The latest action by the Fed pushed interest rates to their highest level since 2001 and put increased pressure on multifamily investors and developers already dealing with a tight lending environment.
But despite the tightening monetary policy, experienced real estate players are still able to close deals and get projects off of the ground. How exactly? By developing high-demand assets in strong growth markets, according to RREAF Holdings Chairman & CEO Kip Sowden. The Dallas-based firm has been active across the U.S. for 35 years, focusing on workforce multifamily and hospitality. Today, RREAF has roughly $4.5 billion in assets under management across its seven verticals.
In the interview below, Sowden expands on how RREAF has kept busy, undeterred by the challenging lending environment.
How have lenders and borrowers responded to the latest interest rate hikes, and how are the restrictive credit conditions impacting your projects?
Sowden: With the latest interest rate hikes, transactions become more difficult to execute. Lenders are still making loans, but the underwriting parameters have gotten tighter and the loans far more conservative. Many community and regional banks are requiring the borrowers to have a large depository relationship with them as they work through the loan process.
Community and regional banks have recently been very selective about who they will give loans to. They will choose the top-tier developers/sponsors—those with a proven track record and years of experience in the asset class. Fortunately, RREAF Holdings falls into this category. We are currently developing over $700 million of real estate projects between multifamily and hospitality.
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Because of debt and equity contraction in the market, those that are still active require a much higher yield to transaction. Transaction volume is significantly less today than it was a year ago. If an owner is not forced to sell, it is unlikely that they will sell in this environment.
RREAF Holdings is an active buyer in this market, but not a seller. Most owners are not prepared to sell at a price that buyers will buy today. Cap rates need to exceed interest rates to bring buyers back into the market. RREAF is less affected by the increases in interest rates as most of our multifamily portfolio enjoys long-term, low interest rate fixed loans in an inflationary environment that bodes well for our cash flow and, consequently, our investors.
How are higher interest rates impacting development, specifically?
Sowden: For ground-up development projects, many developers use traditional floating-rate bank debt to finance their projects. The two biggest changes are the cost of that debt and the amount—percent of project cost—that is being underwritten. Instead of 75 to 80 percent construction loans that were achievable just a year ago, we are seeing 60 to 65 percent max loans today. This requires additional equity, which is a more costly part of the overall capital stack.
The cost of ground-up development projects increased by 40 to 50 percent, with carry cost and overall construction material cost making up most of the increases. We are still active in the space as our primary development projects are in asset classes where demand far exceeds supply—multifamily and drive-to-leisure hospitality—in very strong growth markets.
Texas, Florida and several other states in the South and Southeast region of the U.S. are experiencing a massive migration. More and more people and companies are moving to Texas, Florida, and the more business-friendly environments of these regions. As a result, demand continues to exceed supply, creating economics that can still work for ground-up development for these asset classes.
How are RREAF’s verticals currently deployed, and there any areas where you expect to see a better outcome than others?
Sowden: RREAF is active in five main verticals that we believe to be recession-resilient. Our main verticals are: acquiring existing garden-style multifamily in the South and Southeast, as well as student housing located near Power Five schools and Tier 1 research institutions; acquiring beachfront hospitality/resorts and developing extended-stay hotels; ground-up development and construction services; master-planned communities and luxury RV Parks, our newest vertical.
With the demand for downsizing homes and the perks of RV parks, there’s plenty to invest in this area to meet the growing demand in this space.
We expect all five of our verticals to experience growth in 2023 and 2024. With our focus on affordable housing and affordable hospitality in a region of the country experiencing growth, we should fare well through these economic headwinds.
Are there any types of financing options or loan structures that might be more advantageous for entities like RREAF, given the tight lending environment?
Sowden: RREAF will continue to partner with its long-term lenders and equity partners to promote growth. We believe we will see more private debt coming into the market to fill the void left by traditional banking lenders, albeit at a higher cost. It is critical now, more than ever, that sponsors and developers pay close attention to location, cost basis and asset class as they look to borrow. Margins are tighter today, meaning a developer or sponsor must be more exacting in the underwriting.
To what extent have recent events such as First Republic Bank’s acquisition by JP Morgan influenced the lending environment?
Sowden: It just adds to the overall cost of debt as more and more lenders tighten their lending criteria. We believe we will see more and more banks selling off a percentage of their loan portfolios secured by real estate to reduce the perceived risk. Social media and the general population’s misunderstanding of information conveyed over the internet and by mainstream media can create unwarranted pressure on lending institutions thereby creating a problem that otherwise would not exist.
