When a Project Still Doesn't Pencil Despite Falling Interest Rates

Examining the hidden cost pressures that can keep a good development from working

For the past few years, interest rates have taken much of the blame when development projects failed to pencil. It was understandable. Debt became considerably more expensive, construction financing tightened, and the amount of leverage available on many projects declined. Developers who had underwritten deals in a lower-rate environment suddenly found themselves looking at very different numbers.

So when borrowing costs begin moving in the right direction, there is a natural expectation that some of those projects should start working again.

Except many don’t.

A lower interest rate can certainly improve a development pro forma, but it cannot fix every problem buried inside it. In many California projects, financing cost is only one part of a much larger affordability problem. Construction costs, insurance, labor, utilities, entitlement expenses, carrying costs and lender requirements have all changed. In some cases, the savings created by a better interest rate are being absorbed before they ever reach the bottom line.

That is why a project that did not pencil six or twelve months ago deserves more than simply plugging a lower rate into the old model.

The Cost Basis May Have Moved While You Were Waiting

One of the easiest assumptions to make is that a project sitting on the sidelines has essentially remained frozen in place. The land basis has not changed. The plans are largely the same. The intended use is the same. Maybe rents or sales assumptions have even improved slightly.

But the cost of actually delivering that project may have continued moving.

Contractor pricing can change. Material costs fluctuate. Insurance renewals can surprise you. Utility connection expenses can increase. Municipal fees and consultant costs accumulate. A project delayed by six months can also carry additional architectural, engineering, legal and entitlement expenses that were not prominent in the original budget.

Individually, none of these items necessarily kills a project. Collectively, they can erase much of the benefit created by lower borrowing costs.

This is where developers should resist the temptation to simply update the interest-rate cell in an existing spreadsheet. If the financing environment has changed enough to justify another look at the project, the entire cost structure deserves another look as well.

Get fresh contractor input. Revisit insurance assumptions. Confirm utility and municipal costs. Look closely at the soft-cost categories that have gradually expanded. The objective is not to make the project work on paper. It is to understand what the project actually costs today.

Lower Rates Don’t Automatically Mean More Proceeds

There is another issue that can easily get overlooked. A lower borrowing rate does not necessarily mean the capital stack returns to where it was several years ago.

Lenders are still paying close attention to leverage, debt yield, debt service coverage, sponsor liquidity, contingency levels and exit assumptions. Construction lenders may also be more conservative about how they view future value, lease-up periods or stabilization.

That matters because a developer can save money on interest and still face a larger equity requirement than originally anticipated.

Consider a project where improved financing reduces projected interest expense, but the lender sizes the loan at a lower percentage of total cost than the developer expected. The savings are real, but so is the additional equity check. If that equity has a higher required return, the overall economics may not improve nearly as much as the interest rate suggests.

This is why we believe financing should be evaluated as part of the capital stack rather than as an isolated cost. The better question is not simply, “What rate can I get?” It is, “What does this financing structure do to my total equity requirement, carrying cost and return?”

Those are very different questions.

The Hidden Expense Is Often Time

For California developers in particular, time deserves its own line of scrutiny.

A project can lose money without a single construction cost increasing simply because it takes longer to reach completion and stabilization. Additional months can mean more property taxes, insurance, security, loan interest, consultant fees and administrative expenses. Delays can also push construction into a different pricing environment or move stabilization into a less favorable leasing or sales market.

The danger is that these costs often arrive gradually. There is no single invoice large enough to trigger alarm. Instead, the project experiences a slow erosion of margin.

When reviewing a project today, we would recommend running at least one scenario that assumes the project takes longer than planned. What happens if permitting adds three months? What if construction takes four months longer? What if lease-up or stabilization requires an additional six months?

If a relatively modest delay eliminates the projected return, the project may be carrying more timing risk than the headline numbers reveal.

That does not necessarily mean the development should be abandoned. It means the contingency needs to reflect the real risk.

Don’t Force the Old Deal to Work

There is a tendency in development to become attached to the original version of a project. A tremendous amount of time, money and effort has already gone into it, so the natural instinct is to keep adjusting assumptions until the original concept works.

Sometimes the better decision is to change the concept.

That might mean reducing the scope, phasing construction, changing the unit mix, reconsidering specifications, negotiating the land basis, bringing in additional equity or restructuring the debt. It could even mean waiting.

The important distinction is between improving a project and improving a spreadsheet.

Falling interest rates can create an opportunity to revisit projects that have been sitting on the shelf, but they should not be viewed as a rescue plan. If the economics still do not work after financing improves, the answer is probably somewhere else in the capital stack, cost structure, schedule or development plan.

Before assuming that another small rate reduction will finally make the numbers work, take a fresh look at the project from the ground up.

The most valuable question may no longer be, “How much have rates come down?”

It may be, “What else changed while we were waiting?”