Building apartments just became a lot more difficult. The interest rates developers pay for construction loans have risen sharply in the past several months, and they are set to increase even higher. At the same time, fewer lenders are making loans. Interest rates are just one part of the rising cost of development, but they are still a major problem for developers. Many are scrambling to protect themselves from rising rates or make up for the cost in some other part of their construction budgets.
It helps that apartment rents continue on a growth trajectory. Most multifamily developments create new, luxury apartments designed to appeal to renters by choice who can afford them. But even growing rents may not be enough to make up for rising costs.
“If I am a developer and I have a team that runs financials, I am having them rerun them,” says Dave Borsos, vice president of capital markets for the National Multifamily Housing Council (NMHC). “What can we hedge? What can we change? What can we modify to get the return that we thought we were going to get?”
Federal Reserve Plans More Steep Increases
Officials at the Federal Reserve already increased their overnight interest rate target from close to zero to a range of 2.25% and 2.5% by the end of July. Since most construction loans have interest rates that float above benchmarks like the Secured Overnight Finance Rate (SOFR), many already pay these higher rates. Fed officials have signaled that they plan even higher interest rates in the months ahead to fight price inflation in the overheated U.S. economy— though no one knows for sure how much rates will rise during the life of a construction loan.
“Projections are volatile at the moment, changing every 24 hours,” says Scott Lawlor, CEO and founder of Waypoint Residential, an apartment development firm headquartered in Boca Raton, Florida. “Uncertainty around debt pricing makes it challenging for borrowers to underwrite.”
In the past, lenders sometimes helped developers get deals done when benchmark interest rates rose by cutting the “spread” they add to interest rates. But not this time.
“Banks and debt funds are not shrinking their spreads to offset higher SOFR rates,” says Bill Leffler, senior vice president in CBRE’s Debt and Structured Finance Group. “It’s all a lender can do to keep up with the continual construction budget busts from labor and material inflation, resizing, re-underwriting and re-presenting to loan committees.”
Long-term interest rates are also rising, and that presents a different problem for developers. Eventually, construction loans are replaced with permanent financing. If long-term interest rates are significantly higher, the finished property won’t be able to support as much permanent debt. The benchmark long-term interest rate, the yield on 10-year Treasury bonds, has already risen by several percentage points in 2022, jumping erratically as economists try to understand whether the U.S. economy is still overheating.
“When the spreads on Treasuries bounce 50 to 100 basis points in a few weeks–up or down–the spreads charged by lenders aren’t going to come down,” says Dave Hendrickson, senior managing director for Walker & Dunlop’s Capital Markets group.
Apartment rents continue to grow, and most communities have very few vacant units. However, rents are unlikely to rise as quickly in 2022 and 2023 as they did last year—and that may also create headaches for developers who hope to make up for rising interest rates and construction costs with rents that grow as much as 9% on average in 2022.
“You can make anything work with that kind of rent growth,” says Hendrickson. If rents rise just 3%, that could leave developers with little but their own pocketbook to pay for other rising costs.
Interest Rate Caps Are More Expensive
Interest rates caps, which limit how high the interest rate on a floating-rate construction loan can get, became much more expensive this spring.
“In times of volatility, the cost is going to be prohibitive,” says NMHC’s Borsos.
The cost of a two-year cap on interest rates in June was seven times as expensive as the beginning of 2022, according to Lawlor. The cost of a three-year cap was four times as expensive as it had been in the beginning of the year.
Volatility Hits Debt Funds Hard
Developers also have fewer choices when they look for construction loans.
“If there were 100 debt funds lending two months or three months ago, there are 35 today,” says Hendrickson. That’s because many private equity debt funds plan to pool the construction loans they originate and sell them as collateralized loan obligations (CLOs) to Wall Street investors.
Debt funds still making construction loans offer high leverage, covering up to 80% of the cost to develop an apartment property. In exchange for high leverage, they charge high interest rates, floating in the 500-basis-point range over SOFR. These spreads have increased 50 to 75 basis points due to lack of liquidity in the market to sell their securitizations on the back end, says Lawlor.
Banks Take More Care, Offer Smaller Loans
Banks are still making construction loans to multifamily properties—but they are less willing to make larger ones.
“Borrowers that are sensitive to rate, versus leverage, will likely go with banks,” says Lawlor.
Banks still offer loans that cover 60% to 65% of the cost of an apartment project—if the borrower is willing to accept a loan with partial recourse, according to CBRE’s Leffler. The amount that banks add to their floating interest rates tends to be in the 200-basis-point range over SOFR.
These interest rates spread have started to inch up slightly—around 25 basis points—for quality sponsors since the beginning of 2022, with larger increases for sponsors with less stellar credit.
Even Pension Funds and Life Companies Are Raising Their Interest Rates
Some apartment developers have turned to life company lenders and pension funds to finance their plans.
“Life companies tend to take a longer-term view of construction lending,” says Leffler. “They are not as buffeted by the interest rate volatility as debt funds.”
But life companies are also raising their interest rates—even though their cost of capital has not changed. These institutions are not interested in making loans to apartment developments that earn a lower yield than investments in corporate bonds.
Some life companies now offer recourse loans with relatively high leverage, covering up to 65% of the cost of a project, and interest rates floating roughly 200 to 500 basis points over SOFR, according to Leffler.
Builders Keep on Building, Despite Higher Costs
Despite all these challenges, developers keep moving forward with plans to build new apartments.
“So far, we have not seen higher interest rates derailing any construction projects,” says CBRE’s Leffler.
Optimistic developers are even able to start new plans, especially in strong apartment markets like the Southeast and Southwest. “There are too many positive fundamentals in the Sun Belt, such as population and job growth,” says Leffler. “Interest rate increases are just another part of the construction budget to manage and work through.”
Many developers had to simply increase their overall construction budget with larger interest reserves, more expensive interest rate caps, or both, says Leffler.
Developers who are early in the process are negotiating hard for lower prices from development sites, adds Hendrickson.
