In the past, the construction finance landscape was characterized by lower construction costs, lower cap rates, lower interest rates, higher loan proceeds, and readily available capital. This environment was conducive to development, with growing rents and minimal vacancies. However, today’s reality paints a very different picture for developers, especially at the Ready-to-Issue (RTI) stage. This newsletter will explore the significant challenges developers face at this crucial point and why these obstacles are stalling projects across the board.
The Changing Landscape
1. Unknown Cap Rates:
Several years ago, developers enjoyed the predictability of lower cap rates, which allowed for confident underwriting and forecasting. Today, the market’s volatility has introduced a level of uncertainty in cap rates, making it difficult for developers to accurately project future returns. This unpredictability is a significant deterrent for investors and lenders, leading to hesitation and reduced activity in the market.
2. Rising Construction Costs:
The cost of construction has surged due to a combination of factors, including supply chain disruptions, labor shortages, and inflation. Developers are now facing bids that far exceed their initial budgets, squeezing their margins and making many projects financially unfeasible. The increased costs also extend project timelines, further complicating the financial viability of new developments.
3. Higher Interest Rates:
The era of low interest rates, which facilitated affordable borrowing for developers, has come to an end. Higher interest rates have significantly increased the cost of financing, reducing the attractiveness of new projects. For many developers, the higher debt service requirements erode potential profits, making it challenging to justify new investments.
4. Difficulty in Securing Capital:
Securing capital has become increasingly difficult as traditional lenders retreat from the market. The underwriting process is now “upside down,” with stricter criteria and more conservative valuations. The few banks still willing to finance development projects are offering significantly reduced proceeds (40-60% of the project’s value), forcing developers to increase their equity contributions substantially. This shift has made it challenging for many developers to assemble the necessary funding to move forward.
5. Short-Term, High-Leverage, and Expensive Land Loans:
Many developers acquired development sites with short-term, high-leverage, and expensive land loans, planning to get the projects entitled and ready-to-issue (RTI). These loans were taken with the expectation that construction financing would be readily available once the entitlements were secured. However, the current financial climate has turned this expectation on its head. With construction financing now difficult to secure, developers are stuck with substantial carry costs from these land loans. The high interest rates and leverage amplify the financial strain, leaving developers in a precarious position.
The Impact on Development
1. Underwriting Challenges:
With the underwriting process becoming more stringent, developers are finding it hard to meet the new requirements. Lenders are now demanding more detailed financial projections, higher equity stakes, and additional collateral. These demands are proving to be insurmountable for many developers, leading to stalled projects at the RTI stage.
2. Substantial Carry Costs:
The carry costs associated with short-term, high-leverage land loans are adding to the financial burden on developers. These costs include interest payments, property taxes, and maintenance expenses, all of which continue to accrue even when projects are stalled. The inability to secure construction financing means that these costs cannot be offset by progress on the project, leading to mounting financial pressure.
3. Reduced Market Activity:
The cumulative effect of these challenges is a significant reduction in market activity. Few new projects are breaking ground, and many developers are opting to pause or abandon their plans. This slowdown is evident in the decreasing number of building permits issued and the growing inventory of unbuilt sites.
4. Lack of Buyers for Development Sites:
The current environment has also led to a dearth of buyers for development sites. Potential buyers are wary of the high risks and uncertain returns associated with new projects. This lack of demand further depresses the market, creating a vicious cycle where development activity grinds to a halt.
Difficult Decisions:
Developers now face difficult decisions as they navigate this challenging landscape. Some may choose to sell their entitled sites at a loss, hoping to cut their carry costs and minimize financial damage. Others might seek joint venture partners to share the burden of equity contributions and carry costs. However, these solutions are not always viable or desirable, leaving many developers in a state of limbo.
Conclusion
The RTI stage, once a hopeful milestone for developers, has now become a formidable hurdle. The combined effects of unknown cap rates, rising construction costs, higher interest rates, difficulty in securing capital, and substantial carry costs from short-term, high-leverage land loans have created an environment where few projects are getting built. Developers are in trouble, facing an uphill battle to bring their visions to life. Until the financial landscape stabilizes and more favorable conditions return, the development sector is likely to remain in a state of stagnation.
JDJ Consulting Group provides expert guidance on entitlement, permitting, and construction management. Our seasoned professionals help developers navigate complex approval processes, expedite permits, and optimize construction management. With extensive experience in addressing underwriting issues, cost escalation, and capital challenges, we ensure successful project outcomes. Partner with us to bring your development vision to life.
As we navigate these challenging times, it’s crucial for developers to adapt and explore innovative solutions to overcome these hurdles. Collaboration, strategic partnerships, and creative financing options may provide a path forward.
