The Multifamily Landscape

The multifamily sector has experienced significant shifts and challenges in today’s ever-changing economic landscape. Although the industry thrived in 2021 and through the majority of 2022, slowing rent growth and higher debt costs nationwide have been significant obstacles in 2023. From economic fluctuations to changing demographics, multifamily property owners and investors must navigate a volatile environment to ensure success.

Flight to Quality

Investors are moving away from pursuing risky investment opportunities, such as properties with high vacancy, delinquency, and capital expenditure needs. Financing options such as bridge loans and hard money lenders for underperforming assets have become increasingly expensive and difficult to obtain, making those deals almost impractical. Instead, investors are choosing to buy properties in good condition within top-performing markets that generate steady income and use fixed-rate loans. In light of this, flight to quality has become quite prevalent as investors sell high-risk assets and transition to more secure investment options.

To adequately perform flight to quality, there are three ways to separate CRE investments based on risk assessment. The three categories include:

1. Core Investments: In terms of risk perception, core investments are considered the least risky. These investments involve properties of superior quality and high occupancy rates located in thriving city centers with a reliable tenant base.
2. Value-Add Investments: Value-add investments present lower initial cash flow but hold significant potential for high returns once a property’s physical and operational challenges are resolved. For instance, an investment could be made in a run-down apartment building with tenants of limited quality. After renovating the building and attracting new tenants, the property can be sold for a substantial profit.
3. Opportunistic Real Estate: Opportunistic real estate investments focus on developing new land or acquiring highly distressed properties that necessitate significant renovations and/or improvements in the market. This type of investment is widely recognized as the most risky.

In addition to categorizing investments by risk, several other factors must be considered when navigating a volatile environment. One crucial aspect is purchasing cash-flowing properties while steering away from properties with high vacancy rates, delinquencies, substantial capital expenditure requirements, and overly optimistic projected returns.

Trailing financials have become increasingly crucial as lenders focus heavily on debt service coverage ratio (DSCR) to achieve the desired leverage. Moreover, the location of the investment holds great significance, with a preference for properties situated in favorable areas and unconventional deals in high-risk locations being less commonly pursued.

Creative Financing

In H2 2023, seller financing is expected to increase. Seller financing has become an increasingly popular solution to address reduced leverage from banks and to facilitate the closure of challenging deals that would otherwise be difficult to finance. This approach enables sellers to avoid accepting significantly lower prices by instead accepting payments from the buyer over time through seller financing. This comes with risk naturally to the seller in becoming the lender, but allows them to avoid some of the pricing impact of the current high interest rate environment.

According to Secured Finance Network, seller financing transactions can be structured in multiple ways, including:

1. Bridge Finance: In this arrangement, the seller provides temporary financing for a portion of the purchase amount. The buyer is responsible for securing bank financing within two or three years to cover the remaining balance in a single payment.
2. Subordinated Seller Note: If the buyer manages to secure bank financing, the seller might agree to receive a portion of the purchase price through a promissory note. This note is of lesser priority compared to the buyer’s obligation to repay the bank.
3. Primary Seller Note: In cases where the buyer cannot obtain bank financing, the seller has the option to accept a portion of the purchase price in the form of a promissory note. This note then becomes the main debt obligation of the business.

Loan assumptions are also becoming more prevalent with those who locked in long-term loans with low interest rates in 2020 and 2021. This is being used as a selling point for deals and a method to make the underwriting still pencil at higher prices even in the current debt environment.

Furthermore, agency lenders have come out with new loan programs that can offset higher interest rates and move deals forward. Despite the increase in interest rates, Fannie Mae and Freddie Mac have successfully maintained competitive rates and supported mission-driven loans. In addition, both agencies have expanded their loan product offerings to enhance borrowers’ access to funding.

According to Globest., Fannie Mae provides the Streamlined Rate Lock program, while Freddie Mac offers the Index Lock program. These programs aim to mitigate the risk of interest rates rising during the underwriting process.

Lower Velocity

A growing bid/ask spread between buyers and sellers is preventing deals, leading to decreased velocity within the multifamily sector. Owners who secured cheap, long-term debt in 2020 and 2021 are opting to hold onto their deals and avoid reinvesting that money in the current high-interest rate environment.

CRE transactions, $5 million or more, are down 70 percent year over year, totaling only $37 billion, according to GlobeSt. This drop is not limited to specific property types or geographical areas, with offices, multifamily, and industrial sectors all being affected throughout the country. Average property values have decreased by 15 percent, while the availability of debt has been constrained due to higher interest rates and uncertain valuations. The overall slowdown in the market reflects a challenging situation for CRE as a whole.

According to Forbes, a recent report indicates that multifamily sales experienced a significant decline in Q1 2023, amounting to approximately $40 billion less than the previous year. This downturn reflects a deceleration in one of the thriving real estate markets. The decline in sales can largely be attributed to the diminishing viability of purchasing apartment buildings, as the surge in interest rates has led to increased financing costs for such acquisitions.

According to the MSCI Real Assets Pricing Index, the prices of multifamily buildings declined by 8.7 percent in February compared to the same month in the previous year.

In addition to the rise in interest rates, recent upheavals, such as the collapse of Signature Bank, are anticipated to exert additional pressure on real estate values. Regional banks like Signature Bank play a vital role as the primary lenders for commercial real estate investments, with almost half of Signature Bank’s total loans by the end of 2022 being allocated to real estate ventures.

The fear of being unable to identify a viable 1031 exchange opportunity to replace their current investment also further feeds into the decrease in velocity within the sector.

Struggling Operations | Slowing Rent Growth & Increased Vacancy

Rental rates have plateaued in the past six months while the Federal Reserve has consistently raised interest rates. This has posed increased challenges in obtaining financing for real estate purchases. According to the Apartment List June 2023 report, the national rent index saw a 0.5 percent rise in May, marking the fourth consecutive monthly increase in rent prices. However, rent growth is currently stabilizing during a period when it typically experiences a stronger upward trend.

Year-over-year rent growth is currently at its lowest since March 2021, at 0.9 percent. There is a possibility that in the coming months, the year-over-year growth could even turn slightly negative. According to GlobeSt., the slower rent growth can be attributed to decreased household formation, increased competition from newly constructed units, a shortage of affordable housing options, and reduced demand due to company layoffs. These factors collectively contribute to a decline in consumer confidence.

The Apartment List report stated that rents rose in 76 out of the 100 largest cities in the country in May. However, negative year-over-year growth is observed in 48 of the top 100 cities, an increase from the 40 cities reported last month. Scottsdale, AZ, experienced the steepest decline in monthly rents in May (-0.9 percent), reflecting a broader slowdown in the Phoenix metropolitan area.

In terms of supply, the national vacancy index is at seven percent as of June 2023, surpassing the average rate seen before the pandemic, and it is continuing to increase. The construction of a significant number of multifamily apartment units is underway, which could lead to property owners facing challenges in filling vacancies, something they haven’t experienced since the early stages of the pandemic.

Takeaways

The multifamily landscape operates in a volatile environment that is influenced by a number of external factors. Property owners and investors that grasp these dynamics and apply effective solutions will fare much better. Stakeholders can successfully traverse the multifamily sector by embracing market research and staying current with multifamily fundamentals.