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Pigeons, Chickens and Interest Rates

There was a hilarious video making the rounds on social media last week that featured a pigeon strutting around a barnyard with a puffed up chest and its head cocked high in the air. The pigeon was imitating a flock of brown chickens who were parading about, pecking at the seeds on the ground. I did what anyone would do when presented with such fantastic barnyard comedy: I pressed the screen and gave the pigeon a heart sign.

I sought deep meaning in this pigeon strutting about. It must be some kind of zoological phenomenon. Genetic mirroring or telepathy. Do pigeons have ESP? I have little knowledge of the biological world, and much less about the psychology of pigeons, so I gave up this notion. Instead, I decided this pigeon must have something to do with interest rates. A natural conclusion.

I couldn’t help but wonder which bird was better off. The chickens were destined for one of those plastic containers with the transparent lids sitting under heat lamps, but they would end up on someone’s dinner table. A meal for a happy family. A short life, but a useful one. The pigeon seemed free. It could fly off at the first sign of the farmer. But it’s death was certain to be grisly: Picked apart by a marauding hawk or flattened by an onrushing vehicle.

You can delude yourself into believing that your fate is different, but the end result is the same. In the long run, we are all dead. So goes the old economist joke. Interest rates are the great equalizer and the tombstone of many speculators are marked with a percent sign. Rising interest rates don’t care much if you’re a pigeon, chicken, or real estate developer. Yes, it’s one hell of a stretched analogy, but I’m running with it.

If you have borrowed a lot of money (something real estate developers love to do), rising interest rates can foul up (or fowl up) any investment equation. To see why, let’s look at a hypothetical building that generates income from rents. After paying expenses, the owner is left with $1,000,000 per year in net operating income. How does one value such a building? The equation is fairly simple, you take the net operating income and divide it by an interest rate known as the capitalization rate, or “cap rate” for short.

The cap rate is a weighted average cost of capital. It weighs the investor’s desired return on his or her equity invested as well as the borrowing cost of debt. The cost of debt is more than simply the interest rate. It includes a factor for the amortization of principal. The resulting cost of debt is known as an annual constant.

In November of 2016, the 10-Year Treasury Yield stood at 2.15%. Lenders usually price their loans at about 2% above the Treasury (known as the spread). So, in November of 2016, the rate was 4.15%. Once you add on the amortization of principal (let’s use 30 years as the amortization term), the annual constant was 5.90%. What was the hypothetical the cap rate? Assuming the developer sought a 7% return on equity and the equity comprised 25% of total capital, the resulting cap rate was 6.175%. What’s $1,000,000 of annual income worth? $16.2 million. The developer was able to borrow about $12 million and made up the balance of the funding with equity of around $4 million.

Today, the 10-Year stands at 3.24%. The annual constant is 6.63%. Holding the desired return on equity at 7% results in a weighted average cost of capital of 6.72%. Dividing $1,000,000 by this cap rate results in a value of $14.9 million. This is a decline of 8%. The developer borrows $11.1 million and invests equity of $3.7 million. All is well and good. The value declined, the debt declined, and the equity required declined in tandem.

But what happens when the building was built in 2016 and now its time to refinance a construction loan in November of 2018? We said the developer initially put up $4 million for a $16 million building. The debt amount of $12 million made up the difference. Now the building is worth $14.9 million. The bank will only loan $11 million. The developer must make up the difference between the original construction loan and the new permanent loan. An additional $1 million of equity is required – a massive 25% increase.

This horrifying situation is already playing out on the global stage. Today’s news brought reports that Chinese developers face $55 billion in debt renewing in 2019. Already Chinese Evergrande, perhaps the world’s biggest developer, witnessed a $1.8 billion bond issue go begging. Fortunately, the majority owner Hui Ka Yan was able to personally put up $1 billion to salvage the deal. Meanwhile Indian developers facing a glut of luxury condominiums have watched short term funding costs surge. Investors have pulled $30 billion out of the money market accounts of non-bank institutions that fund such developments. Indian developers are suddenly in a mad dash for capital.

Pigeon meets hawk. Chicken meets guillotine.

Apartment Development has a Big Lebowski Moment

By now, just about everyone knows the boiling frog metaphor. The business parable now sits among the regal pantheon of Vince Lombardi quotes, TedTalks about body postures, and the mystical epiphanies which occur when you gaze deeply in your Steve Jobs mirror. So let’s take the boiling frog story and give it a new level of sophistication. We’ll call it the Big Lebowski moment. This moment occurs when you are chilling out in your bathtub, just like The Dude. Your candles softly glow, the water is nice and warm, and you probably just had some help to induce your tranquil state.

