For more than a year, commercial real estate developers and owners have been struggling to manage the rising costs of development projects. In fact, some find themselves scrambling to raise capital to complete projects as interest rates and construction costs continue to increase.
Trey Korhn and Vince Chillura of Valley Bank see this reality firsthand every day. Korhn and Chillura, based in Tampa, co-manage the commercial real estate lending division for Valley Bank’s operations in the Southeast, helping developers and owners navigate a constantly changing financial landscape.
Valley Bank has been involved in financing for a number of high-profile development projects in west-central Florida, such as the Epicurean Hotel in Tampa, the Ace Hardware distribution center in Lakeland, the Midtown Lofts office project, the Armature Works mixed-use facility, and the Gasworx project in Tampa.
GlobeSt.com talked to Korhn and Chillura to get their insight on what developers and owners need to know to keep their projects moving forward profitably.
Q: Developers and owners are facing the compound problem of rising costs and higher interest rates. What’s the best way for them to navigate this?
Korhn: Most lenders underwrite and size projects based on the level of senior debt that the project’s cash flow can adequately support. However, rising interest rates are pushing down this level of debt and when compounded with rising construction costs, increase the overall cost of the project. This can lead to a project requiring additional equity.
When capitalizing a project, developers should think ahead about how they will bridge that lending gap. Alternatives may include supplying additional common equity, identifying a reliable preferred equity source, or partnering with a reputable mezzanine lender.
Q: How much do rates differ from lender to lender?
Korhn: The market is relatively efficient, and rates are somewhat of a commodity. Like fuel prices, you may see the equivalent of a penny or two difference between vendors but not a dollar. These interest rate differences can often depend on factors such as the loan size, asset class, credit risk profile, and overall banking relationship with the client.
Q: How should a developer pick a lender, then?
Chillura: While specific terms are important, being able to have trust in your lender and their track record is just as critical. A bad capital source can create challenges for borrowers and investors.
First and foremost, it’s crucial to deeply know your bank or senior lender to understand their process and make sure they are both experienced and reasonable, especially in development financing.
The impacts of a lender’s experience in completing construction loans are key factors in whether a project gets completed on time. A lender that understands and can execute on each phase in a practical and timely manner can make a dramatic difference in the project outcome.
Q: Are you seeing developers being able to reduce costs to help make deals work?
Korhn: We have seen some developers successfully negotiate reductions in the price of the land, mainly when there are material changes in construction costs from initial budgeting to receipt of formal bids. Many land sellers find that negotiating a lower price can be more beneficial than starting the process over with a new buyer.
Other options to control or reduce costs include the use of value engineering throughout the design phase, or even reducing the scope or finish of projects. For pre-leased projects we have also seen developers try to pass on cost increases over a certain threshold to the tenants.
Q: Counting on refinancing in the future seems risky, but are there some cases where this strategy could help?
Chillura: Counting on refinancing is certainly a risky strategy. However, we have seen some developers borrow short-term money at the current higher rates with the expectation that they will get better rates in the future when rates decrease. The key is that the borrower must be comfortable owning and servicing the debt while they wait for capital costs to ease.
Trends suggest that rates should ultimately decline, and savvy investors can pursue different hedging strategies that may help mitigate some of the volatility. It’s important to get educated and ensure that your capital partners can come up with mitigating solutions as things change.
Q: How best can developers improve project efficiencies to combat rising costs?
Korhn: Executing well in the planning stage can help reduce costs. There is more focus today on value engineering and design throughout the process. Something as simple as communicating the need for lower-cost finishes with a designer on the front end may make a material impact. Involving the general contractor in the design phase to work directly with the architect and engineer can also help keep costs down.
Also, buying out subcontracts early and planning in advance for the purchase of larger-ticket items like concrete, steel, and equipment can shield a developer from market-price volatility and increased costs.
Q: Are there other strategies for owners and developers to cope with rising costs?
Chillura: Despite the expectation that costs should settle, we have not seen a large impact yet and it’s still a somewhat challenging environment. With net leases, we’ve seen some larger developers pass on the higher development costs to tenants through contingency plans in agreements. For example, a retail tenant might sign on to pay a certain amount per square foot for a location; however, they know that if costs of the project escalate, they will be responsible for or share in some of the overages. In certain cases, tenants may accept this, so it’s likely to continue being a point of emphasis for developers.