Apartment developers are finding ways to pay for new construction projects–without using loans from traditional banks.
For years, multifamily developers have relied on large, short-term loans from banks to finance the construction of new apartment buildings. But rising interest rates and a string of banks failures—most prominently Silicon Valley Bank, Signature Bank and First Republic Bank—have thrown a shock to capital markets. Other banks are encumbered with existing real estate debt that they are concerned about—particularly on the beleaguered office sector. As a result, many local and regional banks simply are not originating new construction loans. And the loans that are in the market are much more conservative with higher interest rates and covering a lower loan-to-cost ratio than previous cycle norms.
However, other types of lenders have been willing to step in the breach allowing apartment developers to find new ways to finance development projects.
Developers who can afford to wait to close their financing are finding relatively large construction loans with relatively low, fixed interest rates from the programs of the Federal Housing Administration (FHA). Private debt funds and commercial mortgage REITs are also providing senior construction loans with generous amounts of leverage—though the interest rates they offer are relatively high, even compared to current bank financing.
Finally, some developers are making due with the small loans at high interest rates now offered by banks. They use mezzanine financing from lenders like debt funds to fill gaps in their capital stack.
“Though difficult, if you can secure the financing then it may actually turn out to be a good-to-great time,” said Carl Whitaker, economist for RealPage, based in Richardson, Texas.
Developers still building
Developers started construction on new multifamily projects at a seasonally-adjusted annual rate of 482,000 units, according to data from the U.S. Census and Department of Housing and Urban Development (HUD). That’s down from highs of more than 600,000 units in 2022. But it is still a lot of new construction compared to historical norms.
These developers may struggle to find financing now, but they might have relatively little competition for senior debt once they finally finish their new buildings, says Whitaker.
Many are starting their projects with relatively little help from banks. Prior to capital markets tightening, apartment developers came to rely on construction loans from banks that easily covered 75% of the cost of development with relatively low, floating-rate interest rates. They typically filled the rest of their capital stack with mezzanine loans, their own equity or equity from partners like private equity funds with end investors like family offices or high-net-worth individuals.
But with rising rates, the capital stack has evolved.
“Recent construction finance offers from banks have been 55% to 65% loan-to-cost, with a minimum debt service coverage of around 1.25x to 1.30x,” says Scott Thurman, head of FHA lending for CBRE.
Those debt-service-coverage requirement are especially difficult to meet as short-term interest rates continue to rise. Many banks now offer construction loans to apartment developments with rates that float 400 basis points over the Secured Overnight Financing Rate (SOFR), according to numerous experts interviewed for this story. That works out to all-in rates that now float at about 9%–a huge increase from just a year ago.
FHA provides fixed-rate construction loans
A growing number developers are closing construction loans provided by FHA programs.
“FHA construction financing is an attractive choice,” said CBRE’s Thurman. These loans are non-recourse and have a fixed rate that once a property is finished and has leased up, automatically converts to a 40-year, fully-amortizing permanent loan. FHA has also not tightened its credit or loan sizing parameters. “In fact, FHA just increased its large loan threshold from $75 to $120 million,” said Thurman.
Also, the fixed interest rates on FHA loans are based on the long-term yield on 10-year Treasury bonds, which were hovered around 4.0% in July.
“FHA financing offers developers a great opportunity to avoid the strain and uncertainty of high, short-term interest rates. Most construction loans provided by banks have interest rates that float over a benchmark like SOFR, which had floated all the way up to about 5.1 percent, as of July 10,” said Joe Averbook, managing director for Greystone, working in the firm’s offices in New York City.
The drawback is that FHA loans infamously take about 12 months to close. The time FHA loans took to close stretched even longer during the confusion of the COVID era, said Greystone’s Averbook.
At the end of 2022, Claret Communities received a firm commitment from FHA to provide a 221(d)(4) construction loan to build 210 new apartments at Noble Vines at Okatie Crossing, Claret’s development project in Hardeeville, S.C.
Claret, an apartment developer based in Chamblee, Ga., had already spent nearly a year working its way through FHA’s long process to approve a 221(d)(4) loan arranged by Greystone.
