“Why don’t we just build in other cities?”: Developers still sour on LA

LaTerra Development has been building, selling and buying apartment complexes in the city of Los Angeles for the past 15 years. But last year, the firm decided it was not planning to sell any assets in the city and was slowing down development, according to Chris Tourtellotte, who heads the effort at LaTerra.

LaTerra is not alone.

Since Covid, real estate players in California have had their fair share of obstacles. At minimum — the fastest rate of interest rate increases since the 1980s, homelessness in L.A. and San Francisco, companies shrinking their footprints in light of layoffs and remote work.

But when it comes to L.A. specifically, multifamily developers are having to jump through new legislative hoops. Measure ULA, the city’s new transfer taxes that came into effect last April, has become so reviled by the industry it even became a villain on a reality TV show.

“It’s causing us to look outside the city of LA for development projects,” Tourtellotte said of Measure ULA. Selling, he said, would trigger hefty taxes — 4 percent on all residential and commercial sales over $5 million and a 5.5 percent tax on sales over $10 million.

These headwinds have led to an overall low volume of  transactions and have added to developers’ apprehensiveness and ‘wait and see’ approach when it comes to investing in L.A. 

“We are seeing our way through a period of volatility that was really hard for our industry to transact in,” said Damian Gancman, the chief operating officer at multifamily developer Cityview, adding that little activity happened in 2020, late 2022 and last year. 

But, with the Federal Reserve expecting to cut rates this year, real estate financiers and developers who spoke with The Real Deal remain optimistic about the market’s long-term prospects and are seeking out pockets of immediate opportunities outside of L.A.

“Now we are seeing a clear path forward: It’ll be better in ‘24, than in ‘23,” Gancman said. 

Getting creative

Only a handful of new financing deals for multifamily projects have closed since the start of the year. Compare that to the regulation-light Miami, where more than $1.2 billion in construction loans have closed over the last couple of months and another $1 billion is expected to close early this year.

Deals that are closing are often rescue deals — cash that helps builders get through the finish line on a project, according to Shlomi Ronen, founder of L.A.-based lender Dekel Capital. He projected that we’ll see more demand for subordinate capital, as loans have become pricier.

Earlier this month, for example, Calmwater Capital provided a $32.3 million loan to GE Property Development to finish construction on a 81-unit project in San Gabriel. Subordinate lender BH Properties tacked on a $3.75 mezzanine loan, too.

Generally across Southern California, with many lenders on the sidelines, developers are using any financing tools possible to get a project finished. 

In nearby Orange County, to supplement a $17 million senior loan from Builders Capital, Nuveen gave a $9.8 million Commercial Property Assessed Clean Energy (C-PACE loan) to Newport Beach-based Westerre to finance an apartment project in Dana Point.

A C-PACE loan gave the borrower the “lowest possible cost of capital,” cheaper than a traditional construction loan, Tyler Beauregard at Concord Summit Capital, who arranged the deal’s financing, said in a statement. 

These two deals are indicative of the type of transactions we may see more of this year both in L.A. and other markets, according to industry insiders.

“Near-term acquisitions will likely be in existing assets as opposed to development assets, because you’re buying 30 percent below the replacement costs,” Gancman said, noting overall costs haven’t come down yet.

The Fed indicated in late 2023 that multiple interest rate cuts are likely this year, which has given a boost of optimism for developers — even if its effects lag into the second half of this year or next. Some are also hopeful that Measure ULA will be shot down by voters in November 2024.

Until then, Measure ULA is still impacting developers’ thinking and planning.

“This tax is making it very difficult to make deals in Los Angeles, and it’s causing the perception of increased risk,” Tourtellotte noted. “Investors, they’re looking at the City of L.A. and they’re saying, ‘Well, why don’t we just build in other cities?’” 

Waiting game

Nobody is under the impression that the challenges Los Angeles and, more broadly California, will be solved overnight. The high costs of construction are likely to continue and securing financing on favorable terms may take a while.

“We continue to see people and companies moving out of state, that’s a challenge, and it’s going to remain to be a challenge in terms of continuing to create demand for the product that we’re building,” Dekel Capital’s Ronen said. 

The size of the loan and the terms also matter, given the type of lenders that are active in the market right now: Debt funds or lenders that are not as regulated.

“The lenders that are active in the market today are higher-cost, more structured lenders, so it’s not the lender you would choose first,” Gancman said. “You have to seriously sit and question whether you move forward with that project.”

Gancman said he was speaking with a lender recently that is capping loans at 45 percent leverage, where previously loans were made up to 80 percent of what it cost to build. This means developers have to find more equity — whether it’s investor cash or more expensive financing, like a mezzanine loan or preferred equity.

But using 55 percent equity in deals is “not the most efficient way,” Gancman said, “And not the way we underwrite things, but that’s the way deals are moving forward today.”

Tourtellotte said other areas around the city of L.A.’s border were “appealing,” given the transfer tax doesn’t apply. Take Burbank in the San Fernando Valley, he said, which has the highest jobs to housing ratio in the country.

Even if their game plan for 2024 is staying on the sidelines, many remain optimistic and understand deals don’t look like what they did in the past. 

“I’m not looking at the traditional market-rate deals right now, they just do not make sense, the construction costs are just too damn high,” said Paul Schon, who runs development firm Schon Tepler Partners.

“But ED 1 with all the subsidies does make sense, so I think some of those will get financed,” Schon said, referring to L.A. Mayor Karen Bass’ executive order known as Executive Directive 1. The directive aims to streamline the approval process for affordable housing by allowing projects to skirt lengthy environmental reviews.

The measure, however, has not yet shown it can do what was intended, as some developers are still facing roadblocks, according to reports.

For now, a lack of housing inventory, prohibitive policies and an uncertain economic environment have stymied development. 

“I’m still a believer in cities as the engines of the economy and cities as drivers,” Gancman said. “But I do think it’s going to be different than it was the last 15 years.”