Construction Delays, Interests Costs Can Hammer Commercial Builders

With rising interest rates, the old cliché “time is money” becomes even more important for developers of commercial real estate in Northwest Arkansas.

The sooner a building can be constructed and leased, the more money the developer will save on the project and the better the rate of return on the investment.

“Every day you shave off construction time, you’ll save money because interest costs are less,” said Whitley Dunn, president of Dixie Real Estate of Fayetteville. “The vertical integration we have has created efficiencies in our construction timeline.”

It costs Dixie Development, which owns Dixie Real Estate, about $6,000 per day in interest charges for Nelson’s Crossing, the 5.5-acre $18.7 million mixed-use project under construction at the corner of College Avenue and Joyce Boulevard in Fayetteville. About $4,000 of that amount is for interest on the land purchase alone.

By comparison, in downtown Fayetteville, The Barber Group is probably paying at least $800 per day in interest alone on 1.4 acres of land it bought for the proposed 10-story Divinity project on Dickson Street. That’s based on a conservative 7 percent interest rate on a $4.2 million loan and was confirmed by Brandon Barber, chairman of The Barber Group.

If Nelson’s Crossing opens a month early and is fully leased, Dixie Development could save $320,000, said Ben Israel, founder and CEO of the company. After the project is completed, carrying costs will amount to about $10,666 per day.

Israel said three main factors have been affecting the market: the rising interest rates, increases in building costs and land prices, and the inability of rental rates to keep up with those rising costs.

Overbuilt

Dixie Development’s goal is to bring investors high “single digit returns.”

“We are oversupplied, overbuilt,” Israel said of Northwest Arkansas. “I think people that are in key locations are going to continue to do well. I think people in secondary locations are going to have difficulty attracting tenants.”

Dunn said he recently has seen landlords offer concessions to tenants he hadn’t seen before in this market.

Six months of free rent, for example, might be a concession. With free rent, the landlord doesn’t have to reduce the leasing rate but can offer an alternative incentive.

Israel said he thinks the market is headed for a correction within the next year. He said when Dixie Development began building in the Rainbow Curve area of Bentonville’s Walton Boulevard, it was paying $7 per SF for commercial land. He said similar land in that area is now going for $14 per SF, and Dixie has been offered as much as $20 per SF for its property.

“You can’t, as an entrepreneurial developer, buy $20 per SF of ground and rent [the building] at today’s market rates,” Israel said.

“In the past, a building might sit empty for three months,” he said. “Now, it is not unusual for a space within a building to stay empty a year before you find a tenant, and you are generally having to make concessions to get that tenant in there.”

“As interest rates creep up, lease rates will have to increase or costs will need to decrease to keep the same profit margin,” Butch Gurganus, leasing agent with Colliers Dickson Flake Partners in Bentonville, said via e-mail. “It is getting more difficult to justify a new project based on the current market lease rates.”

Gurganus said the industrial sector is a good example of land becoming too expensive for development.

“It is difficult to find income-producing properties that a person can leverage,” Gurganus said.

Gurganus said if the capitalization rate on a property purchase is lower than the interest rate on the loan, then the property will not generate a cash flow.

He said the large amount of capital flowing into the real estate market nationally has kept capitalization rates low. Low capitalization rates translate to higher sales prices, he said.

“Overall, the office market is still a good market,” Gurganus said. “I have done a lot of leasing this year, which tells me the vacant space will fill up and vacancy rates will fall if developers hold off on new projects in the short term.”

Gurganus said typically the leasing market picks up in the spring, slows down in the summer, then spikes as tenants rush to get property leased before the Christmas holiday season.

Tommy Van Zandt of Sage Partners in Fayetteville said his company has represented more than 300,000-SF of commercial space and closed 42 different tenant representation deals in Northwest Arkansas.

“There are certain submarkets or areas within the market as a whole where certain types of development for certain tenant needs, tenant amenities and desires make sense,” Van Zandt said.

Case in point: the building Mark Saviers, one of the partners in Sage Partners, is building in Houston.

Van Zandt said Houston notoriously has one of the worst absorption rates of leasing space in the country. Saviers is building a new 200,000-SF LEED-certified building there. LEED stands for Leadership in Energy and Environmental Design.

Van Zandt said an environmentally friendly building can fill a market niche that is not being met, such as in Houston.

“Corporate growth nationally is on the rise,” Van Zandt said. “Corporate America is healthy. They are expanding in their needs nationally. It only makes sense we’d see the same trend here,” Van Zandt said.

Marshall Saviers, vice president at Sage Partners, said he’s seen a 10 percent to 15 percent growth in the need for leased space with his large national vendor tenants.

“Plenty have doubled in size in the last 18 months,” he said.

The Spread

Gurganus said historically, capitalization rates rise with interest rates, which in turn reduces the sales price of a building and builder profit.

The profit is in the percentage points.

Gurganus said merchant builders, or someone who builds who then plans to lease and then sell the property, make a profit based on the spread between the stabilized return on cost and sales capitalization rate.

Whatever the buyer is willing to pay is sales capitalization.

