What Happened? An Analysis of the Multifamily Meltdown

In This Article

We all hate market meltdowns, and this one was bound to happen. We just didn’t know when, exactly how, or how bad things would get. But we now know the answer to the first two of these three questions. 

• When? Currently underway.
• How? See below.
• How bad? No one knows.

The purpose of this article is to explore what led up to the unfolding meltdown of what is happening now. Then, based on the 10 items I consider below, investors can draw conclusions about what may happen next and how bad this could get.  

Recently, the Wall Street Journal reported that thousands of investors lost millions of dollars in a series of multifamily deals. The article highlights a mid-level Dallas IT worker who built a 7,000-unit multifamily portfolio in just four years. Unfortunately, he lost 3,200 units to his lender in Q1, defaulting on $229 million in debt and losing a boatload of syndicated investor capital. 

I’ll comment briefly about what happened here, what’s happening to many syndications right now, and why this failure will certainly not be the last one. Then I will tell you one critical thing you need to do now before you invest again. 

The Newru Effect

I’ve often discussed the dangers of investing with newrus. “Newru” is my tongue-in-cheek label for promoters who were not in real estate until recently but are now promoting themselves as experts who syndicate deals and raise millions of dollars from thousands of investors. 

Newru = Newbie Gurus

The term hasn’t caught on yet, but I’m counting on your help. To be clear, nothing is wrong with being new to investing and getting into syndications. What can be wrong is when some of these folks tell others, “It’s different this time.” They often take colossal risks and convince others to follow in their footsteps. 

Newrus have risen to prominence in the past decade through a variety of converging factors. These include: 

1. Enhanced syndicator capital-raising opportunities resulting from the 2012 JOBS (Jumpstart Our Business Startups) Act.  
2. The broad popularization of real estate investing due to trendy HGTV and other network shows.  
3. Self-promotion opportunities afforded by ubiquitous social media and other online advertising platforms. 
4. A movement away from Wall Street’s casinos toward alternative assets. 
5. A record (time and growth) bull market in commercial real estate coupled with increasingly fading memories of the 2008 disaster.
6. Significant growth in wealth and investable capital among millions of Americans.   
7. An influx of investments from the three I’s: institutional, international, and (self-directed) IRA investors. 
8. The popularity of coaches who promise freedom from the daily grind and great riches by becoming a syndicator (“no experience needed, and yes, you can try this at home”). 
9. A late 2017 tax law change that provided a massive boost to commercial real estate investors. 
10. A common realization by HGTV watchers (see #2) is that they love and believe in real estate but don’t like dealing with toilets, tenants, and trash. Investing in a syndication is a natural next step. 

Don’t get me wrong. I am not generally critical of most of the factors that gave rise to this problem. Wellings Capital and many of you have benefitted from this environment.  

I am critical of how these factors converged to produce a new breed of inexperienced, unqualified, and sometimes unscrupulous operators. Syndicators who collected hundreds of millions of dollars of investor capital to gamble on multifamily assets that, acquired and managed properly, should have produced reliable investor returns. 

This house of cards was bound to tumble, and most of the issues were predictable. But there was one issue I failed to predict in my numerous articles and videos warning of the outcome we’re experiencing now. I’ll get to that in a moment. 

If you have been in Texas, especially these past few years, you might have heard radio ads enticing listeners to join one of several multifamily training programs. Thousands paid the fee and took the plunge in Texas and nationwide. 

These gurus enticed would-be syndicators with the chance to profit from acquisition fees, asset management fees, and other fees paid independent of the deal’s success or failure—an easy path to riches. 

Jay Gajavelli is the subject of the WSJ article. He is a Texas IT guy turned student turned syndicator who lost 3,200 multifamily units and tens of millions of investor dollars. Quoting from the article:

“After finishing one exhausting workweek, he said, he was struck by a thought that changed his life: ‘I’m sick and tired of working for my money.’ That was when he decided to become a landlord, he said. In time, ‘I was able to replace my IT income,’ he told prospective investors last year in a webinar. ‘I live on my own terms.’

He was also quoted on an investor webinar saying: “I never worry about [the] economy now.” “Even if [the] economy goes down, still I make money.”

These programs tend to be heavy on raising capital and finding deals but light on asset management. I heard one of the teachers say that getting the money and the deals are the hard part. But managing the deal is pretty simple with a good property manager. 

Uh-huh. 

Even programs that taught asset and property management couldn’t create the experience that only comes from years in the trenches. 

