Ask Doug Price, CEO of K&D Group of Willoughby, if the company he runs with Karen Fanger could produce its most recent project — converting an office tower at 55 Public Square to a mixed-use building with apartments — and his answer is swift.
“No way,” Price said in a phone interview.
That is the veteran of six such projects in downtown Cleveland speaking. He is not alone. There is a chorus among the can-do crowd seeking added financing sources or new strategies as high interest rates and other factors hamper the pace of new projects.
With more than 1,000 additional apartment suites bound for completion in the area this year, the market-rate apartment boom is finished for now. The hectic deal pace of the past decade is slowing. Development companies are focusing on finishing existing projects, seeking financing for other proposals, working out of town on projects that still pencil and other strategies to stay busy until the Fed cuts interest rates. Although downtown Cleveland has deservedly been held up as a model for solving office woes bred by the pandemic by converting skyscrapers to apartments, the region developed that track record and expertise because its office market is weaker than many. Both office building conversions and the ground-up construction of apartment buildings in the end face new challenges because of cost run-ups.
Tom Charek, president of Welty Development of Fairlawn and the NAIOP Northern Ohio trade group, said the challenge for developers is, in the end, simple.
“It’s a match equation,” Charek said. “You have to be able to cover your debt service.” As interest rates have climbed and banks have dialed back debt ratios, that has increased the amount of equity required to make deals go.
“You need to get creative as a result,” Charek said. “To get a good return, that’s why you need state and federal tax credits, local tax abatements and other measures to lower your costs.”
The Akron projects are still working because the municipality provides a full 15-year property tax abatement. By contrast, effective Jan. 1, downtown Cleveland dialed back property tax abatements to lower percentages in fast-growing areas such as Ohio City and Tremont in hopes of pushing forward projects in other parts of the city. In Price’s case, he is focused on trying to get state historic tax credits for the proposed renovation of the 700 Prospect Avenue building (formerly the United Church of Christ headquarters, which relocated downtown.) K&D is preparing to submit its third application for highly competitive state historic preservation tax credits after missing out to others the last two rounds of state awards.
K&D, he said, is not looking at new development projects until it gets that one moving.
Ryan Sommers, a managing director at Project Management Consultants of Cleveland, which assists developers with projections and receiving government aid, said in an interview, “Projects here already need layers of financing to close financial gaps. That was before changes in financing and construction markets changed the dynamics. That created the momentum for apartment development we enjoyed in 2020 and 2021. With the length of the building cycle, many of the projects opening now were put together then.”
Sommers and others underline the point that although Northeast Ohio residential rents have climbed, they are still lower than those in other cities — but development costs are the same as in other areas with stronger economies and population growth.
“What we have developed here is the expertise among law firms, accountants and developers on how to make these projects work,” he said. “But the reality is that other markets are learning how to do office conversions while we face a greater gap than in the past.” Sommers has developed a case study for today’s Cleveland office building conversion challenges focused on IMG Center, a 16-story office building dating from 1965 that has been undergoing a foreclosure case since 2019. It is a candidate for conversion as it is more than 50 years old and may qualify for state and federal historic tax credits and is in the city’s Erieview Historic District.
Estimating that the 281,000-square-foot structure could be converted to 304 apartments, PMC calculates construction costs at $66 million, with soft costs for fees such as architectural design and engineering at $13 million. With a building purchase price of $9.8 million (a discount), such a project would cost $89 million in total.
Preservation tax credits and property tax abatements would offset costs by around $28 million, and PMC estimates the developer is still shy by $10.5 million. That is the gap that now needs to be closed for the next wave of office conversion projects to be economically worthwhile.
Sommers argues that added incentives to those available are needed, from government or philanthropic sources. Current incentives were developed in the Jackson administration to convert empty buildings like the Halle Building, May Co. and 1717 East Ninth St. (originally the headquarters of East Ohio Gas Co.) to today’s apartments.
However, Sommers believes that, besides IMG and the lender-owned 1100 Superior office buildings, an additional 13 downtown Cleveland office buildings are underwater due to being overleveraged, are in special servicing, are under lender control after foreclosure or are headed that way.
“We face a crisis,” he said. His menu of solutions includes steps such as a district-wide tax increment financing program (such as the Bibb administration’s pending “Shore to Core to Shore” TIF initiative), building code changes to promote co-housing concepts, space sharing, specific housing and mixed-use conversion grants and reduced building permit costs. He also argues that specific financial packages should be developed to whet the appetite of out-of-town buyers for such projects.