“There's a lot of hoops you got to jump through with FHA,” said Lee Terry, managing member of Claret Communities. “Most developers don't do FHA because it's just too much too much brain damage—but the benefits far outweigh that.”
Once a developer receives a firm commitment from FHA, the loan usually closes about 45 days later. During that period, the borrower can lock in the interest rate on the loan.
However, 2022 had not been a usual year. While underwriting officials at FHA had examined Claret’s plans for Noble Vines, the cost of construction growth, pushed to total cost to develop Noble Vines from $55 million up to about $60 million.
“The market was going crazy on us,” says Terry. However, the apartments rents in the market around Claret’s development site had also grown quickly–and that could help Noble Vines qualify for a larger loan. Claret asked FHA to increase the loan amount. “You have an option with HUD to reopen your underwriting even after you receive your firm commitment.”
FHA loans can technically be as large as 85% of the total cost of development, but that size is limited by how much income the property produces. That income must equal 1.18x more than the cost of the property’s loan payments.
When it finally closes, the FHA loan will probably provide about $43 million, according to Terry. That’s about 74% of the $60 million that it will cost Claret to develop Noble Vines.
“Compared to a conventional bank loan where you're putting up 50 percent equity, that's great,” says Terry. He expects Noble Vines to receive its firm commitment from FHA for this larger loan in 60 to 90 days. The loan should close another 45 days after that.
The interest rate of this loan is likely to be fixed at about 150 basis points over the yield on 10-year Treasury bonds, said Terry. That would work out to an all-in interest rate fixed at about 5.5% based on current Treasury yields. Terry hopes that the yield on Treasury bonds will drop over the next few months. So far in 2023, the benchmark yield has hovered between 3.3% and 4.0%.
Claret uses equity from limited partners such as wealth managers, family offices or high-net-worth individuals to finish the financing of its development projects. At Noble Vines, the limited partner is a family office, said Terry. These partners typically receive a preferred return of 7%, plus a 60% share of the profits from the completed development. That typically works out to an internal rate of return of 15% to 20%, he said.
Debt funds provide high-leverage loans a little faster
Private debt funds are another source of financing for developers frustrated with the difficulty of finding a bank loan.
“Banks, you know, are loaning less,” said John Hutchinson, Co-CEO and global head of origination for Trez Capital, working in the private debt fund manager’s Dallas offices.
In late 2022, Trez provided a $26 million construction loan to build 115 apartments in a new five-story building with a view of downtown Seattle and Elliot Bay. Construction started before the end of 2022, after a relatively fast underwriting process. Debt funds typically close their construction loans in 45 to 60 days. The developer declined to be named in this story.
The loan from Trez covers 74% of the $35 million total development cost of the planned mid-rise.
That’s much more than a conventional bank loan would provide. A typical regional bank loan to a project like this would probably cover about $20 million, or just 55% of the $35 million cost of construction, according to Yonah Sturmwind, manager of commercial lending specialty originations at Alliant Credit Union, based in Chicago.
He should know. As a credit union, Alliant is a federally insured depository institution–a bank. Sturmwind is also deeply familiar with the loan to the Seattle property. Alliant provided Trez with about $14 million of the capital for the loan in what Sturmwind calls a “note-on-note financing.” Alliant’s contribution allows it to invest of the Seattle property without originating a loan itself or even having to deal with the borrower.
Alliant’s contribution lowers the cost of capital for the loans, which made it possible for Trez to offer the developer of the Seattle property an interest rate that floats about 600 basis points over SOFR. That’s much higher than the cost of conventional back financing or FHA financing. But it’s relatively low for a loan from a debt fund, according to Sturmwind.
Trez made the loan to the Seattle property using capital from four of its funds: Trez Capital Prime Trust, Trez Capital US, Trez Capital Yield Trust and Trez Capital Yield Trust U.S. Investors in these trusts range from institutions to high-net-worth individuals and wealth managers.
Equity funds managed by Trez that invest in apartments target yields over 20% for their investors, said Hutchinson.