Here’s another quote from the WSJ article highlighting Gajavelli’s lack of asset management skills and financial woes:

“A video for prospective Applesway investors that was posted in December 2021 featured the 704-unit Houston apartment complex called Timber Ridge. Applesway, Gajavelli’s company, bought the complex that month for $56.7 million with plans to more than double investor returns by raising rents and adding tenant fees for washing machines and covered carports.

The investor video showed a tidy complex of apartments arranged around a shimmering swimming pool. By summer 2022, the pool water had turned a sickly green. High piles of trash littered the parking lot. Tenants complained to city officials about rats, mold, illegal evictions and the failure of management to properly maintain the buildings.”

So these programs churned out thousands of inexperienced students into a market ripe for tribulation (see list above). And these students began competing, outbidding one another in a race to the bottom.  

And the continual CRE and general economic boom served as a rising tide to lift almost every boat. Even newru boats. 

Millions were made. New students signed up. The market got even frothier. And successful investors and their friends tripped over each other to invest in the next soon-to-be-sold-out deal. 

The glitziest capital raisers often rose to the top. But the best promoters are often not the best asset managers. Yet few people seemed to care as they collected quarterly payments and went into debt to invest even more. 

With hundreds of syndicators competing for every deal, something had to give. Syndicators had to: 

1. Significantly overpay for assets.
2. Cut costs by financing with short-term, floating-rate debt. 
3. Employ more aggressive growth assumptions to convince willing underwriters and unsuspecting investors of the deal’s merits. 

But here’s what actually happened:

1. Interest rates rose at an unexpected pace, doubling debt service costs in some cases. 
2. Rent growth grounded to a halt and even retreated in some cases. 
3. Operating expenses continued to rise with inflation. For many, insurance and property taxes increased by 50% to 75% or more in the past year. Some Texas and Florida assets saw insurance double or triple.  
4. Short-term debt faces refinancing, but the math no longer works. 
5. With refinances looming, banks are lending less and stiffening terms. 

This wasn’t a surprise to many of us. But here’s what I didn’t see coming.

Many syndicators with floating rate debt paid for an interest rate cap. Good for them. These caps are temporary and must be renewed, often long before the loan comes due. Lenders have a contractual right to demand that syndicators reserve cash for upcoming rate cap renewals. And they’re doing that. 

These interest rate cap reserves are crushing many syndicators. 

I’ve heard firsthand reports of syndicators setting aside a few thousand dollars monthly into a reserve account for their next interest rate cap. Their lenders increased this mandated monthly reserve to tens of thousands of dollars. Sometimes increasing required reserves by 50x or more (you read that right). 

Last week I heard about a successful syndicator who made $60 million over his career. He is now facing complete ruin due to this convergence of financial problems topped off by this interest rate cap reserve issue. 

So newrus, who expected to keep raising capital and sailing through “easy” acquisition-to-sale cycles, hit a horrifying roadblock. Now we’re hearing about suspended distributions, capital calls, and a handful of foreclosures. As I write this, today’s CRE Daily states: 

“Multifamily asset values are still above pre-pandemic levels, but some owners who opted for riskier loans and are looking to sell quickly are finding a desert where they expected at least a trickle of buyers. The multifamily market saw lenders eagerly issue highly leveraged bridge loans to meet demand in years past, but many investors are now struggling to cover these debts, and headline-making defaults may fall like dominoes in short order.” 

What to Expect From Here 

I sincerely wish none of you were on the investing end of any of these deals. But I know many of you are. 

While getting from 9% to under 5% inflation was less painful than expected for most employees and consumers, I believe that getting from here to the Fed’s target 2% inflation rate could be excruciating for America. 

In the meantime, we expect many more apartment projects to return to lenders. This will cause thousands of investors more pain. This situation will also provide opportunities for syndicators and funds with the cash and conviction to step in and acquire these assets. Though we hate to see the pain this is causing, we are watching the market for opportunities. 

The strength of housing demand is not at all in question. And it is likely that this downturn will put the brakes on new supply, resulting in a better opportunity for syndicators and developers when the time is right.  

A Singular Takeaway

I have one takeaway from this rather depressing commentary. The two most essential words in passive investing, both for our team and for all investors: due diligence.

I highly recommend you get Brian Burke’s thorough treatise on performing due diligence for passive commercial real estate investments. BiggerPockets published The Hands-Off Investor in 2020, and you can get some great bonuses by ordering it here at the BiggerPockets Bookstore. 

Some of the greatest fortunes were amassed while blood ran in the streets. We’re not there yet, but that day could come soon. Will you be ready?

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.