Similar to virtually every other market, the commercial real estate market goes in cycles. Throughout much of the country, most product types are in a development cycle, brought on by strong demand and occupancy rates. A development cycle brings on a slew of players chasing the fortunes to be made in the real estate development game. The development cycle is not for the weary and can be characterized by fast-rising land prices, soaring construction costs and market uncertainty – how well will all this newly developed space be absorbed?
The developers who are best fit to thrive in a development cycle are those who can meet the demand by delivering their space the fastest and at the most competitive rental rates relative to comparable assets. A developer who already owns the land has a significant piece of the puzzle solved by the time it makes sense for him to deliver new space to the market, thereby allowing him to move quickly (Objective #1). Additionally, the developer will likely own the land at a lower cost basis versus his competitors who are buying their land during the development cycle, thereby allowing him to deliver the space at more competitive rental rates (Objective #2).
A developer may speculatively purchases a piece of land before it is readily apparent to the rest of the market that it will make a great future development site. He may purchase the land for $2 per square foot and by the time it is ready for development, it has a market value $8, $10, $12 per square foot – a great investment by itself! Most real estate developers, however, having an entrepreneurial mindset and high risk tolerance, aren’t satisfied with the profit of the land investment alone and want to double down on that investment by developing property on top of it.
Historically, the developer will contribute the land at market value (subject to a third-party appraiser) as his equity investment, and take out a loan from the bank to construct, market and lease the property. The value of the land contributed as equity is typically enough that the necessary loan proceeds equate to only 60% to 75% Loan-to-Cost, or enough that the developer doesn’t have to invest additional cash in the project. However, due to recently enacted bank regulations contained in Basel III known as High Volatility Commercial Real Estate (“HVCRE”), banks can now only give the developer equity credit for their ORIGINAL cost in the land and none for the value appreciation of their land investment, thereby forcing developers to come up with cash – either from their own balance sheet or from a third-party investor.
The results of these constraints remain to be seen until this development cycle runs its course, but some of the effects of these new banking regulations seem fairly predictable. One result is that the developer stands to make less profit on his development if he has to put in additional cash of his own or split the profits with an investor. Less incentive for development could mean less development, which could translate into higher rental rates and occupancy costs for tenants.
Another potential result of the new banking regulations is the emergence of private, non-FDIC insured lenders into the construction lending markets. These so-called private lenders, who are not subject to many of the same regulations as their FDIC-insured counterparts, typically have a higher cost of capital and thus, generally lend at a higher interest rates. However, when evaluating their weighted-average cost of capital, those higher rates are often far more attractive to potential developers than borrowing at a lower leverage from their bank and investing additional equity. Depending on how much of this type of capital eventually makes its way into the market, traditional banks may risk losing significant market share on commercial real estate loans.
In an effort to make some commercial real estate loans safer for the banks, and thus the bank’s depositors, government regulations may end up simply pushing those loans from government-regulated banks to less traditional private lenders and possibly suppress development activity.
Over our firm’s 24-year history, Metropolitan Capital Advisors (“MCA”) has arranged billions of capital over several development cycles. For further information on how Metropolitan Advisors can assist you in arranging financing for your development, please contact Brandon Wilhite at email@example.com or visit our website at www.metcapital.com.