The gap between the stabilized return on cost when the building is fully leased versus what the property can sell for is the spread.

The income stream is the same, but for some developers, the “debt service” or mortgage could have changed along with interest rates.

Collins Haynes, owner of Haynes Ltd., a development and architecture firm in Rogers, said most loans taken out by developers for construction are tied to a timeline.

Haynes said he had “paper” or loans taken out on certain developed commercial properties where rates jumped from 4.5 percent to 8 percent.

“The key is to move from speculative to income-generating projects,” Haynes said.

As developers convert short-term construction loans to permanent 30-year loans, they will feel the crunch of interest rates. And they can’t convert those short-term notes into long-term ones without an income producing property, Haynes said.

“So you will keep growing that note,” Haynes said of growing interest rates.

Haynes said many banks charge points at the beginning of a refinanced loan. Those points, or percentages of the debt being assumed by the bank, can range anywhere from 0.5 to 2 percentage points at the closing of a loan.

One percentage point on a $2 million note is $20,000.

“The major fallacy is that people think ‘I won’t pay interest on that until I start construction,'” Haynes said. “It’s a serious timing issue.”

Israel said a slew of commercial loans were made two to three years ago at a 5 percent interest rate.

“It [the loan] is coming due now that it’s the fifth year, all of a sudden that building that cash-flowed really well is now a negative cash flow because the interest rates have gone up 3 percentage points,” Israel said.

Marla Webb, president and chief operating officer of Dixie Development, said they knew lower interest rates couldn’t last forever.

That’s why Dixie gave some tenants the option of paying lower rents while interest rates were low, or paying higher rents up front in anticipation of rising interest rates.

“Some of our leases are tied to interest rates, and for those it’s not a problem,” Israel said. “In some of the properties we’ve acquired that’s not so, and so we will probably have less cash flow.”

Israel said his firm generally factors in a 10 percent rent increase every five years or 2 percent per year.

“It is just smart to do that,” Webb said. “I mean if you have a 10 year lease or 15, 20 or even seven, the CPI [consumer price index] is going to go up. There is always going to be some inflation measure.”

Israel said banks today generally will give a developer’s project the “shock treatment.”

“The bank will say, ‘OK, interest rates today are 5,'” Israel said. “What happens on that project if the interest rates are 9?

“We say to the tenant, we can lease it to you today at this price and you can ride the interest rate curve with us, or if you want us to give you a rate that will exist the entire term, we’ve got to bump [the rate] up.”

Preemptive Measures

Bill Schwyhart, principal with The Pinnacle Group, said his development firm can adjust its strategy based on market conditions.

The group owns more than 700 acres of land it began acquiring in 2001, mostly in the Pinnacle Hills area of Rogers.

Schwyhart said his group has the option of building office space in the “fringe” areas and charging less rent.

“We are very strategic on where things need to go,” Schwyhart said. By offering property at different price points, The Pinnacle Group can stay more diversified, said John George, spokesman for the Pinnacle Group.

By keeping an inventory of “multiple levels of affordability,” George said the group helps abate investment risk.

“There is a lot of equity in real estate right now,” Schwyhart said. “We are starting to see neutral funds come into the market.” Schwyhart said different investment structures, such as TICs or “tenant in common” are arriving in the local market.

When asked about the local market facing a saturation of demand, “I’d want to be really sure I had the best spot to put my office,” Schwyhart said.

If the location is hard to get to and does not offer amenities, it may be harder to compete, he said.

The Pinnacle Group’s commercial properties are 95 percent leased, he said.

RCR Builds Stores In Wal-Mart’s Shadow

Randy Crossno, managing director of Retail Capital Group LLC, said his office in Rogers manages more than 750,000 SF of retail space for its parent company.

In January, Crossno started a satellite office of Silver Creek Properties after leaving his job as a real estate manager for Wal-Mart Realty in November. Crossno spent more than 20 years with Wal-Mart Stores Inc.

“They are very good at site selection,” Crossno said.

He said working for developers nationwide through Wal-Mart gave him experience with “shadow” centers, which are retail strip centers that are built near Wal-Mart stores. The Irvine, Calif.-based Silver Creek primarily manages and leases shadow centers.

Crossno said Silver Creek is actively acquiring and managing retail shopping centers nationwide and is developing property in six states: Idaho, Washington, Utah, Iowa, Tennessee and Texas.

He said Silver Creek decided to open a second office in Northwest Arkansas because of its location in the middle of the country. The company manages a strip-center property in Springdale on Thompson Street that shadows a Wal-Mart Supercenter, and the company also manages a strip center near a Fort Smith Wal-Mart.

Crossno, who holds a CCIM designation, said rents in the national leasing market have leveled off and stayed fairly constant.

“I don’t think you are seeing rents grow at the same rate as construction costs and land value,” Crossno said.

Crossno said each market determines its own rent value.

“It is all about the market,” Crossno said. “It is what the landlord will accept and the tenant will pay.”

Crossno said his company generates revenue through rent growth.

“And what we base our ability to get those rents on is we believe we’ve got the best location in the market for the tenants we are representing,” Crossno said.