Leave aside the financing crisis for a moment and some real estate experts believe this could actually be an optimum time to launch a residential project.
While development has ground to a halt, costs are falling or anticipated to fall for many line items in a pro forma — land acquisition, construction materials and labor. At the same time, units on the market are expected to be slowly absorbed, leaving a dearth of apartments on the market in the coming years.
A residential developer brave enough to break ground might end up doing very well in 18 to 24 months, experts said.
“It can take two years to deliver a project, and that can be two economic cycles in normal times, so if you didn’t have the current capital constraint, this is when you should be looking at developing,” said Veronica Hackett, co-founder and managing partner of the Clarett Group, which has developed nine residential projects of 100,000 to 350,000 square feet in the past seven years.
Another boutique property developer, who asked not to be identified, agreed.
“Conceptually, it’s a great time to do something, so when the market turns around, you’re ready, as opposed to waiting till the market actually turns,” he said.
The trouble with this theory is that most developers point out that financing isn’t largely available. Even when it is, the terms under which it is offered — and the large amount of equity required on the part of the developer — have offset any gains that might be obtained through falling hard costs.
Though LIBOR and Treasury bill rates are at historic lows, banks are offering loans at spreads over indexes that are unprecedented: 400 or 500 basis points over the respective indexes, said Jeffrey Levine, the chairman of Douglaston Development.
“Banks are basically neutering these all-time low rates with these all-time high spreads,” he said.
Kenneth Horn, president of Alchemy Properties, agreed that while LIBOR has dropped, the spread has increased from where it has been the past few years.
“What LIBOR giveth, the spread taketh away,” he quipped.
Alchemy’s story
However, Horn said that a developer might end up reaping great value by being countercyclical. In fact, as of mid-December, Alchemy and its partner, Jamestown Properties, were in the process of bidding out a 95-unit mixed-use condominium development at 800 Tenth Avenue, he said.
“If you buy a piece of property today, [the project is] not going to be on the market for 30 months,” Horn said. “And who’s to say what could happen in 30 months? You would think the recession would be over, because if that weren’t the case, it would be a 40-month recession, which is almost unheard of.”
Horn said the developers closed on the bank loan for the $120 million deal in August.
The 150,000- to 160,000-square-foot building will be built at the site of the former Sony Studios, on 10th Avenue between 53rd and 54th streets.
“We’re in the ground,” Horn said as of mid-December. “We should be out of the ground in eight weeks, and finished by the third quarter of 2010.
“If we weren’t optimistic, we’d land-bank it,” he said. “But we’re optimistic.”
Even with increased spreads on loans and bank demands that developers put 40 to 45 percent equity into a deal, Horn said he believes now is the time to acquire land.
“It’s very hard now to make a development deal make sense, because you’re putting in 40 to 45 percent equity,” he said. “That being said, I do believe that now is the time to buy.
“People are saying, ‘Is the bottom hit?'” he continued. “No one’s ever going to know when the bottom’s hit. But when everyone universally believes the bottom has hit, that means it’s on its way up.”
Other real estate practitioners agree that now may be the time to develop. Adam Kushner, principal of Kushner Studios Architecture + Design, has been an architect-contractor for 25 years and has decided the time is ripe to enter the development field.
Looking at the costs and revenues of a pro forma tailored to the current market, “I still think it definitely pays to develop,” Kushner said. “But I can’t speak for the general market. We’re looking at very unique pieces.”
They include a parcel in Brooklyn.
“I think the going rate of a prime piece of Brooklyn property before was $150 to $200 a square foot developable, and this one is going to be like $85 to $90 a square foot developable,” Kushner said.
“That’s a really good deal, but perhaps it’s offset by the fact that unless we come to the table with cash, the savings will be squandered on the extra money we need to put down — instead of 20 percent, we may have to put down 40 percent,” he said.
In negotiations for another Brooklyn parcel, a 25-foot by 100-foot piece of land on Myrtle Avenue, the seller and Kushner have not seen eye to eye. When the seller was asking $960,000 about six months ago and wouldn’t go below $850,000, Kushner offered $750,000, tops.
Recently, the seller called Kushner willing to let the land go for $750,000, but now Kushner is offering $650,000. The seller, meanwhile, isn’t willing to go that low. “I said, ‘Okay, call me back,'” Kushner said. “Suddenly, the chasee has become the chaser.”
Like many other developers, Kushner is also pursuing some of the halted projects that are growing in number. While Horn was skeptical that those projects would remain bargains with so many developers chasing them, Kushner said he believes the number of abandoned projects is so large — and developers are being conservative enough — that prices aren’t going up wildly.
