Colorado Real Estate Journal - March 18, 2015
For the past two years, we have all heard the concerns about the massive multifamily development pipeline and the tidal wave of new units coming on line in Denver. It is no doubt eye opening to see approximately 20,000 new for-rent units scheduled to hit the market. What’s even more eye-opening are the 7,071 units absorbed in 2014 accompanied by the 12 percent effective rent growth in the midst of this huge pipeline. This fundamental growth is a trend that has raised headlines and opened eyes for the past four years and has drawn a tremendous amount of capital to Denver during that time. 2014 was an extremely strong year for Denver multifamily, but how did we get here? -What started it? Simply put, pent-up demand and jobs. From 2004 to 2012, we delivered 18,817 units, or 2,091 units per year, to the Denver metro area. Absorption outpaced deliveries most years during that time period, leading to the significant pent-up demand from huge population growth and in-migration. To put it into perspective, our population in the Denver metro area has increased by approximately 240,000 people since 2010. Taking a conservative 10:1 ratio, that’s 24,000 new renters to the market in the past five years. You also cannot ignore the job growth story. Denver and Colorado have made a dramatic shift from an oil and gas cow town to a highly diversified economy, where natural resources and mining was ranked No. 6 in job creation (7 percent) last year. Shockingly, construction was No. 1 (23 percent). Denver’s main industries that led us out of the recession and into the hearts of investors across the globe are aerospace, aviation, bioscience, broadcasting and telecom, energy, financial services, health care and wellness, and information technology and software. This highly diversified new Denver has led us to a No. 2 ranking across the country for employment growth (unemployment sits at 3.9 percent today) and more than 159,000 jobs added since 2010. Taking a conservative 5:1 ratio, that’s 31,800 units of pent-up demand directly correlated to jobs. The combination of pent-up demand from jobs and population growth led us to well over 10,000 units of unmet demand since 2010. Five straight years of this unmet demand has directly resulted in 54.4 percent effective rent growth and the historically low market vacancy of 4.1 percent. -Who funded it? Because of these dynamics, Denver has become a shining star across the country and has drawn significant liquidity to our market from a wide variety of capital sources. Banks captured the majority of construction loans for the pipeline with nonrecourse (no repayment guaranty) options tapping out at around 65 percent loan to cost. With a repayment guaranty, banks were providing construction financing up to 75 percent of cost. For longer-term holders, life insurance companies have been providing construction-permanent loans with loan terms of 10 to 30 years. Most of these life company structures provided the ability for the developer to upsize his loan at stabilization and allow for multiple loan assumptions. Alternative full capital stack and participating loan options falling between 80 and 90 percent of cost also have been utilized to capitalize some of these developments, and have been a creative way to bridge the equity gap. On the equity front, life insurance companies and pension fund advisers have been the largest source of capital for this robust pipeline, many of which have signed on for multiple deals in the market with the same or different developers. Those co-invest structures are typically between 85 and 95 percent of the total equity stack with varying preferred returns and waterfall promotes. Other traditional equity investors in the market are fund investors, hedge funds, high-net-worth investors, along with foreign capital. Co-invest structures and return thresholds also vary for those investor types, but are generally in line with the life companies/pension fund advisers with a slight uptick in return needs. The other option prevalent in the market is mezzanine and preferred equity structures. These structures will capitalize 85 to 95 percent of the total capital stack or cost in the deal and have a return threshold of 12 to 16 percent, which mostly accrues on development deals given the lack of current cash flow. This has been a great alternative that allows the developer to capture the majority of the upside in a deal. -Where we are today and where are we going? The market continues to perform extremely well despite the 15,406 units that have delivered since 2013. Thankfully, the construction delays that have plagued our market have helped stagger the delivery schedule, providing more spacing and in turn helping absorption. We are not entirely out of the woods yet and still have significant units to deliver in 2015 and 2016. In fact, reports show the development pipeline continuing to flourish with another 20,000 units in various stages of planning. However, most of those deals will struggle to get capitalized given construction cost increases, the capital shift occurring in the market and fundamental real estate challenges associated with some of them. Fundamentals driving our market are still firing on all cylinders and capital remains very disciplined as they evaluate new opportunities in our market. Equity is highly selective and is focused on the best site available, best-in-class developers and strong fundamentals anchoring the deal. Equity is also starting to evaluate a longer-term hold strategy on new deals and deals that are approaching that stabilization point. On the construction loan front, there has been a capital shift tied to new banking regulations, exposure and construction pipeline perception. The biggest two shifts are the availability of nonrecourse (no repayment guaranty) and the cost of construction loans. Nonrecourse is still available for borrowers with strong balance sheets, but maximum loans-to-value have dropped to 60 percent or below for that structure. Spread/rates have also increased mostly due to the new liquidity requirements the regulations have put on the banks since the start of the year. Deals are certainly still getting done and, frankly, now would be a great time to start construction with the likely slowdown of deliveries past 2016.