Equity Capital Accepts Lower Returns to Absorb Rising Construction Costs

GlobeSt. – The supply-chain interruptions related to the COVID-19 pandemic have put negative pressure on an already challenged construction market. Rising construction costs have been a major challenge for developers, but now some are reporting that contractors are so busy that they are declining to bid on new projects.

Michael Boujoulian, managing director of Alliance Residential, is breaking ground on a 314-unit apartment building in Waltham, Massachusetts, and is dealing head on with these challenges. “We have seen hard to believe year-over-year price escalations,” he tells GlobeSt.com. “We are seeing a 20% increase in construction costs. We are even having some contractors decline to bid because they are busy enough and they aren’t looking to grow. The depth that we rely on in those subcontractor markets has caught up with us. That of course hurts pricing when there is less competition.”

There has been strong rent growth in many of these markets. That has been enough to offset some of the pricing problems, but it’s been a lot less helpful than you’d think, according to Boujoulian.

Despite the challenges, projects are still moving forward. How? Investors are willing to accept lower returns to absorb the increased costs. “The bigger offset in what has kept a lot of deals alive is yield adjustments in the capital markets,” says Boujoulian. “Without that, a lot of deals should have died and pipelines should have started to evaporate. If the same yield metrics from a year-and-a-half ago were in place, the rent growth would not have been enough to keep deals alive.” In addition to appetite from equity investors, the debt markets have also stayed aggressive, which has also helped developers absorb costs.

The equity markets have been a key to keeping projects alive. “Our underwriting is much more sensitive to what the equity markets are interested in, so insurance companies and hedge fund investors,” says Boujoulian. “They have changed their qualifying criteria, and basically, they are willing to accept a lower return on investment. That is much more impactful to our underwriting than debt.”