The Dude Abides

For real estate developers, this can be like the construction phase of the project. You’ve done the heavy lifting of designing the building and gaining approvals from the city. You’ve negotiated the contracts and obtained your financing. You sit back a little and marvel as your dream leaps off the paper (or digital file) and becomes reality. This building is really happening. Sure, you will worry about the rogue subcontractor, the deadlines that may ebb and flow, and the weather, but if you’ve set yourself up with a well-planned project you will enjoy the next 18 months.

Once construction winds down, the stress starts kicking in. Will my glorious creature be the pony that every child wants to ride or do I have an old nag who buries its nose in clover when a rider approaches? Or, even worse, did I open one of those dodgy carnivals in a parking lot of a vacant retail strip center and my ponies just got quarantined by the Douglas County Health Department? Rents get adjusted, special lease incentives are offered, sweat beads appear on your brow and the pulse quickens. In Big Lebowski terms, The Nihilists have just arrived while you’re sitting in the tub, and they’ve started to break your stuff in the living room.

It gets worse. The Nihilists have brought a weasel with them (Hey, is that a marmot, man?). They throw the weasel in the bathtub. All hell breaks loose as the furry ferret turns into a screeching water snake keen on drawing blood from a sensitive region of the body. The tranquil tub becomes a frothing cauldron. For real estate developers, the angry weasel represents their debt. Real estate projects are highly dependent upon leverage. Most developers borrow 70% to 80% of their total project costs. Rising interest rates can threaten even the best developments.

Most construction loans have an interest-only period that terminate about 24 to 36 months after the start of construction. The end of the term is often referred to as the “conversion date”: the date at which the loan resets. On the conversion date, the interest rate adjusts to the current market level and the developer must begin paying some principal on the loan. For the past five years, rates have been in an innocuous range around 4%. Conversion dates came and went without much trepidation. Now, rates have risen dramatically. Many construction loans that were marked at LIBOR plus 3% two years ago will soon reset in a new and very weasel-ish world of 5% rates. One-year LIBOR sat at 1.73% in June of 2017, today it sits at 2.74%.

Well, that’s not so bad, you may say. After all it’s only 1% higher than it was a year ago. Yes, but the problem is exponential: your cost of money just went up by 20%. If you borrowed $10 million to build 100 apartments, you now face an additional $100,000 per year in interest expenses. On a per unit basis, that’s $83 per unit per month that you need to generate. From where I sit in Heartland, USA, $83 per month is a substantial amount of money. It’s probably a 10% increase on a one-bedroom apartment. My sister lives in San Francsco where they step over $100 dollar bills like soiled pennies, but here the number is the difference between two tanks of gas or an upper deck seat to see Kendrick Lamar. In other words, its a problem.

In a market facing over-supply, the pressure could become intense. Apartment construction has exceeded rates of household formation for the past six quarters. Higher interest rates will add to the challenges and pose a threat to developers in a way that has not been witnessed since 2007.

The interest rate environment places the Federal Reserve in a complicated position. The effective Federal Funds Rate is 1.75% and a 25 basis point increase is expected this week. Right now, markets place a probability of 41.7% on rates landing in the range of 2.25% to 2.5% by the December 2018 meeting.

Source: CME Group

There are three problems with this outlook:

  1. The 10 Year Treasury Yield stands at 2.96%. A surge in short term rates would almost certainly invert the yield curve – a signal that portends most recessions. The 5 Year Treasury is already at 2.80% which demonstrates a flattening yield curve.
  2. LIBOR rates track short term Fed Funds rates. Most short term financing is set on LIBOR plus a spread. If you extrapolate my example above regarding apartment rents to the entire economy, I do not believe that borrowers can cope with another 1% increase in the cost of short term funds.
  3. Increased rates will draw capital to the US and strengthen the US Dollar. The foreshadowing of this momentum has already set central banks into a frenzy of currency market intervention in Turkey, Brazil and Argentina. If the Mexican Peso joins the crowd, you could have a full blown currency crisis like 1994 or 1998.

 

The Mexican Peso (MXN) has fallen dramatically against the US Dollar (USD) since April. Source XE.com Currency Charts

Therefore, Jerome Powell must walk a tightrope. He must work to reduce inflation pressure and curb lending excesses, yet the risk of a recession rises with each quarter-point increase. He surely does not wish to create a lending crisis.

The intersection of interest rates, inflation and housing is even more complicated. Most measurements of the CPI show that housing costs are the major driver of inflation. I highly recommend reading the Bloomberg piece on the topic. There is some frustrating irony here: my industry, the one most susceptible to the risks of rising interest rates, is also the cause of the inflation which requires the Fed to raise rates. It’s a logical spiral that circles the drain like dirty water in a candlelit southern California bathtub.

