Year Mortgage:

• 4.54% (range: 4.03% - 4.87%)

• Low: 2.68% (Dec. ’20)

• Current: 6.60%

  *based on monthly averages, daily highs & lows likely fell outside these ranges

So, back to the original question – why sell when prices are at or below current replacement cost? Based on the timeline laid out above, the units being sold in 2023 were delivered at a significantly lower all-in construction cost than can be replicated today. As best we can tell, these are not distressed situations, but developers and/or equity groups who are de-risking and locking in profits.

In thinking back to our previous comments on trying to catch the top – imagine telling a developer in 2017 that their project would be disrupted by a pandemic in 2020, but to stay the course because once finished, they’d be selling at peak pricing in 2022. Hindsight gives us the luxury of being able to explain how it all panned out but we’re guessing the 2017 versions of ourselves would have their doubts.

If you would like to discuss this or anything else, real estate or otherwise, please don’t hesitate to reach out. Thanks for reading, until next time!

Thanks,

John and Ramey