Is a 20-25% Crash in Multifamily Asset Values Realistic?

[Scott Trench]

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?

[Brian Burke]

Great post, @Scott Trench!  Yes it’s bold to post all of this negativity.  But your post is well thought out and your points are solid.

Thankfully my team and I saw some of this coming, and even more thankfully we were bold enough to act on it and sell 75% of our multifamily portfolio at the peak of the market (2021 to early 2022).  And we were bold enough to not buy anything in 2022, for all of the reasons you’ve set forth here. It’s also why it might be a while before we jump in again.

Addressing each of your points with my thoughts:

Supply:  I see some risk here, but it is market dependent.  Some markets have no new supply coming.  Some submarkets have building moratoriums for multifamily.  Some areas have a ton of supply coming, yet not enough to keep up with inbound migration.  Some markets will be awash in new construction and struggle with absorption.  And some of these projects will see delays due to cost of construction and financing constraints.  I see a mixed bag here.

Demand:  I agree on the coin toss. I look at rent growth forecasts going out four years, and while these forecasts can be nothing more than highly educated guesses, it’s interesting nonetheless.  Three months ago there were 50 out of 151 major markets with double-digit rent growth forecasted for 2023.  Now a forecast by the same economists predict double-digit growth in exactly zero markets in 2023, and growth above 9% in only three markets.  When I saw the earlier forecasts, I didn’t believe them.  Some buyers apparently did, however, because I still saw some overpriced trades happening.  I just can’t quantify what will happen with rents.  And I think eventually the economists will catch up and the forecasts will continue to come down.  Without reliable data, nor my own sense of direction, the safer play for me is to watch the game from the grandstands.

Cap Rate / Interest Rates:  Cap rates can be lower than interest rates and massive profits can be made, IF there is massive rent growth.  But I highly doubt we will see that, so cap rates will have to rise in order for deals to pencil unless rent growth goes up and/or interest rates come back down.  I don’t have confidence in either of those events materializing any time soon, so another reason to stand aside.

Timing and Credit:  For the last several years I’ve watched countless buyers acquiring with high leverage short term bridge debt. Yikes.  I know that a large percentage of the assets I sold were financed with risky debt.  And I know that some of those buyers are already under stress. This problem is likely to get worse before it gets better and will likely breed opportunity in the next 2-3 years.

Value Add:  The typical syndication-size deal is pretty large, and the larger the property, the more perfect the market, thanks to the sophistication and capitalization of the buyers in that space.  Market imperfections that yield “incredible deals” are needles in haystacks. Most of what is purported to be an “incredible deal” is really just a calculation or modeling error on behalf of the syndicator.  You are right that the next buyer has to be able to underwrite to a profit, so all acquisitions need to carefully consider exit cap rate assumptions.  This is the third major variable that I can’t confidently quantify (along with rent growth and interest rates) which is keeping me in “watch and wait” mode.

How Bad Is It:  Compared to what?  In some markets, prices are already down 20% compared to trades in March of this year. In some markets (Phoenix, for example) this was like a light switch.  Stuff that was trading for $300K/unit went to $250K/unit almost overnight in late Q2, and has trended down since.  But compared to pricing two years ago, they are still up.  Even compared to 18 months ago many markets are flat to up, yet down sharply from early Q2 trades.  Despite having dropped 15-20% already, I think prices need to drop another 15-20% before buying again makes sense (absent other systemic shifts).

How Long Will This Take:  See above about the light switch.  But to fully play out we need another year or two, most likely.

Bias:  The mechanism in which syndicators make money is a legitimate business practice, but it also introduces a variety of conflicts of interest that require a high degree of ethics to manage. I wrote a whole chapter on this in The Hands-Off Investor…if you haven’t seen it it’s worth the read.  This is one reason why I’ve so consistently advocated that sponsor selection is the most critical decision a passive investor will make.  Sponsors will handle the responsibility of managing the inherent conflicts of interest differently, and this is all about the sponsor’s moral character, their experience, and financial stability.  Choosing a partner that has all three will produce better results than qualifying them based on the metric of how much of their own money they have in the deal.  Remember—an unscrupulous or financially unstable sponsor can drain the bank accounts to recoup their investment before fleeing and leaving the other investors holding an empty bag. 

What Should I Do To Make Money:  If you have money in a syndication, I hope it isn’t financed with short-term high leverage debt.  If you are considering investing in one, I’m less concerned with how much the cap rate rises, but far more concerned on the exit cap rate assumption that was made, interest rate assumption, and rent growth assumption.  It’s funny that you mention buying real estate debt, Scott.  That’s exactly what I’m doing along with my investors.  It feels safer to have someone else’s equity in the first-loss position.  And rising rates play right into our strategy.  We are also contemplating buying properties all cash.  You nailed this one.

Mitigating Factors:  The only thing that will soften price declines will be high rent growth and lowering interest rates.  The housing market is fundamentally strong—there is demand for housing, many areas have varying degrees of shortage of it, employment is still relatively strong (although there are now some cracks appearing in the foundation), and wages are growing.  But inflation of goods and services is competing for tenant’s surplus dollars, leaving them with less capacity to absorb runaway rent growth on the heels of double-digit growth for multiple years.  So high rent growth is unlikely.  And with persistent high inflation, lower rates are unlikely, at least to a significant degree in the short run.

But there is no reason to mitigate.  Prices were too high and needed to come down.  This will present an opportunity for smart investors to earn great returns with their syndication partners that survive the turmoil.