In this Spotlight, Michael Walden and Chris Hermreck of JE Dunn Capital Partners (JEDCP), discuss commercial development trends they are seeing in several markets. JEDCP is the real estate investment arm of JE Dunn Construction and to date, they have sourced over $1 billion of equity and debt in construction projects through developer partnerships and a strong lending network. They will also share their strategies to navigate the latest challenges of real estate lending.
“Trust is at the foundation of every successful construction project and having it already established within the area you are building, protects the project from potential schedule delays.”
“Despite the challenges in the market, the limited number of new developments may create upcoming opportunities for delivering new product into an under supplied market at the right time.”
Cap rate is short for capitalization rate. It’s used to evaluate risk, determine what kind of return on investment a property can provide, and provide insight into the type of market that you’re dealing with.
You can calculate the cap rate by dividing whatever net income an asset generates by the value of the asset. For example, an apartment building that brings in $600,000 in rent per year and has $200,000 worth of expenses per year has a cap rate of 8%. You would first subtract expenses from the $600,000 of gross income to get $400,000 in net income. You would then divide net income by the value of the asset, which is the current market price ($5M) in this case, to get a cap rate of 8%.
You can use cap rates to estimate your return on investment for a property. In our example, if we bought the apartment building for $5M, we could expect a return of 8% per year on that investment since the net income it generates is 8% of the purchase price. Another way to think about this is that it tells you how long it would take for you to recover what you paid. With an 8% rate, it would take 12.5 years to recoup your investment.
This of course is an extremely subjective question that would depend on the investor’s goals. The rule of thumb is that lower cap rates mean lower risk and higher prices while higher cap rates mean higher risk and lower prices. Depending on the asset, a cap rate of 5% or below would be considered low risk and 7% or above would be considered high risk. If an investor is looking for a deal on a piece of property, they would likely try to find it in the high cap rate ranges but if they wanted a safer investment, a low cap rate would be more appropriate. Most often we are working with clients/owners who are developers who will want to sell a completed project for a low cap rate.
The cap rate can reveal risk built into the market value (or sales price in our scenario). The market value for our apartment building was a little high at 8% when the price was $5M. What if the price were $10M? Then our cap rate goes down to 4%, something we would label as less risky. The price is higher in the second example and that’s where the risk is hidden. It could be because the apartment building is in a different area; maybe in the first scenario (priced at $5M) the area has a high crime rate, is in an out-of-the-way location, or the building is run-down. Whatever it is, something is driving the price down compared to the second scenario (priced at $10M) and that something can be thought of as the theoretical risk that isn’t always explicitly disclosed. Cap rates give you the ability to compare that non-numeric attribute quickly and easily.
The Federal Reserve continues to raise interest rates to tame inflation, hoping to reach the tipping point where the economy stops growing and starts to contract, thus tamping inflation. Their latest adjustment increased the federal funds rate to a range of 5.25% to 5.5%, which is the highest level in 22 years. Now that we’ve arrived at that point, it seems the headlines on lending and development are doom and gloom, but is that really the case?
The demand for rental housing has grown significantly in the past several years. This growth has been reflective of an increase in discretionary rental households or “rent-by-choice” households. People choosing to rent in lieu of home ownership cite flexibility to move and disinterest in home maintenance as the top reasons.
And it isn’t just younger, single Americans in urban areas making this choice. Young families, seniors, and the suburbs appear to be shifting away from traditional ownership. According to Harvard’s Joint Center for Housing Studies (JCHS), the number of renters making at least $75,000 annually jumped by 48% over the last decade ending just before the pandemic, to 11.3 million. With this increase, the share of renter households in this income group rose from 20% to 26%. These types of trends, in addition to an ongoing overall housing shortage in the U.S., are making multi-family a strong asset type for the foreseeable future.
We do not anticipate growth in the office market in the next few years. Most companies are still striving to strike a balance between physical office space, which can be crucial to a company’s culture, and employee demand for flexibility. The office sector’s traditional, long-term lease structures have allowed this extended experimental phase to play out. In any scenario, the future of work is likely to contain hybrid elements. Surveys indicate the average office employee will work in-person 3 to 3.5 days a week in the years ahead. As long as the labor market remains tight, employers will likely have to accommodate. Meanwhile, office vacancies are trending upward in many major cities and will likely continue to do so as more lease terms expire. This trend will continue to stress the office valuations and associated refinancing options. The full outcome of these stressed assets may not be fully realized for several years ahead and therefore office sector will be challenged for the foreseeable future.
