Three Major Points of Distress During the Development Cycle

Today, we explore three major points of distress that developers are encountering during the development cycle today. Before delving into these pain points, it's important to understand the current market dynamics that make development so challenging today.

Current Market Background: Why Development is So Challenging Today

Economic Disruptions:

• The economy has been marked by significant disruptions in recent years. The increase in the money supply during the pandemic led to higher inflation rates, with the Consumer Price Index (CPI) reaching 9.1%, far above the target of 2%. This inflationary pressure has contributed to higher costs across the board.

Interest Rates:

• The Federal Reserve has responded to inflation by increasing interest rates, with the federal funds rate currently at 5.25%-5.50%. These elevated rates have a direct impact on borrowing costs for developers, making financing more expensive and harder to secure.

Supply Chain Issues and Material Costs:

• Ongoing supply chain disruptions have led to increased costs and delays in obtaining materials. This affects construction timelines and budgets, compounding the financial pressures on development projects. In fact, material prices have increased nearly 47% in the last 5 years alone.

Labor Shortages:

• The construction industry faces a significant labor shortage, driving up wages and making it difficult to find skilled workers. This further exacerbates the challenges in keeping projects on time and within budget.

Regulatory Environment:

• Stricter regulations and zoning laws add another layer of complexity and cost to development projects. Navigating these regulatory hurdles requires additional time and resources, impacting project feasibility.

Three Major Points of Distress During the Development Cycle

Understanding the current market context is crucial for understanding the specific pain points developers face. Let's now explore these three major points of distress in detail.

1. Distress When Shovel Ready (Ready to issue permits): Navigating Financial Strains Pre-Construction

Current Challenges: The landscape for construction financing has drastically changed compared to a few years ago. Previously, developers benefited from lower construction costs, lower cap rates, lower interest rates, and higher loan proceeds. Capital was more readily available, making the development process smoother. However, the current scenario is starkly different.

Today's Reality:

• Underwriting Upside Down: Traditional lenders have significantly reduced their participation in the market. The few remaining banks offer substantially lower loan proceeds, typically between 40-60% of the total cost, forcing developers to increase their equity contributions.

• Increased Financial Burden:

  • Carry Costs: Developers who have taken on high-leverage land loans are now facing significant ongoing expenses without the ability to recapitalize. This situation strains their financial resources and impacts project feasibility.

  • Equity Strain: The necessity for more out-of-pocket equity places a heavier financial load on developers, making it challenging to maintain profitability.

Choices at a Crossroads:

• Sell at a Loss: In some cases, selling the property at a loss may be necessary to cut financial losses and free up resources for other projects.

• Bear the Carry Costs: Continuing to pay ongoing expenses in the hope of a market turnaround or finding a viable exit strategy.

• Bank Financing: Opting for lower loan proceeds from banks, which requires additional equity injections and dilutes potential returns.

• Private Lending: Private loans offer higher proceeds but come with steep costs (11%+ interest rates) and often demand personal guarantees, increasing the risk for developers.

2. Distress During Construction: The Challenge of Rising Costs and Depleted Reserves

Rate Increases:

• Over the past 24 months, adjustable rates common in many construction loans have more than doubled. This unprecedented rise has significantly increased the financial burden on development projects, rapidly depleting interest reserves.

Budget Overruns:

• Budget overruns are not uncommon in construction projects. However, the added pressure of rising interest rates has made these overruns more perilous, requiring developers to allocate additional funds unexpectedly.

Capital Injection Necessity:

• Developers with access to substantial resources or additional equity have the option to inject more capital into their projects to keep them on track. Yet, this is not a viable option for everyone, leaving many projects vulnerable.

Critical Juncture:

• Sale Under Pressure: With financial resources strained, selling the project at a loss in the middle of construction becomes a real consideration to avoid further financial bleed.

• Seeking Partnerships: Bringing in a partner or securing additional equity investment might offer a lifeline to complete the project. This option requires diluting ownership but can provide the necessary funds to move forward.

• Refinancing Challenges: Refinancing in the current economic climate is fraught with difficulties. The likelihood of securing favorable terms during construction is low, and the process can exacerbate the financial strain on the project.

3. Distress When Refinancing the Construction Loan: The Dilemma of Cash-In Refinancing

Refinancing Challenges:

• Transitioning from construction to permanent financing is increasingly challenging. The expected proceeds from take-out financing often fall short of what's needed to repay the construction loan due to stringent Debt Service Coverage Ratio (DSCR) requirements.

Cash Injection Requirement:

• This shortfall necessitates an additional cash injection into the project. However, securing this additional capital is not always feasible for developers, especially those without readily available financial reserves or access to further equity.

Critical Decisions:

• Asset Sale: Selling the completed asset might provide the necessary funds to cover the construction loan and associated costs. However, this option might not always align with the developer's long-term investment strategy or expected returns.

• Higher Leverage Loans: Opting for a take-out loan with higher leverage can fill the financing gap but comes at a cost. These loans often carry higher interest rates or more onerous terms, impacting the project's long-term financial health.

• Finding Additional Capital: Scrambling to secure the needed cash injection poses its own set of challenges, from diluting equity to negotiating under pressure, potentially compromising the project's profitability and the developer's leverage.

In conclusion, the development cycle is fraught with points of distress that can significantly impact the feasibility and profitability of real estate projects. By understanding these pain points and developing strategies to mitigate them, developers can better navigate the current market landscape and position themselves for success.

Reminder that we provide both land use consulting and construction services throughout the LA area. If you have a project that needs entitlements/expediting or a General Contractor, please reach out.