 

 

 

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Ready for Your CUE?

Opening in July 2016. Aksarben Village.

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Twilight May 2016 - 3

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CUE at Aksarben Village

I was recently asked how we name our projects.

Some are obvious.  Shadow Lake Square Apartments are next to Shadow Lake and Shadow Lake Mall.  Along with the neighboring amenities – the centerpiece of the development collect at a square traffic pattern.   We also name the floorplans.  At Shadow Lake Square – the Monarch is a nod to Papillion – the french word for butterfly is Papillion. There is also the Cottonwood, a tree common to Nebraska and Meadowlark, the Nebraska state bird.

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In Aksarben Village, our first 3 buildings speak to the previous use of the neighborhood- the Ak-Sar-Ben horse race track, and the projects design.  Pinhook is a racing term, Flats is a design term:  Pinhook Flats.  Inside, meaning the floorplans, we stuck with horse racing and named the floorplans after Kentucky Derby winners – Seabiscuit, Winning Colors, Secretariat for example.

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Our latest building in Aksarben, we wanted to do something different from Pinhook Flats.  We looked at the neighborhood – there is much growth and change. Stinson Park continues to hold great events – walks, marathons, markets and bands.  The University of Nebraska at Omaha – is continuing to add space for classes, parking and living.  Baxter Arena is hosting many events – sporting, graduation, conferences.  The retail and restaurants in Aksarben Village continue to develop – along with businesses joining the mix.  The homes here are being remodeled and updated by singles, familes and empty nesters.  We knew that many were looking for the next place to live – unique, bringing a little drama, a step up, a signal to take the spotlight….UP NEXT…CUE

 

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We are coming to the end of this one – we love how the exteriors are coming together for our new building at Aksarben Village!  A few minor finishes outside, then the sidewalks and landscape – will pull the project together.  The colors blend nicely with the neighborhood.  However, many have told us the materials have really made the building take center stage.

Come on inside and you can see we have chosen to use some pretty and unique ones.  It comes together, next level living in Aksarben Village, CUE.

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Omaha Apartment Market, Pockets of Oversupply but No Worries

We continue to have positive views on apartment demand going forward. Occupancy has exceeded 95% for over two years. However, we view 2016 with some trepidation as a surplus of 500 units reaches the market in 2016. 

Market Breakdown

We believe the Omaha Metropolitan Area apartment market is heading towards an over-supply level of 500 apartments. However, this amount is fairly insignificant in light of the pace of job creation, population growth, and the overall amount of units in the market.

Three reasons support this idea.

  1. Supply is roughly in line with demand, but has slightly outpaced typical homeownership percentages.
  2. Multifamily supply has been in line with job growth, but has recently exhibited a ratio that signals some caution.
  3. The perceived amount of oversupply is not only a function of job growth. It is also a function of income growth. Construction costs have pushed rents to levels that many new entrants to the housing market will lack the means of stretching for rental payments in new projects.

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Supply and Demand Equilibrium Levels

The Omaha metropolitan area has grown beyond a population of 905,000 and has a consistent level of household formation around 4,000 per year. With about 70% of new housing demand typically attracted to homeownership, rental housing stays at rough equilibrium between supply and demand at 1,200 units per year. That number is roughly line with current supply numbers, but there are signs that new apartments have begun to outpace growth.

As a percentage of total housing supply, multifamily units have, in aggregate over the past three years, exceeded the typical homeownership ratio by 2%. There were 3,041 single family permits issued in 2013, 2,639 permits in 2014, and 2,830 for the trailing 12 months ending September 2015. Multifamily housing hit 1,370 units in 2013, 1,533 in 2014 and 1,114 through September 2015. The sum of the three years shows that multifamily has been approximately 32% of new housing. Meanwhile, historical averages for homeownership in the Omaha MSA have hovered at 70%. In this instance, the oversupply of 2% translates in 250 excess apartments.

As an aside, the peak single family construction occurred in 2005, when 5,877 units were permitted.

Total Units

Units         Single Family    Multifamily    Total      % Multifamily

2013             3,041              1,370            4,411              31%

2014             2,639              1,533            4,172              37%

2015 ttm       2,830              1,114            3,944              28%

Total             8,510              4,017            12,527            32%

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Job creation and Housing Demand

Apartment demand follows job creation levels in a fairly lock-step pattern. The Omaha employment market has been robust since 2012. Between the 2008 nadir of 437,000 jobs and the recent 2014 figure of 462,500 jobs, Omaha has created over 25,000 jobs. This level far outstrips the supply of housing by more than double. By comparison, the stock of housing increased increased by an astonishing 56,700 between 1999 and 2008, but jobs only grew by 26,200!

