By Jason Schwartzberg, President of MD Energy Advisors
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 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.
Rising costs of debt, equity
The costs 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 Federal Reserve, the cost of borrowing has increased dramatically, particularly over the past six weeks. SOFR was trading at 0.05 percent as of March 1 and as of May 6 it was trading at 0.73 percent, representing a 1,460 percent increase over that nine-week period.
Construction costs have also increased in the past 24 months. According to the U.S. Bureau of Labor Statistics, the Producer Price Index (PPI) for construction materials has risen nearly 18 percent year-over-year from April 2021 to April 2022. Even more dramatic is the 46.9 percent hike between April 2020 to April 2022.
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 $1,600, representing a 13.9 percent increase year-over-year.
Self-storage is among the strongest-performing asset classes. According to Cushman & Wakefield’s latest Storage Data Services report, asking self-storage rental rates were up 20.2 percent nationwide year-over-year from first-quarter 2021 to first-quarter 2022. Rental income is up 15.4 percent in that same period, and the sector has seen a 3 percent decrease in occupancy. This strength mirrors the nationwide health of the multifamily sector, which has been a high-flying performer throughout the public health crisis.
The commercial office and retail sectors have taken their lumps. According to JLL, overall total national vacancy in office is hovering around 20 percent. With regards to retail, JLL cites major market vacancy at 4.6 percent with malls leading at 8.3 percent. Smaller market vacancy like Baltimore hovers around 6.4 percent, 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?
CPACE a tool to lower the weight of capital
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 project’s 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 percent on a 20- to 25-year term and amortization schedule.
CPACE financing is asset class agnostic and can be used for ground-up projects, including seniors housing, self-storage, multifamily, office or even a performance venue or daycare. CPACE can also be used in repositioning a department store to multifamily, repositioning a printing company to self-storage or 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 to 30 percent of the capital stack, with financing terms including a fixed interest rate below 6 percent. CPACE financing will be accretive to the deal for developers and owners using preferred equity and/or mezzanine financing.
Potential challenges for CPACE transactions
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.
Case study for 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 its weighted average cost of capital. The 125,000-square-foot, Class A building is expected to deliver this year. 28 Walker is financing the project using a CPACE loan to supplement a $28 million construction loan from Columbia National 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,” said 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