Why it’s hard to be a developer today
New construction is on pace for one its slowest years in recent memory. 2024 might be even worse. A lot has changed in the past 18 months. Here’s an outline of issue I face as a ground-up developer, shared by many others out there struggling to make projects pencil:
Recession risk is the focus for all capital providers. Banks are more selective on new loan issuance. Stress testing loan is more severe. Rising interest rates not only reflect the Fed’s inflation battle, but also the added risk premium spread by banks still lending this late in the cycle. Equity is also hesitant knowing future growth prospects have dimmed, better opportunities might be around the corner and bonds present an attractive alternative yield option to commercial real estate. Preferred returns and the cost of hybrid debt / equity products like mezz and preferred equity have skyrocketed into the 12%+. To get investors off the bench, the yield premium for riskier plays like development must be there.
Interest rates and bank lending: we’ve seen a near doubling of rates in the last 16 months. The impacts hit projects at all levels. Loan proceeds are down, reflecting covenant challenges. Also, loan features like interest reserves are now larger, requiring more equity upfront from investors or a bigger chunk of overall loan proceeds, depending on how its funded for a project. A lot of banks are also undercapitalized stemming from the run of recent bank failures this past Spring. Regulations are tighter, deposits have fled in search of safety and yield elsewhere, and many balance sheet investments and loans are underwater. It’s not a great backdrop for issuing new loans. And if they do lends, banks now want your deposits.
Construction costs: while lessening somewhat, costs continue to rise with lead times still stretched. Select items like electrical components like panels and switchboards still have 12+ month lead times. Labor costs, took the baton from materials as the new source of major cost concern. Short of a recession, I wouldn’t expect labor costs to change anytime soon. We’ve transitioned from a moderate labor environment over the past 10 years to a much aggressive environment as evidenced by rising minimum wages, hefty pay increases and numerous labor strikes. Those with bargaining power know they have the advantage. It’s always a capital vs labor battle. In the last decade capital prevailed over labor. In the coming decade, we should expect the opposite.
Rents: it’s been a glorious run for the past few years as e-commerce, last mile and warehouse needs exploded during and after COVID. Now, all signs point to a cooling off period . In many markets, somewhat dependent on new supply and other specific factor, rents have leveled off. Question becomes what they do in the years ahead, especially if a recession occurs? Hard to bank on continued rent growth to support a deal knowing project deliveries often takes 2 - 3 years in most markets. Waiting to start leasing as a project drags on and the leasing market deteriorates is a painful game most developers are afraid to play this late in the cycle, especially with interest rates now poised to stay higher for a lot longer.
Wrapping it up, the main factors going into development - cost, interest rates and rents - all seem to be moving in the wrong direction. There’s few places to hide or recoup hits on a project. Capital is nervous as a result. Projects should slow down until better visibility emerges in the years ahead. For me, these signs of visibility include grasping the Fed’s direction on interest rate, severity of recession, timing of recovery and the path of rents and costs.