Typically market research firms such as Axiometrics use a ratio of 5 jobs per unit as a demand equilibrium ratio. In an ideal equilibrium, the 25,000 jobs created in Omaha since 2008 implies a maximum apartment supply of 5,000 units. In fact, over 6,000 multifamily units have been permitted between 2008 and the end of 2014. This implies a ratio of 4 jobs per unit. If one assumes a job growth rate for 2015 of just over 1%, it can be figured that 5,000 jobs have been added during the past year. The ratio for 2015 is, therefore, slightly better at 4.50.

The ratio of jobs to units at a sub-5 level implies an oversupply of about 750-1000 apartments in the metro area.

Year Employment Population Jobs/Population
1999 411,240 761,603 54%
2008 437,478 845,119 52%
2014 462,515 904,421 51%

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Income Concerns

So far, we’ve established that an oversupply of between 250 and 1000 apartments exists in the metro Omaha area. While this number is statistically insignificant out of Omaha’s 100,000 rental units, the direct peer group for new construction is much smaller. The peer group for these units really amounts to about 10,700 units built over the past ten years. These apartments have been built at the top end of rental rates. In this case, a 5-10% oversupply is a number that deserves watching.

Why do we say this? The new apartment math requires an annual income of $38,800 per year. This is towards the high range for single person households who have recently entered the workforce. With young people graduating with significant amounts of student debt, the ability to afford rents approaching $2 per square foot per month may be under pressure.

In Conclusion

Apartment supply as a percentage of homebuilding implies a 2% level of oversupply – about 250 units. When a job ratio is applied as a benchmark, the oversupply level rises to between 750-1,000 apartments. Our best estimate is that the Omaha MSA is heading towards a 500 apartment surplus in 2016 that will cool the occupancy levels from the peaks enjoyed the past several quarters. Additionally, units being delivered to market must be cautious about the pressure of income levels. While employment growth has been robust, student debt is high and many new jobs are below $35,000 per year.

Are we concerned? Not yet. We believe that many of the areas receiving supply have been absorbed at a rate that has exceeded our own expectations. Meanwhile, some experts believe that the Midtown Omaha area is going to be pushing the limits of absorption by late 2016. Also, while supply may have been running ahead of demand recently, the level of occupancy has been in excess of 96% for a few years now. Anything above 95% implies a very tight market. In this regard, there is proof of continued high demand.

One final caveat: We are not in the camp that there has been a paradigm shift in home-buying attitudes. Millenials will eventually get married and have kids. This process may have been retarded by the recession, but it will continue.

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Alchemy Development presents: A New Urban Living Development located in Aksarben Village.

Alchemy Development presents:  A New Urban Living Development located in Aksarben Village.

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Located in a neighborhood with history; and now, with a great Vibe – progressive, education, youthful, urban.  Around the corner from shopping, entertainment and Stinson Park events; the new buildings will be a part of Pinhook Flats.

These new buildings will have a combined 53 apartment homes:  Studios, One Bedrooms, Two Bedrooms, Two Bedroom Lofts.  Each having its own washer and dryer and beautiful finishes.  Each apartment will have access to garage parking, trash chute, recycle program andhave access to Pinhook Flats amenities.

Combining the practical needs of life with urban living spaces for those aspiring to an elevated lifestyle –

             Upscale Living…Next Level Lifestyle.              CUE “Up. Next.”

Final CUE rendering (4)

 

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OWH: Aksarben Village has another $82 million in development planned

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By Cindy Gonzalez / World-Herald staff writer

An additional $82 million in new construction projects headed to Aksarben Village — more office, retail, apartment and parking structures — will close up a couple of the biggest gaps left at the 70-acre midtown Omaha campus.

Not all of the tenants have been secured for those proposed properties, but developers say the village’s history suggests that won’t take long.

And except for a few hitches, such as the scrapping of a plan for owner-occupied town houses, the ongoing transformation of the old Thoroughbred racetrack grounds near 67th and Center Streets continues better than expected, said lead developer Jay Noddle of Noddle Cos.

So far, he said, the investment on projects built, under construction or planned at the village totals about $500 million. Original estimates a decade ago were about $150 million. That is just the village portion, not First Data Corp. or university-related buildings on the larger former Aksarben site.

City Planner Bridget Hadley said spinoff activity and property improvements in and around the village are what the city had hoped for: “Not only bringing forth more density, but a vibrant mixed use of work, play, entertainment and living options,” she said.