This market is making a moderate comeback post-pandemic. Mid-week travel patterns have begun to show promising strides toward a more sustained recovery. High demand locations are recovering quickly, corporate travel spending continues to increase, and international travel is picking up as well.
Due to the increasing number of insured people following the introduction of the Affordable Care Act of 2010, as well as an aging population, the demand for medical services has continued to grow significantly and the shift to outpatient care has been concurrently increasing. Primary reasons for the shift to outpatient care include advances in technology, changes in reimbursements and consumer preferences.1 In-person visits currently account for 90% of all healthcare visits. Telehealth peaked at 52% during the Covid pandemic and quickly dissipated back to 10% today.
From 2016-21, the share of outpatient Medicare payments increased from 28.5% to 33.3%, with the greatest growth coming from surgery and dialysis. This type of patient care growth has also contributed to the demand for outpatient care. Spine, orthopedic, and vascular care are other areas of patient care experiencing substantial growth. Given these stats, medical office has been one of the most active asset types since interest rates have spiked. We foresee sustained sector growth for the immediate future.
Student housing rent growth and occupancy were at all-time highs in the Fall of 2022. While difficult to measure whether these trends are sustainable, the return to normal campus life appears to be steady for the near term. This property sector continues to see institutional capital flows as the largest Real Estate Investment Trusts (REITs) and asset managers enter the space.
The historic rapid increase in interest rates over the last 12 months has challenged the real estate investment markets. This trend has created a lot of uncertainty and therefore has been limiting the transaction volume in the commercial real estate markets. In addition to the interest rate disruption, many regional banks are dealing with additional scrutiny in the aftermath of the collapse of Silicon Valley Bank, Signature Bank, and First Republic Bank. Reuters notes “regional banks, the largest lenders to the beleaguered U.S. CRE and construction markets have reduced their exposure to the section by tightening standards and making fewer loans.” 2 With these headwinds, it has become more challenging to find lenders and equity groups that are willing to partner on projects given challenged investment returns.
With this being said, there has been a recent decline in new project starts after the U.S. has seen record amounts of supply for both multifamily and industrial projects. Slowing supply in 2025 may drive continued opportunity for developers to start new projects in the next three years. Investors are still “viewing multifamily as a safer place to park capital than other investment products or other commercial property classes such as office or retail.”3 In addition, “Multifamily investors are increasingly favoring markets that not only provide population and job growth but also have less political risk. Large coastal states have more areas subject to rent controls and are more likely to pass new laws that impact investors’ “bottom line.”
In this environment, it is critical to have trusted financial partners with history of successful execution. Despite the challenges in the market, the limited number of new developments may create upcoming opportunities for delivering new product into an under supplied market at the right time.
So what should investors look for when choosing whether to proceed with a new investment and deciding which assets offer attractive returns with minimal risk? There is no easy answer. However, establishing partnerships with trusted and experienced partners is the right first step.
Teaming with the right partners sets a strong foundation for collaboration, efficiency, and risk aversion. Projects setup the right way, will see less hiccups and more focus on the best interests of the project.
Second, utilizing a diversified and strong lending network can help protect you from large-scale turbulence outside of your control, perfectly exemplified by the recent banking crisis. This isn’t always an easy task but having a strong enough balance sheet and a good relationship with your lenders can afford you the ability to use multiple funding sources.
Next, project and product type experience. By selecting development, design, and construction firms specializing in the desired product type, you can expect a team who will foresee and proactively mitigate typical challenges of pricing and building these projects. For example, selecting the most optimal multi-family finishes to maximize the quality of the units, thus maximizing rents, while minimizing the cost premium. Other examples, would be selecting the most optimal (price & performance) HVAC system based on the building parameters. Furthermore, leveraging an integrated approach with trade partners to lock-in pricing early to mitigate cost escalations and concurrently release long lead equipment to fast-track the overall schedule.
Last, look for teams with specific experience in the desired local market and network. The knowledge they have of local building codes and other governance issues paired with trade partner relationships, will prove valuable. Trust is at the foundation of every successful construction project and having it already established within the area you are building, protects the project from potential schedule delays.
