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October 2, 2018, Author: Mark Graffagnino

By Mark Graffagnino


October 2018

We hear it over and over again…there is a shortage of affordable housing.  Pretty much any city in any region, it’s the same story, a lack of workforce, or blue-collar housing.  (For this analysis, I will be analyzing Class B product as affordable, middle class, workforce housing.  True low income, Class C, product is being built, typically with some form of subsidy either from direct government involvement, tax credits or public/private partnerships benefitting from low- or zero- interest financing)


It would seem that, if the market is telling you there is a real need for a certain sector of product, the market would naturally create the supply to fill that sector.  So, for this example, the easy answer would be to build more Class B developments.  But that has not been the case.  Let’s explore some of the reasons why I think this is so.  Here is a recent story about how new apartment construction in 2017, in my market, Atlanta, GA, was 90% Class A luxury units: https://atlanta.curbed.com/2018/9/25/17900776/rentcafe-new-atlanta-apartments-luxury-rent


In my opinion, these are the main factors why there isn’t a surge of Class B development:


Institutional Buyers Paying Top Dollar for Class A Luxury Product

Going back to my previous point about the (rental) market saying “we need for affordable housing”, the buyer’s market is saying “we want to buy more Class A deals”.  Guess which market is winning out?  Low interest rates, and investors more concerned with capital preservation over returns, has driven up demand for Class A properties.  In basic terms, Class A is what is selling, so Class A is what is being built.


Merchant Builders

Apartment developers generally come in two categories, a) those that develop, hold and operate their properties, and b) those that develop and sell their properties at or before stabilization. Those in the b) category are known as merchant builders.  Their model is based on earnings from development fees and profit made at the sale.  Merchant builders need buyers to complete the cycle and, as noted above, buyers are clamoring for Class A apartment developments. They are giving the market what it wants.


I think ego also plays a part in this.  People who take risks on $250 million projects tend to have sizeable egos.  Not many trade magazines want to do spreads on apartment developments with white electric element ranges, or an efficiently designed clubhouse.


Cost of Construction

Even with institutional buyers gobbling up new Class A developments, it is still a struggle to make the numbers “pencil out” on a development pro-forma.  Many times the decision to red light or green light a deal comes down to how much risk the developer is comfortable with that in 18-24 months, the market will be favorable and the deal will sell at the compressed cap rates that are selling now.  It’s been a long time since I’ve seen an owner run a development pro-forma and think “slam dunk, let’s move forward”.


The main culprit of these pro-forma worries are construction costs.  Please see my prior blog post “Why Do Construction Costs Remain So High” for further discussion.


So if developers are having a tough time making the numbers work on a Class A deal, with Class A rents, and Class A exit cap rates, how in the world can the numbers work on a Class B deal?  Again, using Atlanta as an example, Class A rents at $2.00/sf are not uncommon.  Class B rents are more in the $1.25/sf range.  On a 200 unit development, that could mean nearly $2 million less in annual gross revenue.  What does that do to your NOI, and sales price?


A very broad analysis of the savings in construction costs for building a 200-unit Class B project, for things like moderate level finishes (carpet, laminate counters, black appliances, etc.), much more modest amenity packages (do we really need our own LA Fitness, outdoor kitchen and Starbucks machine?), would be a reduction of about $5-7 million. There are other variables, such as land cost, which is higher for Class A properties.


So it doesn’t make sense to save $7 million in development costs, and end up with a project with $15-20 million less value.  I think it would take a significant event, such as a market correction, to shake up construction costs, to make it feasible to develop Class B apartment projects.  Of course, if there is such an event, creating a downward movement in construction costs, developers would take advantage to spend less money building Class A deals.


I don’t think we’re going to see much development of new Class B product.  The historical cycle of older Class A deals falling into the Class B category will be where the lion’s share of that product comes from.


Anyway, that’s my two cents.  As always, feedback, conversation and disagreement are always appreciated in the comments below.