Risks as Growing Construction Pipeline Spreads Beyond New York City
Jotham Sederstrom Oct. 18, 2011, 10:24 a.m.
The din of construction is rising across New York City. Apart from long-term endeavors that predate the downturn, including the rebuilding of the World Trade Center and Brooklyn’s Atlantic Yards, a spate of new projects has entered the planning and proposal phases in recent quarters, portending an uptick in development over the next several years.
The rebound in core office and apartment prices that distinguishes Manhattan and a subset of the nation’s other cardinal markets has been a key factor in motivating plans for new development. Contrasting the mixed outlook for job growth, Manhattan’s investment momentum and the expectation that new, well-positioned properties will capture a disproportionate share of net absorption render favorable results from long-term feasibility analyses.
Some trophy projects that have been agreed upon in principle for a decade or more are finding new urgency amid a convergence of property market optimism and supportive government; cautiously accommodative financing partners and looming deadlines are certainly elements of the motivational mix, as well. If realized, transformative projects at Penn Plaza, the Port Authority and Hudson Yards could result in a surge in new office inventory before the end of this decade. Absent measurably stronger employment trends, changes to the skyline will push market vacancy rates higher.
Acting opportunistically, however, the best-positioned developers can expect to outperform the broader market statistics. Historical patterns suggest that the relative age of the city’s core office inventory, coupled with internal migration of tenancy within the metro area, will see new trophy assets outperform co-located comparables.
Not every proposal will bear fruit, as negotiations with key stakeholders and financiers may prove to be insurmountable obstacles to developers’ plans. Nonetheless, the city’s construction tides are rising.
Multifamily on a Tear
Few of the large projects that seemed improbable a year ago have advanced enough that shovels have hit dirt. Most are in the planning and permitting phases. For the projects that are furthest along in that process, construction is anticipated to begin in late 2011 or early 2012 at the earliest. Even in New York City, year-over-year construction employment is still down, reflecting the lag between project announcements and activity.
At the national level, as well, an observable increase in planned and proposed projects has yet to make a significant impact on national construction payrolls or spending activity. In terms of permitting, the apartment sector may be furthest along. But office and hotel projects are being announced with surprising frequency as well.
In the second quarter, 37,000 rental apartments units were started, according to the census count. That is the highest tally since the fourth quarter of 2008 and more than double the recession’s low. Nonetheless, the lagging impact of the recession’s construction slowdown is readily apparent in the construction data. While apartment demand is robust, recent construction starts have yet to result in inventory additions. Only 24,000 rental units came online in the second quarter, the smallest number on record.
There is no shortage of apartment development projects to cite as indication of the national supply response to improving fundamentals. Among high-profile projects, Kensington Investment and National Development have reportedly just broken ground on a 27-story, 385-unit apartment building on the edge of Boston’s Chinatown. Less than a month earlier, AvalonBay broke ground on Avalon Exeter, a 28-story, 187-unit apartment building in the Prudential Center in Boston’s Back Bay.
In some instances, development plans are not a response to improving apartment demand but reflect broader master-planning efforts, including significant investments in new infrastructure. One of the most visible examples of a long-term, large-scale project is the transit-oriented Tysons-Spring Hill Road metro station in the Virginia suburbs of Washington, D.C.
Abstracting from the anecdotal, the lists of projects are growing longer across the property sectors. In a limited number of cases, developers are proceeding without preleasing commitments. In Houston, for example, Prologis has kicked off construction on a 147,000-square-foot speculative industrial property in its fully leased Prologis NorthPark. Prologis is the exception to the rule rather than the norm. Not far away, work has begun on the 276,000-square-foot Sense Road Distribution Center. In this case, the property is significantly preleased to one tenant.
Philly’s Convention Center Draws Hotels
The surge in hotel development activity in New York City has been supported by a succession of banner years for tourism. Development downtown anticipates a further rise in tourist visits to the World Trade Center as monuments and buildings approach completion. But New York City is not alone in the growth of its hotel-room inventory. In markets from Savannah to Chicago, new hotel projects are getting underway. In the latter, work is underway on a three-hotel project at 501 North Clarke Street that will introduce more than 650 rooms to the city’s inventory in 2013, coinciding with the opening of the 320-room Langham Hotel in Mies van der Rohe’s 330 North Wabash Avenue. A harbinger of things to come, Chicago’s Radisson Blu is nearing completion and is scheduled to open on Nov. 1.
Albeit on a smaller scale, hotel projects are getting underway in Philadelphia as well. Marriott Hotels, Liberty Property Trust and Ensemble Hotel Partners announced the development of a new, 168-room Courtyard by Marriott at Philadelphia’s master-planned Navy Yard Corporate Center. Subject to Ensemble’s negotiation of project financing, the new hotel is projected to come online in the second quarter of 2013. The announcement followed less than a month after the Sept. 15 groundbreaking on a 268-room Kimpton Hotel that will overlook Independence Mall. Parkway Corporation announced plans in late September for a Hilton Home2 Suites hotel near the expanded Philadelphia Convention Center. That project, estimated to cost $60 million, has been facilitated by at least $10 million in H.U.D. Section 108 loans and other low-cost assistance.
A few blocks from the campus of the University of Pennsylvania, construction is underway on a 136-room Hilton Homewood Suites. The project represents Campus Apartments’ first foray into hotel development and has been facilitated by a low-leverage loan supplemented with a bevy of public and private financing sources and access to the New Markets Tax Credit program. Chandan is tracking at least two other Philadelphia projects that are in the early stages of planning, including one at the Convention Center and another in Philadelphia’s Old City. Three hotels opened in the City of Brotherly Love during the recession.
In the absence of a collusive supply response, individual commitments to large-scale construction inevitably represent a degree of risk-taking by developers and their lending partners. The apartment sector may be the one instance where the downside risks are mitigated by a weak economy’s drag on housing outcomes. Even in this case, however, markets where real and artificial barriers to entry are weak may suffer a destabilizing period of overreaction as new rental units flood the inventory. Overall, the same tempering of enthusiasm that qualifies the economic and labor-market outlook should inform our assessment of loss mitigation strategies when extending credit for property development. As compared to stabilized assets, lenders’ loss severities are generally much higher for these projects; in today’s environment, the probability of that loss depends inordinately on factors that are external to real estate.
Sam Chandan, Ph.D., is president and chief economist of Chandan Economics and an adjunct professor at the Wharton School.