JE Dunn Capital Partners believes these challenging times create opportunities. We take a flexible and long term approach when evaluating deals. We are fortunate to work alongside our JE Dunn Construction teams to leverage their strength and knowledge to continue delivering excellence in the commercial development space.
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ESG concerns have become increasingly topical and important as owners and investors are starting to look at these factors when deciding where to invest in their next projects. Project owners consider ESG factors when deciding which vendors and partners to do business with and prospective employees, especially younger generations, consider ESG factors when applying for jobs.1
Incorporating ESG considerations into business practices has been more commonplace in Europe than the U.S. for the past couple of decades. In general, public financial institutions also have greater defined standards than any private company which is not subject to regulatory practices. As ESG evolves within the U.S., one of the first issues facing corporations is which standards to follow. Consultant companies are now able to offer you a “grade” on any of the three factors, but which entity will hold the final say so? Should companies hold their suppliers accountable to the same standards and values they establish within their own culture?
These are questions facing every company in the corporate arena. In the following articles, we examine ESG issues specific to the construction industry and what measures we are taking to balance our internal ESG passions with the resources required to implement the required processes and programs.
In addition to the terms explained above, you might see the following terms in relation to ESG.
Carbon: Carbon is a chemical element, but reducing carbon is a focal point of environmental strategies because carbon emissions affect the planet significantly, as they are the greenhouse gas with the highest levels of emissions in the atmosphere.
Carbon Neutral and Net Zero Carbon: Carbon neutrality means having balance between carbon emissions and absorbing carbon from the atmosphere while Net Zero means no carbon was emitted from the onset.
Carbon Offset: a credit that a person or organization can buy to decrease its carbon footprint or an action intended to compensate for the emission of carbon dioxide into the atmosphere as a result of industrial or other human activity, especially when quantified and traded as part of a commercial program. Currently, companies can pay a broker to provide the offset. The customer calculates their emissions level, and the broker then charges a fee based on that level. The broker will then invest a portion of that money in a project that reduces carbon emissions. For example, an individual may take a flight that will release a certain amount of GHG into the atmosphere. The person uses a tool to calculate the emissions released on that flight and then buys a carbon credit from a broker to offset that amount of emissions. The broker subtracts its fee and uses the rest of the money to invest in an emissions project, such as a reforestation effort.
CSR: Corporate Social Responsibility. Very similar to ESG, but more specific to the balance between the governance and the responsibility to the communities where we work.
Embodied Carbon: the greenhouse gas emissions arising from the manufacturing, transportation, installation, maintenance, and disposal of building materials.
SDG: Sustainable Development Goals. These are 17 interlinked goals set forth by the United Nations in 2015 to serve as a shared blueprint for peace and prosperity for people and the planet, now and into the future. Included in the 17 are things such as Zero Hunger, Reduce Inequalities, Clean Water and Sanitation, and Decent Work and Economic Growth.
Sustainability: Within the construction industry, this often refers to the environmental impact of a building material or the impact of construction itself. Within ESG, this term has evolved to be about the balance between our current practices and future needs, i.e. is what we are doing now “sustainable” for the long term?
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The Producer Price Index for softwood lumber resembles a roller coaster since the beginning of the pandemic.
Prices shot up 166%, then plummeted 48%, then jumped up 71%, and then slowly cooled again to where prices are now only 22% higher than January 2020 levels. Compared to the relative stability of the previous decade, this has been an extremely volatile material.
Obviously, the pandemic had an enormous effect on lumber pricing and availability. Housing makes up a large share of the lumber demand and, after an initial drop, the demand for homebuilding was very strong up until around the second quarter of 2022. The labor strain in mills and lumber yards resulted in prices skyrocketing as output was extremely low and couldn’t keep up with demand.
As homebuilding demand began to wane in May of 2022, lumber prices came down as well. Homebuilding continued to decline through the end of 2022 but as existing housing inventory dwindles, homebuilding looks to be stabilizing.
What can we expect for lumber prices going forward? We should see some reduction in volatility as overall demand eases. On the supply side, production capacity and output have found their footing again, as disruptions initially caused by furloughed workers followed by the slow on-ramping time for new mills needed to meet demand have been largely ironed out. A cooling labor market in general will help prevent supply-side snarls as well. Demand-side shocks from China are a threat, but not nearly to the degree that we have recently experienced.
