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?

[Jon A.]

Very interesting post and I think you make a number of excellent points. The one piece i think is missing, unless i missed it in your post, is the Fed. Imo in the next 12 months the Fed will either cause a recession or solve inflation. In the former scenario, the Fed will be forced to cut rates and mortgage rates will likely drop substantially. In the latter scenario, long term rates will likely drop but more moderately, as the mortgage market seemed to have priced in long term inflation. Either way, potential drop in rates in 12 months would potentially mitigate the 12-18 month scenario you described. Who knows what will happen. Just my two cents.

[Bjorn Ahlblad]

@Scott Trench I think 20-25% fall in RE across all markets is a pretty realistic expectation. Some areas will fare better than others. Some markets rose about that much in 12 months anyway. 

Rents exploded over the last 12 months in many markets, so the expectation for them to fall makes sense. Again some markets will be OK others not so much. 

To me the key is will you have enough money in reserves so your business will get through. Prices go up and they go down, if you can survive the trough you will be fine. Those who are forced to sell in a bottom market will be in a world of hurt. Being too heavily leveraged is not good in the coming downturn if there is one.

[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.

[Chris Seveney]

Quote from @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?

 It is good to see BP posting about some of the realities of what is coming down the pipe in real estate as there are a lot of newer investors on this platform only listening to one side.

I agree with a lot of what you say. Also I saw a post from Jonathan Twombly on Linkedin that noted 

"1,457 Multifamily Properties Currently Barely At or Below DSCR Requirements - and What This Means for You

Today it was reported that real estate data provider Trepp has 1,457 multifamily properties in its database that currently do not meet or barely meet the 1.25x DSCR requirement on their loans. That translates into $18.6 billion of debt, and assuming 75% LYV, translates into $23.25 billion of MF property.

What does this mean for you?

It means that bargains are on the way, especially for properties with maturing bridge debt, where the sponsors underwrote an refinancing into permanent debt at pre-2022 interest rates.

The potential is way larger than the mere 1,457 properties identified by Trepp. Some $1 trillion of real estate loans will mature in the 2023 and 2024 across all flavors of commercial real estate, and a substantial amount of this will be in MF. These properties will need to refinance in a much higher interest rate and cap-rate environment than existed when they obtained their original debt.

"Extend and pretend" won't work as well as the last crisis, because interest rates are rising, not falling as they were in the aftermath of the Great Financial Crisis. And many lenders won't want to work with sponsors who did not perform, so many of these sponsors will be forced to sell if they cannot refinance.

This means that, for strong and experienced sponsors, who are not tainted by forced sales or foreclosures, there will be more opportunity to purchase MF at attractive prices than we have seen in a very long time"

I agree with you about syndications, as I am already hearing from some of our investors that they are having cash calls and cannot exit their syndication.

People may want to consider funds vs. syndications. Reminder a fund invests in multiple assets not just one, and funds are not strictly multifamily there are debt funds that take on no leverage (cough cough). As noted the returns may not be as exciting as what some SAY they were getting with MF in the past, but in todays market risk aversion is real and people who have not been through a downturn will understand how risk plays out in real estate when you have limited exit options. 

[Arn Cenedella]

@Scott Trench  @Brian Burke

Thank you for your reasoned input.

I’d like to second the notion that real estate is local and specific markets will react differently to the (negative) factors you note.

Data I have reviewed indicates Class A and B product is down 7% to 8% and for Class C maybe down 15%. Again with the caveat about market specificity. So to indicate 20% to 25% down given interest rates will continue to increase seems a reasonable notion to me.

We are in a situation where short term factors are negative whereas long term factors are still largely positive.

My approach will be to continue to look for solid properties that can be purchased at value pricing and think long term - ie I will buy an asset in a market I like knowing it’s value may drop over the next 12 to 18 months provided I have confidence in that market 5 to 7 years from now. 

[Scott Trench]

@Brian Burke I am going to review your book thoroughly in the next week.

This is an incredible response. Wow. Thank you for the huge value-add here. I think we need to invite you back on the BP Podcasts soon here and am alerting some members of the team here at BiggerPockets to your points. 

Could you potentially link some of the sources you use to get data on regional cap rates/valuations? 

I feel like I have to piece my analysis together with google searches one by one, and as an amateur in analyzing the multifamily market, I haven't identified the sources that publish some of these forecasts (however bad you think they might have been) or the ways to get basic raw data - like cap rates and information on typical debt financing structures.

