Financing West Coast Multifamily Is Tough, But Here's Why Investors Keep Coming Back
Financing a multifamily project in the West certainly is not getting any easier. Developers are walking away from projects that do not pencil due to strict housing regulations, difficulty getting a loan and increased costs.
Developers are having a tougher time getting sufficient financing because lenders are providing construction loans at or below 60% loan-to-cost, according to Essex Property Trust Chief Financial Officer Angela Kleiman. In the previous cycle, construction loans went as high as 75% loan-to-value.
Lenders are pulling back in part because they were lending over the last two years and bank allocations to construction loans have filled up, she said. Another reason relates to market dynamics.
“Higher costs in both labor and construction make deals much harder to pencil and makes a loan at the right size much harder to get,” Kleiman said.
Some lenders are concerned too many units have been delivered in urban markets and rental growth is softening, according to Cypress Equity Managing Director and Chief Financial Officer Alla Sorochinksy. Despite these trends, major institutional players continue to raise funds and maintain their appetites for high-quality multifamily, especially in core and core-plus markets.
Over the last five years, rental rates have risen across every asset class, according to Sorochinksy. Now the cycle is maturing, multifamily rents are softening and landlords are offering more concessions. This trend will likely be temporary, especially in highly desirable coastal markets where supply never reaches renter demand.
“In the short term, softening of rental growth will force debt and institutional equity providers to remain disciplined and extremely selective in their investment choices,” Sorochinksy said. “Developers and investors will look toward mezzanine and preferred equity partners, [which] tend to be more aggressive, to finance deals.”
Rents started to show some signs of heading upward in June across West Coast cities, according to Apartment List. San Francisco rents peaked in 2014 and decreased in 2016. After declining during early 2017, rents in San Francisco inched up 0.5% in June compared to the previous month, but were still down 0.6% compared to a year ago.
San Jose rents rose 1% month-over-month and 2.2% year-over-year. In Oakland, rents rose 1.2% month-over-month and 2.8% year-over-year. Los Angeles rents went up 0.5% month-over-month and 5% compared to a year ago. Comparatively in Seattle, where development is booming, rents have risen relatively consistently in the last four years and increased 1.3% month-over-month and 5.6% year-over-year.
Along with difficulty in financing and stagnant rental rates in California, regulations are making it more difficult to build. A push for rent control is anti-housing, Kleiman said. She said it reduces the supply of housing, which ultimately pushes market rents higher.
“Legislative challenges are a big piece of what is increasing the costs,” she said.
Other regulations have made it difficult for developers to build projects. For example, recent legislation such as Los Angeles’ Measure JJJ requires developments to use a labor pool within a certain number of miles, but if there are no qualified workers in that area, it makes it difficult to build.
What is impacting multifamily development activity the most is the rising costs; it no longer makes sense to build, Kleiman said.
Why Investors Keep Coming To The West
Despite these challenges, high rents, barriers to entry and high demand will continue to drive investment into markets like Santa Monica, San Francisco, Portland and Seattle, Sorochinsky said. Cypress focuses on urban development, both core and merchant-built. What makes California particularly worthwhile is its huge economy and job and income growth, which is a huge factor in developing apartments, according to Kleiman.
“Unfortunately, lack of supply, which is difficult for renters, is a helpful dynamic for developers," Kleiman said.
Home prices are over $1M, which makes it more difficult for renters to become homeowners and perpetuates the demand for apartments. There also are many renters by choice around the country who are looking for high-quality apartments in great locations, Sorochinsky said.
“Apartment demand is on the rise with no end in sight,” Sorochinsky said. “There is a lower propensity to purchase homes across all age groups.”
Seattle also has benefited from more development because there are fewer restrictions on developers than California there. Kleiman said building is more cost-effective and it is more affordable to live there. Facebook, Google and other major tech companies have opened offices in Seattle because talented workers are moving there. Essex has about 18% of its portfolio in Seattle.
“[Seattle] also is a riskier market because you can develop and build much easier,” Kleiman said. “There is more supply and more competition … If job growth slows down and a huge amount of supply comes online, it is more volatile.”
When there is strong job growth, Seattle does really well, but when the economy turns bad, the multifamily rental market performs very poorly, Kleiman said. Seattle was among the hardest hit of all of Essex’s markets during the Great Recession.
Kleiman said she hopes multifamily financing remains at a healthy, disciplined level. Staying around 60% loan-to-cost exhibits good discipline. Comparatively, in the early 2000s, aggressive lending at 75% loan-to-value was often largely based on the future value of a project. Developers did not have enough equity or skin in the game, and that was why a lot of projects ran out of money.
Essex has an acquisition target of $400M to $600M. Essex’s appetite includes multifamily assets near job centers. It invests heavily in suburban markets. Developments underway include a project in Downtown San Francisco, a large project in San Mateo and one in North Hollywood that will each have around 300 units. Essex has a total of 2,000 units in the pipeline and actively leasing. It also will invest in preferred equity and mezzanine loans within its markets.
Learn more from Kleiman and Sorochinsky about multifamily financing trends at Bisnow's Big West Coast Multifamily Event in Los Angeles on July 20.