Developers and Landlords Interests Largely Align
Rising rents are needed for private multifamily development to deliver required rates of return and secure financing. Falling or even flat rents usually lead to a sharp reduction in multifamily starts. Some contend that since most developers sell their projects to landlords upon completion, they are indifferent to falling rents because they don’t intend to hold the property long term. The implication is usually that building into falling or flat rents would occur if zoning allowed it. This argument is wrong and this article debunks it.
Developer and Landlord Business Models
Most multifamily developers sell their projects upon completion. Their business plan is usually to sell at a 20 to 40 percent profit margin to an investor group, aka, landlords. Suppose newer vintage buildings trade at a roughly 5 percent cap rate. If a developer reckons they can construct a new building at costs equivalent to a 7 percent cap rate, they can sell to investors at a 5 cap and make a roughly 40 percent margin, that is, sell at 140 percent of their costs.
They could of course, hold the building and earn a higher than normal rental yield. This higher yield does not represent excess return because there are substantial risks to any construction project. Any build can easily run into large cost overruns or long delays. Developers specialize in assessing, pricing, and managing this kind of risk.
Landlords do not. They specialize in pricing and managing the risk that comes with owning and operating rental property. Thus, firm specialization dictates that a trade occur. So developers sell to landlords.
Another factor plays a role. Developers could collect their returns from bearing construction risk in the form of a higher rental yield. But by selling at a profit, they receive a large, one time cash flow. In present value terms, these two cash flows ought to be equivalent. However, in practical terms, a large upfront payout from a profitable sale allows developers to invest in the next project. This heavily pushes developers towards a quick sale.
Developers need willing buyers
Ok, so developers sell to landlords. Nevertheless, their interests still largely align. In order to get the right price for their finished product, developers need to sell into an environment of rising rents. This is because landlords will not purchase properties at low cap rates (or equivalently, high prices) if they expect rents to stay flat or fall. Again, rising rents, which drive capital gains, are needed to provide sufficiently high returns to clear hurdle rates. If rents are flat or falling, investors will significantly revise down the price they are willing to pay for any piece of rental property.
The need to be able to sell into an environment where the eventual buyer will realize sufficient returns (and thus pay the right price) if they purchase the completed project is not lost on developers. Developers are keenly aware of the underwriting criteria of potential buyers and do not build if they believe the market conditions will not line up. They absolutely understand the fallacy of building into falling or flat rents only to try to offload a building sure to under-preform to a hapless investor. They know any potential investor will just lower their offer to account for the slow rent growth, and developers won’t hit their margins.
Conclusion
Developers are not the enemies of landlords. Landlords are their customers. Developers only build when they expect market conditions will be such that they can sell their projects at high prices. If rents are flat or falling, landlords simply reduce the price they are willing to pay for buildings and developers are unlikely to realize a sufficiently profitable sale to justify the substantial risks to construction. Developer and landlord interests broadly align.