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July 07, 2023

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Getting new BTR and multifamily projects off the ground is harder today than since the Great Recession, but a prize is waiting for those who manage.

The supply side of the purpose-built, single-family rental housing market is being pummeled. Multifamily, including build-to-rent (BTR), starts are way down from last year, with recent surveys reporting that 40% of project delays are due to availability of financing.

Why? You’ve seen the headlines—the regional banking sector, which accounts for most commercial real estate (CRE) loans, is under stress. Consequently, many operators will tell you that CRE lending is in the middle of a full-blown credit crisis.

The first signs of brewing liquidity problems arose late last year, shortly after interest rates rapidly increased. Many banks that planned to move 2021 and early 2022 loans off their books found that those lower-rate loans had devalued. Thus, fewer dollars than planned flowed back into the banks’ vaults.

Also in late 2022, regulators showed up at the proverbial (or actual) door of many CRE lenders, telling the banks that they needed to increase the reserve holdings that backstop many of their development and construction loans, further restraining liquidity.

Then earlier this year, CRE lenders experienced more blows. Silicon Valley Bank collapsed, along with several others, and deposit outflows from regional lenders to either G-SIBS or Treasuries became an ongoing, sectorwide concern.

Alongside that, more and more borrowers with loans maturing began asking for extensions instead of repaying their loans. And finally, lenders with significant office exposure began taking an extremely conservative approach to liquidity management given the likelihood that they will need to cover losses.

Frozen Pipeline

In the absence of a robust, liquid senior debt market, new project starts have cratered. Operators are canvassing potential debt partners, frequently with grim results. Banks that were previously closing double-digit loans per month are now lucky if they close one or two.

Further, banks have dramatically lowered their acceptable loan-to-cost thresholds, often by up to 10 to 15 percentage points, leading to unexpected gaps in capital stacks that developers now need to cover with more equity (severely impacting cash-on-cash returns) or gap capital (dramatically increasing the overall cost of capital and adding another stakeholder into the mix).

Private lenders have become more active, but they lack the capacity, infrastructure, and, at times, the know-how required to cover the gap created by the traditional banking sector’s pullback. A massive reallocation of capital in the private markets to debt vehicles is underway, but it will take some time to have an impact: New markets must be underwritten, deployment opportunities must be sourced, deals must be closed, and transaction and servicing teams must be hired.

Relatedly, and despite continued reports of an abundance of dry powder, institutional common equity markets are not too far behind the traditional senior debt markets in their inaction, though as much by choice as by a lack of liquidity.

Unfortunately, today’s conditions still have an overwhelming anchoring effect on underwriting, even though no one can confidently predict market conditions more than 12 months out (or less). And in an industry where the reputational (and fiduciary) consequences of being wrong are understandably perceived to outweigh the upside of being right, the result is higher hesitancy among capital allocators, leading to fewer deals.

The Time Is Now

Today’s conditions could create a major hole in new supply a few years from now. Multifamily and BTR projects take roughly two years to build, leading one to conclude that come 2025, very little new supply will be hitting the market if these conditions hold.

If rents are a function of supply and demand, and conservatively we hold demand relatively constant over the next few years, then operators who are able to get started today may see well above-average returns a few years from now (though this is not investment advice).

On the spend side of the project pro forma, supply reduction can only ease construction cost dynamics. No wonder that groups I talk to who believe most in their own decision making and instincts on the market are trying as hard as they can to get projects moving.

Back in February, I wrote about how the current and coming macroeconomic conditions would result in entrenched operators gaining an advantage and “friends and family” capital networks rising in value.

Events since February have only reinforced that conclusion. Operators who have strong preexisting relationships with debt providers (and substantial deposits) are getting priority in today’s debt markets.

Similarly, operators with strong equity relationships with partners who are willing to take a longer-term view are able to get moving. Operators who have partnered with friends and family networks have more options to capitalize projects and get them out of the ground.

But the broader point is, regardless of the mechanism, now is a fantastic time to start a project, if only you can find the right set of partners who view the world the same way.

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