Also - I should have stated this in the original post - but yes, absolutely, I believe that this "crash" (if this happens) will have drastically different outcomes at the regional level. The supply/demand dynamics can change massively region to region. I was looking at things from a top down, national level, but I think that certain markets may have harder or softer landings based on their specific characteristics. 

[Todd Dexheimer]

I agree with a lot of your points. As always, real estate is hyper local, but also national. I expect to see some markets, like Phoenix, Tampa, Austin, Dallas, etc drop by 30-40% and others that have had less of a run up and cap rate compression to drop 15-25%. 

If the high population growth markets drop by large amounts, they will be markets to jump into, as they are still poised for future growth. 

Price reductions will happen due to factors you mentioned, but will also depend on how many sponsors NEED to sell. There are a lot of bad loans out there that will force sales over the next few years. These owners will not be able to refi or sell for a profit due to interest rates and market conditions. The other pricing factor will be determined by if there is a recession and how deep it is. 

There are factors at play that may make a 30-40%+ decline impossible. First, there is a ton of money chasing yield and multifamily is seen as a safe haven. As prices reduce enough, will that money flood in to buy the discounts, therefore stopping the price reductions? Second, there is still a housing shortage, so will demand and rent growth continue to prop up the market, which in turn will stop a large slide? Third, will interest rates drop as fast as they went up, allowing investors to refinance and sell? 

The next 12 months is going to be a bumpy ride. Buckle up and pay attention!

[Nicholas L.]

@Brian Burke

Any perspective on all of the new start-ups that are turning SFHs into syndication-like opportunities, like Arrived Homes?  Is there similar risk to their portfolios to what @Scott Trench described?

https://techcrunch.com/2022/05...

Just to be clear, personally, I'm completely uninterested in having a $100 share of a SFH... as I'd like to own and control the whole home.

But I'm interested in other perspectives as to whether these operators are going to find themselves overleveraged and unable to deliver dividends and appreciation, or whether they're here to stay as a way to invest in RE.  Especially if prices stay high despite the actions of the Fed.

[Nick H.]

@Scott Trench great analysis. On timing and credit considerations, which is pretty key here, if can't find the data, I'd be curious what % of the multi fam market is large PE RE players ($10B - $100B+ AUM) vs. mid-size RE PE ($1B - 10B) vs. large syndicators $100M - $1B vs. smaller or one-off syndicators. 

I think larger players are likely locking in longer term debt, maybe 7+ yrs? I'd be surprised, though, even for 1-off syndicators, any substantial part of the market is sub 5 year debt (someone correct me if that's wrong). So I'd educated guess that the avg of total apt market is closer to 7 years term length of debt. 

Let's run with your 5 year example though. If that were true, I wouldn't expect 20% of market to have to sell in 2023. 2023 sellers would be the cohort that took on 5 year debt in 2018 (or 6 year debt in 2017, etc). Depending on repayment penalties, I'd expect the bulk of 2018 5 year debt cohort, 2017 6 year debt cohort, 2016 7 year debt cohort, etc to have refinanced in 2021 or early 2022. 20% would assume zero refinancing, but I'd guess the majority of the market may have refinanced in 2021-22. 

So that + longer than 5 yr debt term may swing your analysis a bit. Just food for thought. 
 

[Shauna O'Donnell]

@Scott Trench, thanks for this informative post!

On the supply side, you stated that there is a massive supply coming online in the next 12 months. Where are you pulling that information from and what kinds of constructions trends have you been seeing? I keep reading inventory is low and it will take years to catch up, but do you have data that this is shifting in some markets already? Curious about this because it would obviously not only impact big syndications but also the small MFR investors like myself.

I also agree with other people who posted that rates aren't likely to hold here, especially as we begin to see a slowing of inflation. What's to stop that from offsetting some of the decline in prices that you are predicting?

[Chris Seveney]

@Shauna O'Donnell

I was having lunch today for an attorney for a family owned multi billion dollar developer. They have some loans maturing on some of their older properties and are having trouble getting new financing. This is a company with little debt and billion plus in assets. We were talking about multi family in general and she mentioned if they are having trouble getting financing she can only imagine some of these syndications and funds and the equity calls that are coming.

There are going to be a lot of operators who will be forced to sell. This is not only MF but your gonna see it in all aspects of commercial.

