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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   December 2016

Focus on Urban Opportunities

Redevelopment projects offer a solid lending niche to pursue

Focus on Urban Opportunities

Commercial real estate construction and development tend to be cyclical — trending up and down in line with other economic indicators. Despite the volatile nature of this industry, commercial mortgage originators sometimes may find developers to be overly optimistic, hoping that somehow a new building boom will be different from previous ones and will not end up in a bust.

There are many examples of volatile markets in real estate that have surged from undersupply to extreme oversupply, creating millionaires and sometimes destroying huge amounts of wealth when the market drops. Urban redevelopment, however, seems to buck this trend as a niche that takes advantage of the industry’s longer-term trends, and is therefore at least partially insulated from the volatility of the real estate market.

Smaller-scale residential or mixed-use urban redevelopment, close to the best jobs, is considered one of the most durable niches available to developers today. This type of redevelopment is spread across major cities in the nation, and Los Angeles is a good example of this niche’s growth and opportunities.

The key to understanding Los Angeles is that vast areas of the city were developed as low-density, single-family homes with generous front and back yards. As the city’s population grew, development expanded horizontally, requiring many people to commute as far as 30 miles to their jobs. Los Angeles’ freeways accommodated the growth for a while, but they eventually reached and surpassed their tipping point, and commute times ballooned to as high as 90 minutes each way.

As much as people like to have a home with a large yard, many realize that spending hours in a car each day doesn’t contribute to a quality lifestyle. Today, there is consensus among many city leaders — including elected officials — that the way forward is to build more transit options such as light rail and to allow for denser development of the urban part of Los Angeles. This trend offers opportunities for large and small developers and for the commercial mortgage brokers who help them find financing for these projects.

Because large parcels of land are hard to find in urban locations, small developers in particular stand to gain. They will be busy redeveloping Los Angeles for decades to come, as World War II–era, low-density housing is replaced with higher-density apartment and mixed-use projects located close to the best jobs.

Re-urbanization

According to a 2013 thesis written by a then-doctoral candidate at the University of California, Los Angeles, the Los Angeles metro–area population increased from roughly 2.5 million to more than 4 million between 1960 and 2010. In the same period, vast tracts of land were zoned for low-density housing rather than higher-density development. As a result, the “population capacity” of the area dropped from 10 million in 1960 to just slightly more than the actual population of 4 million in 2010. In other words, zoning decisions from decades ago created the current vast suburban sprawl.

For a number of reasons, today’s Los Angeles does not fit what is needed. First, there is the issue of excessive traffic, a direct result of sprawl having reached the tipping point and insufficient growth in transportation infrastructure. Second, companies are increasingly moving from the suburbs to the central business districts of large cities. Third, many young adults no longer seem attached to the previous generation’s American Dream of owning a house in the suburbs.

With reduced crime and more amenities in urban areas, more people are encouraged to live closer to their city jobs. This re-urbanization trend has already begun. According to the U.S. Census Bureau, the nation’s urban population grew from 79 percent in 2000 to 81 percent in 2010.

Takeaways

Commercial mortgage brokers can capitalize on their knowledge of these trends by taking steps to build connections with developers and lenders specialized in redevelopment projects. In particular, they should focus on the following points.

  • Forge relationships with urban developers. Urban redevelopment requires special skills and experience. Make a point of meeting with developers focused on urban projects. They are the ones most likely to continue developing throughout the next market cycle and beyond. Their projects are most likely to lease up or sell out, even when the next recession is underway.
  • Build connections with investors and lenders focusing on the urban niche. This is not hard to do, because many investors and lenders understand the opportunities in this niche.
  • Pay attention to smaller developers and investment groups. Ironically, capital is increasingly concentrated among the largest investment managers. In 2015, The Blackstone Group raised $15.8 billion for the largest real estate fund in history. These mega-funds aren’t interested in a 10-unit development, however, even if it is located in a terrific location and is likely to be highly profitable. They need to put out money in larger increments to operate efficiently. One way to source capital for smaller projects is to meet smaller, local and regional investment groups.
  • Get to know nonbank construction lenders. Many of the best urban projects are smaller, and developers of these projects are usually small partnerships. Given bank regulation today, however, banks often cannot lend to these small partnerships unless the developer personally has lots of liquidity and cash flow from other investments. Small-scale construction lending is increasingly provided by private lenders. Find and build connections with lenders that are active in your area and learn their lending criteria, terms and pricing.

Commercial real estate development will always be cyclical. New construction activity in 2009 was a fraction of what it was in 2006. With that in mind, some types of development are more likely to continue once the next recession hits. This industry is in the midst of a decades-long secular trend — a trend that is likely to continue regardless of the ups and downs of the economy — toward urban redevelopment in places like Los Angeles, which will create more density close to the best jobs.

Redevelopment with higher density is needed to correct the outdated development patterns of the post-World War II era. Millennials increasingly prefer urban living and shorter commute times, while large companies are relocating employees to urban core areas from the suburbs. All of these trends bode well for smaller urban residential and mixed-use developers. Mortgage-industry professionals can position themselves well by recognizing these trends and making connections with the next generation of successful urban builders and developers.


 
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