Our forecasting partner, Moody’s Analytics, has the Producer Price Index for lumber falling slightly through the end of 2023 and then rising again in the back half of 2024 as construction and homebuilding demand begins to strengthen (forecast values in light grey).
Unlike lumber, steel has stayed closer to its mid-pandemic peak, and though it did trend downward for eight consecutive months, it has since rebounded again.
Most steel production happens in two ways: 1) from integrated mills that use blast furnaces to melt iron ore, limestone, and coke to make new steel or 2) electric arc furnaces (EAF) produce recycled steel from steel scrap and waste. During the early stages of the pandemic, mills reacted quickly to the sharp decline in demand by shuttering furnaces, which severely reduced capacity—by approximately 40,000 daily tons (mostly on the integrated mills side). Once demand resumed, supply was extremely low and the mills’ ability to ramp production back up was hampered, sending prices soaring. In three months, the price index for steel mill products increased by over 150%.
Although prices have moderated a fair amount, prices remain roughly 75% higher than their pre-pandemic levels. Somewhere around 10,000 to 12,000 tons of capacity from integrated mills never came back online, resulting in the need for electric arc furnaces to increase production, putting more pressure on scrap demand. Production is still not back to prior trend levels. For manufacturing, new orders for steel products are hovering near all-time historical highs and backlogs are still elevated.
Production levels are forecast* to slowly increase and come closer to equilibrium as demand spikes ease.
Prices should settle to their new normal, although more volatility will likely exist than the forecast shows as pricing is still being quoted at shortened intervals. This allows producers the ability to ramp up quickly if necessary.
Ready-mix concrete (RMC), along with steel, copper, and lumber, is one of the “big four” components of our Quarterly Cost Index, accounting for roughly 7% of the materials featured in the index. Prices for RMC are roughly 28% higher today than pre-pandemic levels so this one element can have an outsized impact on the total bill for construction.
We track concrete in the ready-mix product form as it is extremely common in vertical construction, but it also allows us to view it as one fungible product instead of following the prices for the individual materials separately.
Several commodities have shown price fluctuations, but that hasn’t been the case for RMC. The aggregate (yes, a concrete pun) price level has increased in all but two months over the last two years. Regionally, prices have increased the most dramatically in the West since the beginning of the pandemic.
What is keeping concrete prices so consistently high? Why haven’t we seen any kind of moderation in prices? Let’s first look at the cost drivers for concrete. Concrete is made up of a fairly simple list of ingredients: Portland cement (a specific type of cement–sort of like stainless steel is a specific type of steel—made up mostly of crushed limestone and silica); sand and gravel aggregates (our pun from earlier); and water.
It also takes an extremely large amount of energy to produce concrete, particularly when making the Portland cement component, and most producers use fossil fuels for that energy.
Now, for our overall list of construction inputs, supply chain stress and logistics issues that hampered inventories and availability, along with the increased levels of demand, are the fundamental factors that drove prices up for most materials. Lumber prices declined thanks in large part to the fall in demand that came from the housing downturn, particularly on the single-family construction side (labor supply and mill productivity played a role too of course). For steel, producer prices (cost of inputs) came down for a time, allowing market prices to ease somewhat. We haven’t seen either of those things happen at scale for concrete. Demand has stayed elevated (thanks to the construction sectors that have flourished, such as manufacturing) and input prices for things like limestone and, for a time, energy have helped push prices further up.
The rising cost of the fuels used for producing concrete added upward pressure on prices from the beginning of 2020 through roughly the summer of 2022. Energy prices have since fallen, and we still haven’t seen price relief for concrete. The rest of that upward price pressure is coming from the crushed limestone and aggregate costs. Those costs have continued to increase in response to demand, and there hasn’t been the same kind of supply-chain-easing impact because crushed stone markets are very local. For instance, they aren’t nearly as trans-continental as lumber. When a product is more mobile, it’s more substitutable, so price changes for more localized products are much slower to come about. It took prices for RMC longer to increase compared to other inputs and, by the same token, it will take them longer to decrease when compared to other inputs. As long as demand remains strong, so will prices.
The forecast for concrete is steady. Demand will likely slow over the next few quarters but not drop to the point where we would see concrete prices come down. Prices will continue to increase, just at a slower rate. As the economy transitions to a more expansionary environment in 2025, price increases would likely reaccelerate.