“I haven’t seen a lot of competition over sites, even these ones that seem to be super bargains, that are 50 percent-off sales,” he said.
“We’ve identified a couple of properties where they’ve been abandoned midstream, and it makes sense on many levels,” he added. “The returns will be good, if not equal to what they were during the highest and best boom. And, yes, we are looking at rentals as a fallback.”
The sideliners
For their part, other developers said they couldn’t be so certain about returns.
“To build a project with 50 percent equity, there’s a whole redefining of the pro forma that needs to take place,” said the boutique developer who asked not to be identified. “No one knows what the residential market is right now, because no one’s buying apartments.”
Though there is a strong historical precedent for being countercyclical and developing at the market’s bottom, “the counter-argument to that is that, depending on how deep the recession is, it’s going to take you a lot longer than two years to get out of it,” Hackett said. “And this is one of the deepest ones we’ve had.”
Eric Brody, principal of the Brody Group, another boutique developer, said he didn’t believe he’d break ground on a project, even if he had cash in his pocket.
“When it comes to the pro forma, a lot of your assumptions may be incorrect at this point, because the markets haven’t settled,” he said. “As developers, we speculate on a year or two out if it’s a major capital improvement or new construction, and most of your theories that have worked in the past are no longer applicable to take risk on such types of projects.”
Brody also pointed out that though land acquisition costs may be falling, even a 10 percent reduction is not enough to make rental apartments financially feasible.
However, before they lend, lenders are requiring that projects work as rentals.
One real estate lawyer who works for some of the city’s biggest developers, but who asked not to be identified, said he was reticent to recommend any developer launch a new residential project with condominium prices remaining unknown at the same time that rents are falling by as much as 20 percent.
“I’m optimistic, but no one knows what will happen in two years,” the lawyer said.
It is the first time in 15 years that the two market segments have experienced falling prices at the same time, making a serious dent in developers’ revenues, Levine said.
Cheaper materials …
However, partially offsetting those revenue losses are reductions on the hard-costs side.
“Steel is coming down,” said one Brooklyn developer who also does some construction. “There’s no doubt about it — there’s an oversupply. Same with odd lots of materials.”
Levine, who also does his own construction, said he has seen the price of some construction materials fall as well.
“Just like oil prices — copper prices, cement prices, gypsum prices and timber prices have fallen,” he said. “The lack of development throughout the country, and the global slowdown, have obviously caused a burst in the commodities bubble, and yes, there is some reflection of that.”
But in New York City, the cost of construction materials is typically dwarfed by the cost of labor, Levine said.
“New York City is a union town, and therefore, a high-cost labor town,” he said. “And the commodity prices are not as significant to our overall development costs as they would be in some other places.”
However, Levine said that for the first time in years, the trade unions “have become cognizant of the lack of financing, because jobs are not starting.
“As a result of that, the trade unions are happy to have discussions about work rules and possible wage and fringe concessions,” he said. “These are all on the table now.”
Kushner, the architect-contractor, said he hasn’t reduced his bids because he hasn’t yet seen construction materials come down much in price. However, he said he does have signed contracts to do work for a certain fee where clients are asking him to cut out certain items, ultimately reducing his fee.
“Even though my contract doesn’t allow that, because everything is interrelated, I’m finding myself saying, ‘I don’t want to piss off the client,’ and [I’m] reducing the scopes of my jobs,” he said.
… Higher taxes
On the other side, most developers agreed there would be few reductions in soft costs, such as professional fees, marketing, and real estate taxes and permit fees, among other costs.
“Insurance, I assure you, is not going down, especially on the development site,” Horn said. “If anything, it’s going up. And Mayor Bloomberg’s most likely going to raise taxes, so your soft-cost line items are most likely going to remain consistent.”
Levine agreed that real estate taxes will likely be increased, and added that marketing costs may also grow. “When the market is tough, you almost have to spend more on marketing in order to secure your share,” he said.
Levine also said he believes that architects and engineers are indirectly lowering their fees.
“Architects and engineers are, for the first time in my recollection, willing to provide preliminary services on projects without compensation just to keep themselves busy until these projects come on board,” he said.
Brody, whose father is an architect in Brooklyn, said architects are more likely to contract their offices than lower fees. Kushner, the architect-contractor, said he hasn’t lowered his architectural fees, but he is casting a wider net for projects.
“I’m looking at projects I wouldn’t have pursued before,” he said. “They’re not glamorous; they’re the meat and potatoes.”