Pablo Picasso said, “The chief enemy of creativity is good sense.” In just 24 months, multifamily permitting in the Denver MSA has dropped 43%. Rising construction costs and land prices are leading developers down a dead-end road. Many deals, even in great locations, simply will not pencil. Good sense, it’s defined as sound judgement often instinctive or unlearned, and the best developers often possess it. They don’t even need to plug the numbers into their model to see the outcome… good sense tells them to move on.
In particular, middle market developers are having an especially tough time getting projects to pencil as they lack the economies of scale, in-house services (leasing, mgt, construction), and the preferred financing to keep pace with the massive institutional developers. Multifamily projects of 50-100 units as a percentage of total completed projects have steadily declined over the past four years, from 25% in 2016 to just 14% in 2019.
Stagnating rent growth in heavily supplied submarkets has made traditional lenders wary of budgeting any rent growth, let along above average. At this point, it seems like the only deals getting done are by well-capitalized groups in their traditional markets and with their traditional product type. However, fundamental macro-economic indicators relating to job and population growth combined with a shrinking development pipeline leads one to believe above average rent growth is on the horizon. For the developer struggling to find a deal, it’s time to get creative.
Creativity comes in many forms and can be applied to numerous aspects of your business model. Today’s environment requires a competitive advantage – getting creative with product type, unit sizes, locations, partnerships, purchasing structures, revenue streams, and even financing. However, one must always keep in mind the old saying “Never confuse leverage with creativity”, so maintaining an efficient risk to return profile is key.
Some participants are simply taking themselves out of traditional ground-up development, moving towards existing assets or low cap covered land plays as a hedge against a downturn; or, moving up the capital stack to reduce risk while maintaining the possibility of owning the asset should the developer stumble.
Those unable to justify land prices in the urban core should give more considation to the suburbs, where land with similar zoning can be had for a fraction of the price. While top-line market rents may be confined to the core, cap rate compression is not and sales comps for suburban assets continue to set new records.
For some projects, leveraging advancements in construction technology may be the answer. While modular construction is not a new concept, it is gaining more interest. Modular has the potential to accelerate project timelines by 20-50% and reduce construction costs by more than 20%. But with a track record of mixed-results, many are still skeptical. Projects with labor intensive activities and high levels of repeatability are a couple examples where modular can drive down costs. Modular’s value boils down to the specific project, the partners involved and their understanding of its application.
Some developers are restricting their focus to only the markets they live in, have the relationships in, and have had experience developing in. The locality of their business may be able to give them the political sway to get projects approved that other developers couldn’t. With continued anti-growth sentiment and the increasing power of hyper local lobbying groups, this hyper local development strategy may be necessary to getting projects approved.
Another area developers may look towards are government sponsored redevelopment areas, P3’s, and affordable housing as risk hedges to a potential downturn. While these types of deals come with their own unique set of challenges, the belief is that these types of projects would be most recession resistant due to the likelihood of continued investment, intrinsic incentives to see their targeted areas continue to develop, and the ability of the government to waive potential hardships to get projects to work.
Others in the market have been looking towards developing different or smaller versions of their traditional product type. In particular, the downsizing and economization of building forms has been a huge boost in the ability to get projects to pencil this cycle. In many situations, the delta between the increased return per square foot and the increase cost to build per square foot is positive. Micro-units, co-working spaces, food halls, and boutique hotels are all great examples of this phenomenon. Financing is still a challenge though, as many lenders scoff at the ideas of these product, but as it starts to prove out, financing may become easier to obtain.
For the more surgical and precise mindset, opportunity can be found in various code exploits or being the first to respond to regulatory changes in a market. This involves detailed analysis and study of codes and a perverse desire to participate in local government planning meetings, but opportunity is still out there. A few examples, Aurora’s recent change in zoning recently now allows for multifamily development in almost every district that was previously zoned commercial only, there are a few sections of Lakewood that are fully exempted from their one percent growth ordinance, or that the small-lot parking exemption in Denver still provides real value and may have a loophole to fully reduce parking for any height development.
The opportunities are still there for those with a creative mindset, and/or have the investor capacity to execute on these novel strategies. However, any change needs to be tailor made for your business, personality, and investors as getting too far outside of your comfort zone can lead to costly mistakes.
- Travis Hodge
Sr. Investment Advisor
- Anthony Bobay