For Price’s part, he said the solution would be for the state to reduce its cap on state historic preservation tax credits the way Texas has done. “We’ve been a victim of our own success,” Price said, reflecting on the positive momentum of prolific urban projects over the past decade.
Welty’s Charek said techniques such as using PACE financing, which provides benefits for energy-efficient conversions, are helpful.
The same dilemma faces builders of new apartment buildings that have transformed sections of Ohio City and Tremont over the past few years. Sommers estimates those costs climbed 20% over the past two years.
Indeed, Robert Stark, chairman of Stark Enterprises of Cleveland, pointed out that when the firm opened its Beacon apartments in 2017 at 515 Euclid Ave. the project was partially possible because it was constructed atop an existing parking garage that was designed to accommodate a future apartment addition.
Michael Panzica, owner of Panzica Development of Cleveland, felt that rising rents would keep the momentum for ground-up development going in 2022 but that is no longer the case as interest rates and higher construction costs have outpaced rent growth that staggers many Cleveland natives.
“In a nutshell, it is definitely more difficult to build apartments here than it was two to three years ago,” said Panzica, who has led apartment projects such as The Abbey Townhomes and Flats on the street of that name in Tremont and Church+State, 1436 Church Ave., Ohio City.
“You can borrow less than in the pre-interest hike era,” Panzica said. “Without rental increases in the market, this would be even more difficult. Projects require more equity (or developer or investor funds) to get the returns you need.” Panzica declined to comment on Bridgeworks, an apartment-hotel building next to the West 25th Street side of the Detroit-Superior Bridge.
The other solution is for real estate developers to put more of their own money into projects to meet increased equity requirements, which increases their personal risk by millions of dollars, or to bring in more investors.
Gina Merritt, president of Northern Real Estate Urban Ventures of Washington, D.C., has garnered substantial local media attention because she is that rarest of people: a Black woman undertaking substantial real estate projects in Cleveland.
“I lack the generational wealth of many of my colleagues,” Merritt said in a Zoom interview. “They have resources at hand to meet increased equity requirements. The playing field is not equal. I would probably not be in the jam I am in if I emphasized profit more than community because I believe there are rock stars among communities of color who need a little help.”
Merritt expected to have Ninety-Four Ten Hough, a project to restore a long-empty 10-story apartment building at that address, opening up this year. Instead, she is hopeful she has gained adequate financial support from corporate, philanthropic and government sources just to close on the financing package this year.
“We had the project fully funded in May 2022,” she recalled. “Our final (Housing and Urban Development) loan was for $10 million. But it became $7 million after the increase in interest rates. We then had to reprice the project because of the increase in interest rates. Our construction costs went up $5 million.”
However, the proposal to return 116 suites in the building to active use, she said, gained local support because of its location in Hough and the fact it would have cost $10 million to demolish it. A new project on the site would not offer as many units, she added.
“It’s been very difficult carrying this for an additional two years,” Merritt said. “We’ve deferred the developer fee (usually taken at the time of financing) and expanded it over 15 years. This economy is affecting developers of color exponentially compared to others because we don’t have family resources.”
Merritt said she has started to consult on other developers’ projects to make ends meet. She’s looking at joint ventures to provide affordable housing units in market-rate projects.
Yvette Ittu, president and CEO of Cleveland Development Advisors, a corporate-backed fund providing patient capital for catalytic real estate projects, would be a source for developers to seek gap financing; the fund already has provided it for multiple market-rate apartments.
However, the gap developers face is so great that Ittu has not been seeing more potential applicants because prospective borrowers need to have working financial projections and bank loans. The group has focused on community projects such as schools and job training centers and is providing some funds for developers to fund studies. It has also made a few senior debt commitments, she added.
Other developers are raising cash by selling older assets to meet equity requirements or looking to find ways to phase projects.
Panzica said he keeps hunting new projects to have things ready when conditions improve.
Charek said Welty also is pursuing projects in areas with higher rents and population growth in areas such as the Carolinas because they are easier to finance.
In K&D’s case, Price said the company is focusing on improving the efficiency of its operations and preening its properties. It is also focusing on landing office tenants for its properties. “A lot of tenants are available because they feel uncertain about the current ownership of their buildings in this environment,” Price said. “It’s an advantage to be local.”
https://www.crainscleveland.com/real-estate/rising-costs-threaten-future-realty-development-pipeline
Leave a Reply