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February 6, 2023 Deal Watch

Tightening money supply dampens development prospects

HBJ PHOTO | STEVE LASCHEVER Mike Goman, principal of East Hartford-based real estate advisory firm Goman+York, said flattening rental rates, higher interest rates and dramatic increases in building costs have negatively impacted new development projects.

With economic uncertainty persisting, many lenders are pulling back on the free flow of cheap and easy cash that has recently helped fuel robust development in Connecticut.

The effects of the tightening money supply, in concert with the economic challenges that led to it, are prompting some developers to pause or retool their plans.

This can be seen in East Hartford, where Massachusetts-based National Development recently received additional town-approved tax relief so it could have breathing room in its efforts to construct 2.5 million square feet of logistics space at Rentschler Field.

“Banks have all but stopped lending on new construction projects and any debt that is available has more than doubled in rate over the course of 2022, which has severely increased our project costs,” National Development Managing Partner Ed Marsteiner wrote in a Dec. 20 letter to East Hartford Mayor Michael Walsh. “This change in financing alone has put immense pressure on the viability of the project.”

A short distance away, developers who have been approved to build 477 apartments on a roughly 25-acre site off Silver Lane now want to dial back the minimum number of units required.

A rendering of the Concourse Park apartment development planned on the site of the demolished Showcase Cinemas multiplex in East Hartford.

Partners Brian Zelman and Avner Krohn said they still have every intention of building more than 400 rental units as part of their Concourse Park development at the site of the former Showcase Cinemas movie theater. But they only want to be obligated to build 300 apartments, allowing flexibility in case further economic challenges arise.

“The capital markets are tight right now,” Zelman said. “We are seeing the same thing, despite the very strong demand for housing, for rental units, which we don’t see going away.”

Factors stressing financing

A national slowdown in rent-rate growth is upsetting lending potential for multifamily development, noted Mike Goman, principal of East Hartford-based real estate advisory firm Goman+York.

Builders had been able to estimate returns based on 4% to 5% annual growth in rental rates “for a long time,” Goman said. But many lenders are now not factoring potential rent growth into underwriting.

“It’s that uncertainty everybody is looking at this year and now we are seeing people looking at the first quarter of 2024 and a lot of these guys are saying we don’t know where things are going on an economic standpoint, so they are pulling back,” Goman said. “They are being a lot more careful.”

Flattening rental rates are exacerbated by interest rates that have doubled over the past 18 months and dramatic increases in building costs in the past two years, Goman said.

“Some of these more expensive projects we used to say $245 a square foot was a reasonable cost,” Goman said. “I looked at one the other day and it’s coming in at $325 a square foot.”

Many lenders that had been willing to fund 80% of project costs are now only willing to lend 60% or 65%, Goman added. Some are requiring greater debt service coverage, allowing for a cushion should occupancies fall.

Development prospects may be dampening in the near term, but Goman said he sees this as more of a normal shift in the ebb and flow of the economy, which will moderate as interest rates become less volatile and inflation calms.

Challenges will persist for most of 2023, he predicts.

“Typically, we would expect to start seeing people start to come back into the market probably in the fourth quarter,” Goman said. “They’ll start to look at ’24 and realize they have to get some deals done. If you are in the business of lending money and you are not lending money, that’s not good for business.”

Bracing for recession

Many of the banks that have released their fourth-quarter earnings are preparing for the possibility of a recession in 2023, said John Carusone, president of the Bank Analysis Center in Hartford.

“Certainly, banking behemoths like Citibank, JPMorgan Chase and Bank of America are in that mode as all three have reported earnings in the fourth quarter, which have been diminished by setting aside reserves for future potential loan losses in 2023,” Carusone said.

Carusone noted the backers of the proposed New Canaan Bank in July received preliminary approval to launch the state’s first startup commercial lender in more than a decade, but they promptly withdrew their application a few months later in December citing deteriorating economic conditions.

Other banks are tightening lending standards, prompting developers to pause or scale down pending projects, he said.

“I don’t see this changing anytime soon and I don’t see the Federal Reserve backing off on the objective of continuing to ratchet rates up to the point where the back of inflation is broken,” Carusone said.

Bankers’ perspective

Andreas Kapetanopoulos, Connecticut president for New York-based NBT Bank, which began lending in Connecticut several years ago, said some developers are pulling back on their own in the face of rising costs.

Andreas Kapetanopoulos

“We are seeing a mix out there of some projects being put on hold and some moving forward on the developers’ side,” Kapetanopoulos said. “Some projects were being worked on for several years now. When their budgets were being put together, interest rates were much lower. So now interest rates are higher, you have to go back and look at the viability of the project and determine if costs can be reduced, or rents increased to make up for the increased costs of the project.”

Kapetanopoulos said NBT is giving greater scrutiny on a project-by-project basis.

“For us the focus is not on tightening the credit, it’s really just focusing the credit on the current economic conditions and making sure that we’re vetting those out and our customers … are on the same page and comfortable with the project moving forward,” he said.

Matthew Purtell, KeyBank’s head of real estate capital for New England and Washington, D.C., said his board wants to cut back on a real estate loan portfolio that, like most banks, “has grown exponentially.”

“This year, in 2023, we are being very disciplined in who we lend money to,” Purtell said.

KeyBank continues to lend but has increased its underwriting standards. Today’s loans also come with a 60% or 65% loan-to-value ratio, he said. That means borrowers need to put more equity into developments.

KeyBank is also subjecting borrowers to “a lot more scrutiny,” looking at how much liquidity and cash equity they possess, as well as the strength of their existing portfolio, Purtell said.

Purtell said a lot of developers with shovel-ready projects are pausing until the second-half of 2023, hoping for better interest rates.

“A lot of developers are mothballing projects because they don’t make sense, they just don’t pencil right now,” Purtell said. “And they are asking towns to give them a little more time to go forward.”

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