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Construction Costs Rise Up To 10%

Project Location: Los Angeles
May 19, 2017
Author: Kelsi Maree Borland - GlobeSt

Kevin Farrell

Developers have a lot to think about, but the rise in construction costs tops the list. In some situations, construction costs have increased 10% from land acquisition to ground breaking, and that can be a difficult to underwrite into a deal. We recently sat down with Kevin Farrell, COO of Century West Partners—the developer behind huge L.A. projects, like K2LA—to find out how construction costs, construction lending and the supply pipeline is affecting their business. Construction costs have risen rapidly. How are you able to underwrite projects with construction cost increases?

Farrell: Rents have gone up fast enough to cover the increase in the construction costs. It has been almost impossible to underwrite the increase that we have seen. Typically, when we take down a piece of land, we build in some escalation, maybe 3% per year, but some years, we have seen 10%. There have been some contract surprises where we are scrambling to fill the gap with debt or equity or some combination. It is certainly doable in the right markets, but admittedly, these deals have gotten a bit leaner and the yields are lower. So, you are talking about a different type of equity partner and a different type of lender that are a little more patient and hold a property for the five to eight year range so that they can take advantage of rent growth and build yield over time. Do you believe that construction costs will continue to rise?

Farrell: It is tricky. There is still a lot of pipeline coming. We are hopeful that construction cost increases will take a pause, and I think that mirrors a pause in the projects that are breaking ground. If the number of units that we deliver go up 10% or 15% a year, then you are never going to see a reduction in construction costs because they are really driven by a shortage of labor. I think that all of the easy sites to develop on have been built in this cycle, so I think that we are now getting to the tricky deals and sites, and those are tougher. I think for that reason we will see a reduction in the amount of pipeline, and that will translate directly to these subcontractors that have teams that they need to keep going. Right now the subcontractor pricing that we see reflects the fact that they have no capacity. Has it been difficult to get construction debt as a result of the development boom?

Farrell: A lot of lenders jumped into the apartment game, and now you are seeing a lot of supply. There is no way to get around it, and so they are a little more conservative in their underwriting as a result. Now, on deals where we were getting 67% to 68% of our costs on a construction loan are more like 55% to 60% of our costs, so you just need a little more equity to get the deal done. There are certainly lenders that are interested, but they are going to give you a little less. Rates have also moved a little, but it isn’t a big movement. Everything is a challenge because the sites are trickier and the costs have gone up, but it is all still doable. Do you believe that there will be enough demand to absorb the new supply?

Farrell: There is definitely going to be enough demand to absorb everything. When you get into a situation where there are multiple projects in the lease-up mode, especially when a lot of those projects are owned by REITs with pretty patient money, you get into a concessionary market. That is really what lenders are afraid of. You will see lease-up concessions for one month go to two months. That is where you see some softness in effective rents, but that is what you see when you have multiple projects in a one-mile radius area in lease-up. Some markets are already experiencing that and will experience it over the next year. There is plenty of demand in all of the good Los Angeles markets. What is your capital markets outlook for the remainder of the year?

Farrell: There is still a lot of money that wants to invest in real estate, really in all asset classes, especially apartments, office and well-located retail. We specialize in multifamily and mixed-use apartment projects in Chicago and Los Angeles, and we have a lot of lenders that are interested in investing in those markets. It might feel like so many people are interested is because it is really hard to find good deals now.

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