Philly CRE Is In Contraction Mode, And Deal-Makers Are Poised To Take Advantage
For all the talk of whether the economy is heading for a soft landing or a harsher recession, bad times are already here for commercial real estate in Philadelphia.
Across asset classes, operating costs have ballooned while access to capital has remained scarce, panelists said at Bisnow’s Philadelphia State of the Market event at Live! Casino & Hotel Philadelphia on Thursday. Even well-capitalized developers and owners are struggling to make new projects pencil out.
But an alternative strategy has begun to emerge, especially in multifamily.
Low interest rates and pent-up demand created a deluge of construction starts from late 2020 through mid-2022 in multifamily writ large.
But in Philadelphia, the expiration of the full 10-year tax abatement at the end of 2021 threw gasoline on the fire, resulting in the city issuing permits for more units than New York in 2021. Investors who used the low-interest-rate environment to secure long-term, fixed-rate debt for their portfolios now find themselves being asked by contemporaries in cash crunches to provide rescue capital, panelists said.
“You’re getting a call from someone who controls an asset that has no liquidity, and it’s a potential conversion or a piece of land,” Post Brothers co-founder Matthew Pestronk said. “Throw out the lowest number that they won’t be insulted by, say you need this much time to execute, and you’re getting answers of, ‘Huh, let us think about that.’ It’s a painful period, but opportunities are starting to emerge.”
Verde Capital President Jake Reiter said his company has been brought similar offers, as did EQT Exeter Investment Officer Tony Ewing. EQT Exeter put together a structured financing template for its investors to understand and underwrite such transactions, Ewing said. In some circles, the portmanteau “dequity” has begun to gain buzz as a term for the normally ad hoc financing structure.
“Call it mezzanine financing, call it preferred equity, whatever works,” Ewing said. “But we can insert capital into the stack for a process to get to the other end. So if something were to go wrong, we clearly underwrite it so that if it fails, it would revert to us as a business owner and we would have to then execute on the project and make a decision on doing so at that time.”
Even for developers that complete their projects, transitioning from a construction loan to permanent financing hasn’t been this difficult in a generation — an issue compounded by the historic increases in supply Philadelphia will experience this year and next.
Though panelists expressed little doubt that the city can absorb all the new multifamily units eventually, they said that lease-up will be slower and more competitive than was likely expected when developers plotted out their path from short-term debt to either long-term debt or exiting the asset.
Even if a new-construction apartment building leases up at the underwritten rate for a 2021-vintage loan, interest rates have gone up so much in the past year that the cash flow threshold for declaring an asset stabilized has shifted, Pestronk said.
“In a lot of asset classes, higher margins and higher returns need to be there right now,” he said. “You sign up for financing and it gets worse every day for four or five months. It feels horrible.”
With so many loans maturing this year and next and so few refinancing options in the market, owners pursuing new debt are struggling to close even when they can sign letters of intent because the economics of deals are deteriorating during due diligence periods, JLL Capital Markets Senior Managing Director Carl Fiebig said.
Bringing in a better-capitalized partner that also has a strong track record helps get financing deals across the line, The Michaels Organization President of Development Michael Flanagan said. Michaels has massive portfolios in both affordable and student housing and also invests in market-rate apartment buildings.
“With our size and strength, there are joint venture opportunities with smaller operators looking for a path to close,” Flanagan said. “So that’s where we’re trying to get creative.”
In periods of contraction, those with the capital and the vision to take advantage of opportunities are the biggest winners when the next period of expansion comes around, Pestronk and Dranoff Properties CEO Carl Dranoff said. That window for action may be open right now, even before conditions bottom out.
“We’re in a generational cycle, and we’ve been through this before,” Dranoff said. “I remember at the end of the 1980s and the beginning of the ’90s, all the real estate developers at conferences said, ‘Things will be fine in 1995, things will be great in 1998.’ But the time to take advantage is not when things start to spike. It’s to get ahead of the curve.”
Despite the cyclical optimism, most of the deal opportunities that have come across the desks of executives like Ewing and Pestronk still aren't good enough to act on, panelists said. One reason could be property owners still not willing to fully bridge the gap between their internal — and possibly hopeful — valuations and where the market stands now.
“If we go out and put an offer in for asset X, we’re told we’re not even close,” Ewing said. “And maybe not in multifamily, but say, in industrial? We may get a call three months later saying, ‘Hey, is that price still on the table?’ And the answer is, ‘No. It’s gone down.’ But we have found opportunities that way.”
