I've been noodling on this for a few weeks, and the more I think about it, the more I'm starting to convince myself that large multifamily is one of, if not the most, riskiest asset classes in America right now.

Here's my premise:

Supply: According to Ivy Zelman, backlogs for new construction in multifamily are at the highest levels since the 1970s. She estimates 1.6M backlog units. Builders will complete this inventory, and they will monetize it. This will put downward pressure on rents, and asset values (upwards pressure on cap rates).

Demand: We think rents are a coin flip in the next 12 months, and that a good forecast is zero rent growth. Vacancy is ticking up, as rents are falling in recent months in the multifamily space. If vacancy is already ticking up, and rents are declining, this kills the thesis for most multifamily value-add with fixed 2-5 year time horizons.

Cap Rates and Interest Rates: Interest rates are higher than cap rates right now. That's really scary. It means that every dollar of debt that you take on in a no or low growth environment reduces returns AND increases risk. The only way you can justify making an investment in an environment like this is if you believe you can rapidly increase rents/NOI, or if for some reason you believe that cap rates will decline still further.

The market is essentially going all-in on rent and NOI growth in the next 12-18 months. Given the massive supply coming online in the next 12 months, and the question marks around rent growth, I think this is really hard for me to believe.

I think that if anything, interest rates are likely to continue rising quickly in the multifamily space, and that NOI has a very good chance of flatlining or remaining stagnant.

Timing and Credit Considerations: The debt market is already starting to tighten, and (I do not have data on this) I believe that most multifamily properties are financed with variable debt with a 5-year Weighted average Life (WAL) in the range of 60/40 to 70/30 debt to equity. I believe that this varies considerably across the industry, and that folks are in all sorts of different positions. But your typical syndicator will finance this way to maximize returns in a growth environment. This puts timing pressure on deals. If I'm right about the 5-year WAL hypothesis, then about 20% of the market that has financed their portfolios will need to refinance or exit in the next 12 months. The pressure will mount by another 20% in the following 12 months.

Value-add: I can already hear some folks arguing that none of this matters if you can find an incredible deal, well below market, and add a ton of value to reposition the asset and increase rents. Fair enough, the value-added deal sponsor still has to consider the likely buyers at an exit. And that buyer will want a return. The end buyer is not likely to purchase a property with little value-add opportunity at a cap rate that is lower than interest rates - it's almost preposterous.

How bad is it and when will it hit?

Massive supply, weakening demand, debt that is so expensive relative to cash flow that it dilutes returns in all but the most aggressive growth forecast scenarios, and a slowly tightening credit market. These are incredibly tough market headwinds. I don't think the question is whether cap rates and multifamily valuations will decline. The questions for me are how much will asset valuations decline by and when will it happen?

First, I believe that multifamily valuations could decline by as much as 20-25%. Take a look at this chart:

How Much will Cap Rates Rise? Cap rates typically hover about 150 bps higher than interest rates. Is it unreasonable to project that cap rates rise in the current environment from ~5% to 6.5%? That is a BIG deal if that happens. It means that a property that generates $500K in NOI drops from being worth $10M to being worth $7.7M. That's a 23% drop in valuation. If you are financed at 60/40 debt/equity, 58% of your equity is wiped out. At 70/30, that's 77% of the equity eliminated.

How Long will this take to come into effect? If you believe that this is a reasonable projection, then the next question is when. When will this rise in cap rates happen? My guess is that the change will be a process, and not an event. I don't see cap rates rising 150 bps overnight. I think it will be a slow ramp over the next 12-18 months as more and more supply comes online, and more and more folks are forced to exit.

Bias in the market? The syndicator pitching an investment deal is perhaps a fine, but definitely a biased, source of information on the market, deal, and opportunities. Remember that syndicators make money in multiple ways on a deal. First, they often charge an acquisition fee - they make money just by buying large investments. A gimme. Second, they typically charge management fees - often a few percentage points of the equity investment in the deal. Third, they often get carried interests - or a percentage of the profits, if any, in the deal. Many syndicators invest nothing or very tiny percentages of their net worth in individual deals. There is no incentive, other than reputation (which I hope is very powerful), to do anything other than raise as much money as possible, and buy as much real estate as possible. If valuations keep climbing, GREAT! HUGE profits via these fees and carried interest. If valuations decline, "Oh well!" - they get acquisition and management fees, and get little/no carried interest. It's their investors who actually have large amounts of capital at risk.

I'd have a very hard time ESPECIALLY with investing through a syndicator who was not investing a material portion of their net worth in their deals at this point in the market.

What should I do to make money?

- If you have money in current syndications, pray.

- If you are considering investing in a syndication, make sure it is a huge winner even in a no rent growth environment, and one where cap rates rise at least 150 bps.

- Consider getting on the debt side, via a debt fund or private lending - the interest rates are higher than the cap rates! Might mean better returns with lower risk.

- Consider investing in a syndication that uses no leverage at all - as this might yield higher cash flows, and come with less risk - if there is a low growth or no growth environment, it will also yield better returns.

This is a super bold post. I'd appreciate any feedback here before I post these thoughts to the main blog and/or state these forecasts any podcasts!

I'd especially like to know about any mitigating factors - what would soften any price declines in this market?

Scott Trench

Podcast Guest on Show #223