The real estate development industry has been negatively impacted by a continued series of hardships over the past 24 months, including rapidly escalating construction costs, breakdowns in the supply chain, inflation, labor shortages, rent freezes and, most recently, rising interest rates. Many projects are still managing to receive financing and get underway, but the current environment presents significant challenges for owners and investors to place a project under contract, achieve entitlement, obtain construction financing, and then build, deliver and stabilize the building or development.
For a project to move from concept to completion it must first meet the Internal Rate of Return IRR) or hurdle rate, also known as the Minimum Acceptable Rate of Return (MARR). Developers and investors maintain various thresholds for the definition of an acceptable IRR, but the return of the project must ultimately be commensurate with the risk undertaken to complete it. Variables associated with construction and market risks also factor into the equation. There are several methods to increase a project’s return in order to reach a desired hurdle rate, some of which are outside of the developer’s direct control. Major inputs that significantly impact returns include the cost of equity and debt, hard and soft construction costs, absorption and rent growth.
The rising costs of debt and equity
The cost of debt and equity have increased considerably over the past two years. Most construction loans are tied to a spread above and beyond an index such as LIBOR or SOFR. According to the New York Fed, the cost of borrowing has increased dramatically, particularly over the past six weeks. SOFR was trading at .05 as of March 1 and as of May 6 it was trading at .73, representing a 1460% increase over that nine-week period.
Construction costs have also increased over the past 24 months. Figures have not been released for the first quarter of 2022, but according to the Turner Building Cost Index, Q4 2021 construction costs rose 1.91% from the previous quarter and costs were up a total of 5.04% from Q4 2020 to Q4 2021.
Rent growth and absorption are heavily asset class dependent, with multifamily, self-storage and industrial posting strong outcomes. According to Paul Fiorilla, author of the latest Yardi Matrix Survey, “the recent rent growth acceleration [within multifamily] is unprecedented.” The average national asking rent for multifamily has reached another new high, eclipsing $1600, representing a 13.9% increase, year over year.
Self-storage is among the strongest-performing asset classes. According to Cushman & Wakefield Storage Data Services, asking self-storage rental rates and rental income were up more than 20% nationwide, with less than 1% decrease in physical occupancy. This strength mirrors the nationwide health of the multifamily sector, which has been a high-flying performer throughout the healthcare crisis.
The commercial office and retail sectors have taken their lumps. According to JLL, overall total national vacancy in office is hovering around 20%. With regards to retail, JLL sites major market vacancy at 4.6% with Malls leading at 8.3%. Smaller market vacancy like Baltimore hovers around 6.4%, a slight decrease over the previous quarter, with decreases in absorption and rental rates according to MacKenzie Commercial Real Estate Services.
With the cost of equity, debt and construction costs consistently increasing, and fickle rents and absorption, how can developers reach their hurdle rates and move forward with projects?
Effectively lowering the weight of capital presents viable solution
The cost of borrowing is one factor that owners and investors have in their control, and reducing the weighted average cost of capital has proved to be a successful strategy for achieving an acceptable IRR. The Commercial Property Assessed Clean Energy product (CPACE), typically used to finance a real estate projects energy and water-related improvements, is one financing mechanism that can be utilized. New construction and gut rehabs are strong candidates for this product as it is fixed rate, long term, non-dilutive and non-recourse, with rates routinely under 6% on a 20- to 25-year term and amortization.
CPACE financing is asset class agnostic and can be used for ground up projects, including senior living, self-storage, multifamily, commercial office, and even a performance venue and a day care. CPACE can also be used in repositioning a department store to multifamily, repositioning a printing company to self-storage, and gut rehabbing an office building.
The CPACE program is available in more than 30 states. Budgetary items for energy and water-related improvements include, but are not limited to, HVAC, lighting, roofing and building envelope that are designed above and beyond base building code are considered qualified expenses.
The CPACE program starts with state-level government policy that classifies the clean energy upgrades as a public benefit similar to a new sewer, water line, or road. The CPACE is repaid as a benefit assessment on the property tax bill over a term that matches the useful life of improvements and/or new construction infrastructure (typically 20 to 25 years). The assessment transfers on the sale of the property and can be passed through to tenants where appropriate.
CPACE loans can typically finance 20%-30% of the capital stack, with financing terms including sub 6% fixed rate, long term, non-recourse, and non-dilutive on a 20- to 30-year term and amortization. CPACE financing will be accretive to the deal for developers and owners using preferred equity and/or mezzanine financing.
Potential challenges in executing a CPACE transaction
There are three possible obstacles in a CPACE transaction: financial sizing, the energy technical review, and first mortgage lender consent. Like most transactions, the key to success is assembling a strong team. A project developer with a good understanding of CPACE can help companies maneuver through the financial sizing and energy technical review internally.A thorough understanding of the applicable building code will ensure that the project is designed properly and passes the technical review threshold.
It is critical to educate the first mortgage lender about the use of a CPACE loan. The lender will need to sign a document consenting to the CPACE, so it is important to head off problems prior to reaching the finish line to avoid any financing collapse. To date, nearly 300 first mortgage lenders have consented to CPACE transactions.
Developer constructing five-story, all heavy wood timber building uses CPACE financing
28 Walker Development Group, which is constructing 40TEN, the first commercial office building in Baltimore to exclusively use heavy wood timber materials, chose CPACE financing to reduce their weighted average cost of capital. 40TEN, a 125,000 square foot Class “A” building which is expected to deliver this year, is using a CPACE loan in addition to a $28 million construction loan sourced by ColumbiaNational Real Estate Finance.
“This represented our first use of a CPACE loan, and following a thorough analysis of the process, we determined the funding mechanism would be a highly-beneficiary component of the 40TEN capital stack,” explained Scott Slosson, Chief Operating Officer for 28 Walker Development. “The funds will be applied to sections of the building envelope that contribute to its energy efficiency, such as the windows, façade assembly and exterior skin. A portion will also be used for specialty HVAC systems engineered to improve air quality and stimulate outdoor air flow.”
Headquartered in Baltimore, MD Energy Advisors is a customer-centric energy management, marketing, and efficiency firm providing energy solutions to utilities, private companies and residential clients. The company identifies opportunities to reduce energy-related operating expenses, offers strategies that improve environmental impact and provides financial vehicles to help implement these strategies. For additional information, call 410-777-8144 or visit www.mdenergyadvisors.com