Merchant Developer Model Hits Skids After Years Of Driving Returns

Merchant developers, or those who build a property and sell it shortly thereafter instead of holding on to investment properties, have enjoyed ideal conditions for their business model for years, with cheap capital and plentiful investor demand.

No more.

With high interest and cap rates, combined with an economy teetering on the edge of recession, longer-term holds are back en vogue, either by choice or necessity as the buyer pool dries up.

“When you can buy a two-year Treasury at 4.5%, you're not going to buy an apartment complex at 4%,” Cross & Co. founder Ed Cross said.

In short, the current environment makes merchant building a tough, though not impossible, feat since the pot at the end of the rainbow (the sale) isn't as certain as it would have been only a year ago. There’s no set definition for what makes a merchant developer, but one generally sells properties within a year or two of completion, usually shortly after achieving tenant stabilization.

The model became especially popular among multifamily developers in recent years during the apartment boom that sent sales prices through the roof in many major markets.

“The merchant build model was, at least for suburban apartments, you build it for a six and a half, and sold it for a five or a four and a half,” Cross said. “Or if you're downtown, you built it to five, five and a half, and you sold it for a three and a half more. There was a margin there that gave you a good profit return on your equity.”

Now developers aren't even sure what cap rates are, even for well-located projects, Cross said.

“So everybody's kind of hit pause on sales, even though leasing is holding up, the rental rates are holding up,” he said. “But we don't know what the assets will sell for.”

In the multifamily market, investment sales have indeed taken a dive, making cap rates hard to gauge. The most recent NMHC Quarterly Survey of Apartment Market Conditions, conducted in October, reported a sales volume index of 6, well below the breakeven level of 50.

The shock to the market is more than the high-level interest rates, LD&D Managing Partner Diego Bonet said. 

“The uncertainty is keeping investors on the sidelines,” Bonet said, and the reduced pool of buyers means that properties selling now need to drop prices.

LD&D has developed mostly residential properties in New York and Florida, and has acted as both a merchant builder and a build-and-hold developer, depending on the deal.

With the recent decrease in the value of stabilized properties and continued high cost to build, spreads often aren't attractive enough to justify the risk of developing, Bonet said.

For multifamily developers in particular, the slowing growth of rents is another important factor impacting the merchant build model.

Not long ago, deals could be done in a negative leverage environment, where the yield of the asset was lower than the cost of the capital or the cost of the debt, Integra Investments principal Nelson Stabile said. Developers could do that because they had confidence that the rents would grow, which would allow them to get out of the negative leverage.

Until recently, that confidence was well-founded. After a growth lull in the wake of the Great Financial Crisis, multifamily rents began a skyward trajectory that has only recently moderated. In 2013, according to NMHC data, U.S. apartment rents averaged $14.33 per SF. By 2021, the average was $20.28 per SF.

Now rents are sliding, or at least stalling. Between April and October 2022, for example, rents dropped 3% in Las Vegas, 2% in Phoenix and 1% in Tampa, Florida, according to Apartment List, a reversal (albeit slight) from the previous two years, when those markets experienced rental growth of more than 30%. Other markets, including even high-cost San Francisco, are dropping as well.

"I think there's going to be a lot of turnover of apartments," Diane Ramirez, the chief strategy officer of Berkshire Hathaway HomeServices New York Properties, told Bisnow in December. "That's going to help with supply, and with supply, you might get a little bit of an easing with prices, so I think the rental market is going to just become a little more normalized."

“Well now, that's another struggle, right?” Stabile said. “Let me put it this way: If you're moderate or conservative from an underwriting approach, it's very hard to keep looking into the next 12 or 24 months and assume that we're going to have this double-digit rent growth.”

His company has mostly acted as a merchant builder in recent years, developing a property, leasing it up and stabilizing it, and looking for opportunities to sell after a year and a half or so, Stabile said. That is getting harder to do, and some deals make more sense with a longer hold.

That is the case with a 128-unit townhouse development that company is preparing to develop in Boca Raton, Florida, Stabile said.

“We have a seven- to 10-year hold horizon on this particular asset,” he noted. “Fortunately, our investors also have a longer-term sort of outlook.”

Other adjustments to make the deal pencil included more equity and lower leverage, because the interest rates are high, Stabile said.

Interest rates may be a disincentive to build and sell, but they can also be something of an incentive to build and hold, according to Atkins Cos. principal Cory Atkins.

“At a high level, it probably makes more sense to hold a bit longer because right now, at a higher interest rate environment, it's not, it's just not the most advantageous environment,” Atkins said.

That is true even for a previous darling of investors such as medical office buildings, which is his company's specialty, Atkins said.

The current uncertain environment mostly has an impact on the underwriting of deals, but less so on the actual management of a property, should a developer decide to hold an asset, Atkins said.

After all, larger developers tend to be sophisticated enough to have a property management division, or well-established relationships with property managers, and even smaller developers can hire management without too much difficulty, Atkins said.

Multifamily wasn't the only property type that merchant developers had been gung-ho about in recent years. Industrial had its day, too, but not so much anymore, Denholtz Properties CEO Steven Denholtz said.

“On the industrial side, people were building to a forecast and selling at three and a quarter cap,” Denholtz said. “With numbers like that, merchant building was the greatest thing ever. Those were big spreads. They don't exist any more.”

Long-term holders, which Denholtz said his company is, are now better suited for the current environment.

“Long-term holders know that building tomorrow is going to be more expensive than building today,” he said. “It just is. And so wherever you can get it built now, you build, if it makes financial sense.”

Not every developer or investor sees a definite end to merchant building, however. In the current environment, development is tougher than it used to be for everyone, and should interest rates moderate or the economy improve, there will still be an important place for merchant builders.

“Financing requests for development projects both from merchant builders and buy-and-hold developers have waned due to the increasing cost of financing,” BridgeInvest principal Alex Horn said. “With that being said, there's no discernible difference in loan requests between both strategies.”

BridgeInvest is a private real estate lender with $1.3B financed over the past decade, and according to Horn, the company is taking a countercyclical lending approach by still deploying capital for deals that meet its fundamental criteria.

Many merchant builders are still developing with an eye toward the future and the expectation that cost of financing will normalize and asset prices will rebound by the time of sale in three to five years, Horn said — betting that the future will go their way, in other words.

“This imbalance should correct itself — either investors will start coming back into the game as they become more comfortable with the economic outlook and values bounce back, or construction prices will drop,” Bonet said.

In any case, given the long timeline of some projects, they may still make sense for developers who believe that property values will recover in the medium-to-long term, by the time they need to divest from the property. 

“When coupled with the large demand from institutional buyers to own inflation-resistant real assets, the build-and-sell model can continue to flourish, even amid uncertain economic times,” Horn said.