- Apartment complexes drew record investment in 2021, but rising rates may spoil the party this year.
- Buyers and sellers are drifting apart on building valuations, stalling transactions.
- One investor expects deals to emerge later this year as some investments collapse.
Rising interest rates have set off debates over a setback in US home prices. For apartment buildings, the darling of institutional investors last year, the reckoning may already be here.
The multifamily market grew by leaps and bounds last year as fast rent growth and low interest rates attracted $240 billion in investment from investors such as the world’s largest landlord, Blackstone, and Adam Neumann, WeWork’s founder and former CEO. An intoxicating mix of record rent growth and cheap debt attracted capital from sophisticated investors and neophytes alike.
Apartment buildings, as the narrative went, would be the most effective hedge to an inflationary economy because rents were projected to rise for years to come. For the first time since at least 2009, demand for them exceeded that of office buildings, which were staring down a sketchy future as employees embraced the work-from-home opportunities that expanded during the pandemic, according to Savills.
But the party is ending, at least for now. As interest rates rise, those with cash in hand want to buy properties at a discount to the lofty prices of just a few months ago because borrowing costs affect valuations of commercial real estate. Sellers scoff, saying that their rental income looks as good or better than it ever has, which enhances values.
This stalemate may be a speed bump as the market readjusts to a new reality or a sign of serious dislocation, especially if high financing costs persist and lending stalls. Whatever the final outcome, industry leaders are feeling the heat, Manus Clancy, a senior managing director at Trepp, a firm that analyzes real-estate debt, said on the firm’s podcast last week.
“Over the last 10 days, there’s been a decidedly severe turn in that sentiment from people reaching out to me,” Clancy, whose data is used by executives across the commercial-real-estate industry, said.
He said the gist of the complaints was: “Liquidity hasn’t dried up, but it has tightened considerably.”
Indeed, many of the eight multifamily investors and experts who spoke with Insider about the shifting winds shared those views. Most still considered multifamily the most secure part of commercial real estate because rising interest rates were making it difficult for homebuyers, which increases demand for rentals. But the risk, some said, is that a recession hits, curbing rent collections and perhaps forcing financially stretched owners to dump their holdings.
One investor, Adil Hasan, a director at Yieldstreet, is preparing for fire sales, expecting increasingly costly debt to capsize some deals. He said he wasn’t not the only one, with many investors rich with capital that must be deployed. Yieldstreet, a crowdfunding platform, has raised over $640 million for real-estate deals.
Many multifamily purchases in the past few years were made with short-term loans financed in the market for commercial mortgage-backed securities, a favorite of bond investors seeking a bit of extra yield in the low-interest-rate environment. Easy access to these loans — originated when prevailing rates were far lower — contributed to a rise in overall debt on multifamily properties to a record $287 billion by the end of last year, according to the Mortgage Bankers Association.
Rising rates and higher yields demanded by the bond investors haven’t yet upended the market, which is still supported by rising rents. There are many market participants who think Hasan is waiting for what will never come. But the swift move in borrowing costs has at the very least put the market on pause, at best, or a deep freeze, at worst.
“Absent any shift in the macro conditions, we’re probably in for a cooling in the marketplace in terms of transactions and new development,” Bradley Tisdahl of Tenant Risk Assessment, which analyzes commercial real estate, told Insider.
Indeed, investors who must put their dollars to work are finding few opportunities lately. Hasan, who helps oversee Yieldstreet’s portfolio, estimated multifamily deal volume had plummeted by as much as 90% in recent weeks.
Coincidentally, the market for cheap short-term loans has seized up.
As of the July 14 episode of Trepp’s podcast, issuance of commercial-real-estate collateralized loan obligations, the complex bonds that finance the lending, had entirely dried up, with not a single deal happening in this month so far. The collateralized-loan-obligation deals totaled $24 billion across 23 deals in the first six months of 2022, with nearly half the volume done in January alone.
The shift is affecting the value of buildings, at least where buyers are concerned. This month, multifamily-property values are likely down anywhere from 5 to 10% in most markets, Lonnie Hendry, the head of commercial-real-estate advisory at Trepp, said on the podcast. Clancy projected they could drop as much as 15%, a view he said led to audible gasps during a private call sponsored by an investment bank.
Disagreement over valuations has ramped up so much over the past few weeks that Tides Equities, which says it’s the third-biggest buyer of apartment buildings this year and was the second-largest last year, has “taken its foot off the gas,” Sean Kia, its cofounder and principal, told Insider. His firm has gone from a pace of closing as many as two deals a week to nothing in the past six.
“We were extremely active,” Kia said.
He has been “pumping the brakes” on borrowing for commercial-real-estate collateralized loan obligations, where lenders have sharply increased interest rates and the amount of equity they require of borrowers, and is instead seeking funding from banks and the so-called agencies, such as Freddie Mac. He told Insider that firms like his expected certain borrowing rates to double from last year’s lows to 7% in the coming months.
Investors who thought they had great funding a few months ago have had rude awakenings. Lenders are busy canceling those deals or forcing borrowers to make larger down payments and pay higher rates.
“Some of the deals right now circulating in the market are deals that were signed two to three months ago,” Yieldstreet’s Hasan said. “People are going back to the sellers and repricing every deal.”
Could a frozen tundra turn to fire sales?
There are early signs that affordability concerns may slow rental growth, and that’s while the economy is still hot enough to warrant more interest-rate hikes by the Federal Reserve.
Hasan doesn’t think rents will decrease but expects a significant slowdown in their growth, he said. For some buildings financed with riskier underwriting — such as lower debt-service coverage ratios — reduced income could push owners into a corner, triggering sales.
“There is no way that they can fulfill all the debt obligations because of the rising interest costs,” Hasan said. “So they are going to be a forced seller of their assets in the next three to six months. Those are sort of the interesting opportunities that we are going to wait around for, and I think we can get some really remarkable deals at really good prices.”
Adam Deermount, a partner at RanchHarbor, which manages about $150 million in real estate assets, said shrinking rents relative to debt costs wouldn’t be enough to threaten the investment for borrowers.
“If you look at COVID, you had people who couldn’t or wouldn’t pay,” Deermount told Insider, referring to the effects of rising unemployment as the pandemic unfolded. “You never had an inducement to sell, meaning that your lenders and equity partners were willing to work with you and make capital available.”
In the last financial crisis, there was both property-level distress — caused by a deep recession — and reasons to sell as liquidity dried up. Right now, funding has dried up, but multifamily properties continue to be cash cows for their owners. According to the Urban Institute’s rent-collection tracker, most tenants are continuing to make monthly payments even as their rents increase.
“I’m not sure a whole lot of distress is going to come unless a recession lasts a lot longer or net operating income starts to take a hit,” Deborah Smith, the CEO and a cofounder of the real-estate investment bank CenterCap Group, told Insider.
John McNellis, an investor and developer, recalled countless times that investors salivated for distressed opportunities that never materialized. There was one big one, but it was under much more extreme conditions: when the government auctioned off foreclosed properties during the savings-and-loan crisis from 1989 to 1995.
What’s more, multifamily is typically the most stable of commercial-real-estate assets and would be an unlikely source of sales, McNellis said.
“Everyone knows this. If you’re going to go out and try to grab a great deal, multifamily is probably the last place you’ll find one,” McNellis told Insider.