The formula to finance real estate projects is in a vice as rising construction costs, inflation, higher interest rates and bank failures have headlined the complex economic landscape in recent years.
Real estate developers are having to find ways to adapt and close the gaps in financing in order to get their projects off the ground. However, not all projects will pencil out and the ones that do are taking longer to finance and are requiring more complicated financing packages.
Economic headwinds create perfect storm
To finance a project, developers typically get most of the money in the form of debt, usually from a traditional lender like a bank, and fill in the gaps with equity from investors and other capital streams.
Developers generally prefer to get as much of their development costs as possible covered by debt because it’s the cheapest to pay back.
Historically, multifamily housing developers, for instance, could secure upwards of 80% of their project costs this way, meaning only 20% of their costs needed to be covered by investors, which is more expensive as investors generally expect at least a 9% return, experts said. However, due to rapidly increasing construction costs and higher interest rates, banks are only covering around 60% or 65% of development costs, leaving a much larger gap for developers to fill.
“That extra equity is difficult to come up with, and oftentimes, even if developers have the ability to come up with it, they would choose not to because the returns they get on that amount of equity are just insufficient to take the risk associated with the project,” said Pat Lawton, senior vice president, commercial real estate regional manager at Racine-based Johnson Financial Group.
Further, following a few notable bank failures in 2023, lenders and their regulators are more concerned about liquidity and are being cautious about the amount of money they are willing to lend for any one project, according to Lawton, creating more of a financing gap.
Weathering the storm
There are ways to close the gap, but they are expensive, time-consuming and not sustainable in the long run, developers said.
For instance, apartment developer Mandel Group recently closed financing on two suburban Milwaukee projects: Caroline Heights, a 237-unit apartment complex in Elm Grove, and Norden Range, a 270-unit apartment complex in Oconomowoc.
For Norden Range, Mandel covered 60% of the project costs with traditional debt, but gathered it from three different banks, allowing each bank to contribute a smaller amount.
“That takes a lot of time and effort, and you’re asking friendly competitors to cooperate on a deal,” said Bob Monnat, senior partner at Mandel.
Norden Range also attracted a good amount of attention from investors due to the project’s high-end finishes and amenities, as well its attractive location in Oconomowoc, where city officials recently passed an updated housing ratio that will limit the amount of new multifamily housing that can be approved.
“That accrues to the benefit of the projects that are approved,” Monnat said.
For Caroline Heights, Mandel received tax incremental financing (TIF) from the Village of Elm Grove to help cover the costs of bringing a Lake Michigan water main in from Wauwatosa.
Leveraging government programs – like tax credits, loans and grants or TIF – is one solution, Lawton said, but it adds time to the development process and might require altering projects.
Another way developers are closing the gap is through mezzanine debt. Mezzanine debt typically has a higher interest rate, and developers typically want to refinance quickly once the property is stable.
Milwaukee-based New Land Enterprises used a mezzanine loan to finance its mass timber apartment tower, Ascent, in downtown Milwaukee. New Land refinanced Ascent in February with a new $98 million loan after the property had stabilized.
Coming out of the storm
While financing challenges are pervasive throughout the country and evident across all segments of real estate, some projects are coping better than others.
Multifamily and industrial projects are most likely to get financed over office, hospitality and retail projects currently, according to Lawton, though as demand softens in the industrial market, lenders’ appetite for speculative industrial projects has decreased as well.
Within multifamily, suburbs can fare better right now because suburban projects can often be built over phases, while urban projects are typically one and done.
“For phased projects, if leasing was good the first time and the market is good, you just build new buildings,” Lawton said. “While the moment you go in the ground on a high-rise project, you’re all in.”
With many expecting interest rate cuts on the horizon and construction costs plateauing, Lawton said he’s optimistic about where the market is heading.
“I think those will have a significant effect not just from the way the numbers work, but also psychologically,” he said.
However, developers say that with construction costs as elevated as they are and shifts in lending, there likely will not be a return to the easier project financing of a few years ago.
“With every property every year, you have to create a certain financial outcome that pays the debt, pays the investors, operates the property and hopefully there’s a little leftover for the developer,” Monnat said. “Each part of that is becoming tougher and tougher.”