The latest changes, according to documents submitted to Omaha planners, total more than $82 million and seek $9.75 million in tax increment financing. The plans call for:

» An 80,000-square-foot office, retail and restaurant building on the corner of 67th Street and Mercy Road. A large corporate user reportedly has committed to occupying the top level of what would be a three- or four-story structure.

» A four-story retail and residential building fronting Frances Street that would have 10,000 square feet of retail and apartment lobby space on the ground floor; upper floors would contain 21 apartments.

» Another four-story building with 40 apartment lofts, facing west with a view of College of St. Mary softball fields and campus.

» As announced six weeks ago, a five-story building with Pacific Life Insurance Co. as anchor on the northeast corner of Mercy Road and Aksarben Drive. Restaurants, other retail shops and offices would occupy the rest.

» An 880-stall, four-story parking garage, replacing an existing surface parking lot and connecting by sky bridge to the Pacific Life building.

» About two blocks to the east, southwest of 64th Avenue and Frances Street, two apartment buildings. The largest would have four levels, 45 units and 31 parking stalls. A three-story eight-plex is designed in a “walk-up” style. Parking for both would be available in an existing garage servicing nearby businesses.

Construction on the Pacific Life building and connected parking garage are to begin soon, with opening of the office structure expected late next year, planning documents said. The other office and housing structures in the entertainment zone are to be done either next year or in 2016.

The other apartments are to be completed by fall 2016.

The TIF funding, a tool that allows property tax revenue from new construction to pay some redevelopment costs, is to be a topic at today’s City Planning Board meeting.

Alchemy Development, which is planning the new apartments at 64th Avenue and Frances Street, already has developed 183 other units at Aksarben Village. The next group would resemble the existing Pinhook Flats buildings, said Alchemy owner Bert Hancock, but have a distinct name and feature red and bold color elements to complement the neighboring DLR Group.

“We want to have an impressive corner element so when you’re looking from the new arena it will really attract people’s attention,” Hancock said, referring to the $88 million sports arena that the University of Nebraska at Omaha is to open next year at 67th and Center Streets.

Earlier plans by Noddle Cos. had called for the Alchemy site to be 21 upscale “live and work” town houses, the first owner-occupied residences in the village. But Hancock said people who could afford the homes typically are older and don’t like all the stair-climbing.

“If everything had gone as planned, there would have been more town homes, but that market really evaporated in the recession,” Hancock said. “We adjusted course, added apartments and everybody is happy. It has added to the amount of people that live and work in the area.”

The other proposed apartments and office/retail structures are projects primarily of Magnum Development and McNeil Co., which previously partnered on Aksarben Cinema.

John Hughes of Magnum said that new chunk would, for the most part, finish off the 8-acre entertainment “Zone 5” bordered by Stinson Park, Aksarben Drive (parallel to the Keystone Trail), 67th Street and Frances Street. (Also in that zone is the theater and businesses including DJ’s Dugout and Aspen Athletic Club.)

Securing TIF funds is an important part of making the proposed parts fall into place, Hughes said. He said he is in negotiations with various tenants to fill the space.

The land remaining lies mostly in Zone 6, the vacant block where the $50 million Waitt Plaza is to rise. Announced six months ago, the eight-story office and retail building with a parking garage is scheduled to be completed at the northeast corner of 67th and Frances Streets by early 2016.

Plans for that block call for two other office/retail buildings. Noddle said marketing and tenant recruitment for all three has ramped up.

A few property patches “here and there” remain and could become homes to various users as the village further matures, said Noddle. “It’s those little eclectic pieces that get filled in and really round out the mix in the village.”

Alchemy’s Barb Terry shares her thoughts with the Midlands Business Journal

Midlands Business Journal article featuring Barb Terry

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WSJ: Omaha Gets Smarter?

Is Omaha getting smarter? Well, not necessarily. At times, the level of intelligence actually seems to be inversely proportional to the amount of letters appearing after one’s name. European finance ministers are a case in point. Other times, the only reason some people were able to put on a cap and gown is that they managed to stay sober for 7% of their college career. Pity the chaps who were inebriated 94% of the time and just missed the gentleman’s D. If only Basketweaving 101 really was still on offer. Budget cutbacks are so cruel.

In spite of these collegiate misadventures, earning an advanced degree is still considered a nice way to develop an affinity for a football team or to have a reason to get a tattoo with Greek letters. It can also help obtain gainful employment. The fact is that people with sheepskins tend to earn more than their less-educated peers.

So the great news is that Omaha ranked sixth among US metropolitan areas With the biggest growth in the percentage of adults with college degrees over the past ten years. This bodes well for the health of the Omaha economy as these well-educated folk feed the grist mill of capitalism.