Real estate is reliably cyclical. What goes up will certainly come down again and vice versa. If economic conditions become less favorable for development — whether it be rising interest rates, skyrocketing inflation, or other changes in the outlook — some might choose to play it safe and hold off development plans until the rising costs subside.
This could be the way to go for many amid the precarious state of the US economy, which continues to be plagued by inflation that has topped 8 percent in recent months. A longer phase of stable low interest rates has also come to an end. After a prolonged period of interest rate stability, the Fed approved a quarter-point hike in March (the first hike since December 2018), a half-point hike in May (the biggest hike since 2000) and a three-quarter-point hike in June (the largest since 1994). All signs point to further hikes in the near future. We’ve already seen some deals canceled or temporarily suspended due to escalating rates, inflation and skyrocketing construction costs.
These inflated costs will impact profits across a wide range of sectors. However, that doesn’t mean it’s not the right time to begin or pursue real estate development plans. For those willing to roll up their sleeves, smart planning and a creative strategy could make all the difference in getting the best outcome later. The following are important considerations for any multifamily real estate developer seeking financing in today’s economic climate.
Buy less prime land
Success may be easier when conditions are on your side, but that doesn’t mean there aren’t great opportunities now. A little creative thinking about less direct development paths could pay off in the long run, especially when steady rent increases could become unsustainable.
As higher costs erode potential returns, investors can look to maximize profit by buying less prime land at much lower costs. There are many ways to go about this, from crafting off-market deals to buying on the edge of a prime area. Tertiary markets could also be another avenue, although cap rates tend to be higher and the amount that can be charged for rent will be less than primary markets.
Another smart creative move would be to purchase a great property that is not zoned for your intended end use. There is certainly a cost associated with rezoning and the process can increase the timeline of your project, but the main goal to keep in mind is: How can I add value to the community and help offset increased costs?
Plan for cost increases
Increased costs also require more cash on hand. When financing, developers should be prepared to set aside a larger amount for interest reserves. The amount earmarked for interest accrual is based on an estimate of how much cash will be needed to fund payments before a project generates enough cash flow to cover costs. As interest rates are projected to continue to rise, the amount of reserves required will increase at the same time.
Other areas of increased attention on the financial side are rental and business metrics, construction schedules, and contingencies for increased construction costs. You should also choose contractors extra wisely, with an eye on whether they have the means to stay afloat when business slows. The financiers will carefully review contractors’ credentials, analyze their financial data and litigation for red flags, and review their performance histories, not only in good markets but also in challenging ones.
Look for the rebound
While the economic outlook is far from ideal for many, it could be far worse from a historical perspective. As of this writing, the average interest rate on a 30-year fixed-rate mortgage is 5.9 percent. That may be a lot more than the 3-series interest rates (or less) borrowers benefited from a year ago, but it’s still historically cheap. In fact, the federal funds rate has been below its historical average for 16 years. In the early 1980s, that rate reached as high as 20 percent amid efforts by the Fed to combat its highest rate of inflation on record, 14.6 percent in 1980.
Across the spectrum of potential investments, real estate remains one of the more stable — and tangible — growth avenues. Whether developers dive into new ventures now or wait for the waters to calm, there will always be recovery on the horizon.
Ben Jacobson is a Managing Director, Southeast US origin, for Trez Capital, a Canada-based private commercial real estate lender with nine offices throughout North America.