If you are anywhere near the real estate industry, you probably hear your colleagues talking baseball with increasing frequency – everyone now seems to have an opinion about what inning of the cycle we are in. What the national-pastime-loving prognosticators are implicitly suggesting is that we are watching a ballgame we have seen before. Whatever your view on the timing of the end of the cycle, one has to acknowledge that something is very different this time around.
It is becoming significantly harder to get projects financed despite the signs one might typically observe in the late innings. And the current state of the lending market has significant potential implications for new supply fundamentals. The silver lining may be that fewer deliveries have a positive, corrective impact on the market and reduce the severity of the next downturn, if and when one does occur.
The recent deterioration of the construction financing market is profound, especially given the context of the continued resiliency in fundamentals. Loans to cost have declined, covenants are more restrictive, guarantee requirements are more onerous, and some lenders are even reluctant to lend on any project located in a submarket with a large volume of planned supply deliveries. This current tightening in standards is occurring despite low and declining commercial delinquency rates. For a historical comp, in the last cycle the growth in nationwide commercial mortgage-backed securities issuance did not reverse until late 2007, well after the first increase in delinquency rates in mid-2006.
In addition to new BASEL III and HVCRE restrictions, explanations persist for the current state of lending markets. Maybe the market is more prescient than past cycles. Maybe the pain of the Great Recession was significant enough to temper the hubris that typically increases right until the bitter end and bring out the bears. And maybe memories of lenders’ efforts to clear real estate-owned off their books are so fresh that they are less bold than a market showing the kind of strength that Denver truly warrants.
In the Denver apartment market, Class A rents have increased 10 percent year-over-year and vacancy continues its downward trend. Absorption has been increasing and now is around 8,000 units annually. Expected future supply is significant with approximately 23,000 units under construction, which will take 18 to 24 months to deliver.
Granted, it is not ideal to have deliveries of several thousand units in excess of a very robust current rate of absorption. However, with approximately 187,000 apartment units in Denver as a whole, it is hardly insurmountable. While the pipeline in planning stages is similarly robust, these projects are or will be seeking financing in a significantly tighter lending market.
To be clear, certain areas like downtown will see significant new supply, especially relative to existing stock. Some softening is inevitable and its vitality will rely on continued strong absorption. However, with its 24/7 live-work-play attributes and trends favoring city living, downtown should continue to emerge as a highly desirable submarket. In the meantime, we believe projects in locations and submarkets that benefit from supply constraints and irreplaceable qualities are the best places to focus our efforts.
One would also hope some of this sobering up causes the dramatic rise in construction costs to plateau or reverse. Maybe this is wishful thinking, but what looks inevitable is a new equilibrium between construction activity, construction costs and lender-risk appetite. Such a new equilibrium would make it less likely that we will someday talk about 2017 vintage deals in the same way we talked about those from 2007 or loans from the same.
In looking at past cycles, construction usually increases into the end of a cycle. Then the pipeline of projects previously green-lit and under construction deliver to the market during the downturn. These increases in supply while absorption is muted or negative make the trough deeper and longer. Supply dynamics are reacting approximately 18 months behind changes in demand, a lag that not only amplifies real estate cycles but also is a main cause of the cyclicality in real estate markets in the first place.
Downturns are worsened by new supply deliveries and recoveries are pumped up by a supply pipeline that has abated. If the prognosticators are correct and the downturn is around the corner – and absorption declines while the 23,000 additional units in the pipeline come to market – it will matter little whether it was June or October when financing markets decided to recoil. But in looking at the current state of the market, if the downturn is not immediately around the corner and if multifamily starts decline for some time, what will the next downturn look like?
With developers less likely to build new projects, the recent increase in multifamily starts looks unlikely to persist. Not only does this make us feel good about the projects we are building currently, but also it may be the case that developers who succeed in breaking ground on new projects in 2016 and 2017 are not necessarily lemmings headed toward a cliff.
While my career in real estate does not span many cycles, I do not remember industry pumping the breaks in the mid-aughts like it is now, nor do I remember so much talk of baseball. The question may be, if the current dynamics of the lending markets persist long enough, the supply pipeline adjusts and the market fundamentals show stability in the meantime, will we find ourselves searching for a new sports analogy?