[Jay Hinrichs]

Scott,

I am no expert at all in MF but you raise great points and as I was shopping personally for an end of year purchase for cost seg.. I was coming up with the same thoughts  who is buying 4.5 caps when the best rate I personally can get from my commercial bank is about 6% these days or a tad north of that.

the bias from syndicator or sponsor cant be under emphasized in looking at some of the larger offerings a 1 to 3 million dollar up front fee is a lot of temptation to take the deal down and work it through the best you  can. 

But  for us individuals who are trying to buy our own deals and actually want/need a return on our invested capital the inverse interest to cap rates make ZERO sense unless your paying cash ( which I know a lot of folks do and we do ourselves). but for the cost seg  leverage is the main driver for that play.

Not to mention DSCR simply dont work with inverted interest rates and cap rates.

bottom line as I have been hunting in Q 4 at least here in the PNW I am seeing cap rates rise and starting to get into the 6 range.. Credit at least for me is still available through my commercial bank but we are not talking 20 to 50 million dollar loans either its community bank size.

I dont know that finance world of the big MF loans.. But I do know on my SFR construction loans and my bank they have rolled out a portfolio loan for my buyers that buy MY product to retire THEIR construction loans.. And this is mid 5s right now. What I am seeing back east with lower price points is business is still moving along for lower end rentals you know the under 250k SFR type or small plex's and those seem to be working with the higher rates just fine right now.

Lastly I will 2nd 3rd and 4th Brian's comments on Sponsor,,   Great Sponsor will normally mitigate a rocky road,, Bad Sponsor kills projects

[Mike Dymski]

Great post and replies.

Many properties purchased before 2022 experienced huge increases in rents, NOI, and value and have a yield on cost that is well above current interest rates. The fed then naturally raises interest rates in the normal course to slow this economic growth. All of this is happening at a rapid pace due to excessive government intervention. The properties that will struggle are those that did not (or will not) experience the run up in rents/revenue...and have a debt maturity in the short or medium term.

Feel free to shoot holes in this thought process.

[Luka Milicevic]

Excellent post and analysis.

Back in June I had a discussion with my attorney who invests in commercial RE. I remember he told me he sees a massive crash on the horizon in multi fam due to over leveraged buyers jumping on the "cheap money" 

It was hard for me to believe as I predominantly invest in single fam development. 

Fast forward to today and I can very much see it happening.

I mean the cap rates people were paying in my market were between 0 and 2! I don't understand why-at that point just buy bonds....

Opportunity is on the horizon.....

[Brian Burke]

Quote from @Scott Trench:

Could you potentially link some of the sources you use to get data on regional cap rates/valuations? 

 

CBRE has a free twice-per-year cap rate analysis, it’s available for free by giving up your email address.  Plus cap rate data is available for individual trades on CoStar with a paid subscription. But I don’t get my data from either of these sources. Instead, I underwrite a lot of deals and see where these assets ultimately trade, so I can see the temperature of the market (that’s really what cap rate is) first hand.

I feel like I have to piece my analysis together with google searches one by one, and as an amateur in analyzing the multifamily market, I haven't identified the sources that publish some of these forecasts (however bad you think they might have been) or the ways to get basic raw data - like cap rates and information on typical debt financing structures.

You’re right—this data is hard to find, and if you find it without paying for it, it’s worth exactly what you paid. Media members use free data to create talking points…business leaders should never make multimillion dollar decisions with free data—yet it happens all too often.

[Brian Burke]

Quote from @Nicholas L.:

@Brian Burke

Any perspective on all of the new start-ups that are turning SFHs into syndication-like opportunities, like Arrived Homes?  Is there similar risk to their portfolios to what @Scott Trench described?

https://techcrunch.com/2022/05...

Just to be clear, personally, I'm completely uninterested in having a $100 share of a SFH... as I'd like to own and control the whole home.

But I'm interested in other perspectives as to whether these operators are going to find themselves overleveraged and unable to deliver dividends and appreciation, or whether they're here to stay as a way to invest in RE.  Especially if prices stay high despite the actions of the Fed.

I can’t comment on these specific groups or their strategy, Nicholas, because I don’t know them and haven’t seen what they are doing.  I can say that you can’t generalize the strategy by saying that they will be over leveraged or deliver dividends (or not) because each of these ventures can be structured differently and play in different markets.  Certainly some will have trouble, and perhaps some will execute as planned.

I did this about 13 years ago, before it was cool.  I bought over a hundred homes in the SF Bay Area as a syndicated SFR buy/rent strategy.  Sold out of the last of them a couple of years ago.  It was a tremendous success.  But that was then, when I was buying just after a 50% price drop and before a long real estate bull market.  I just don’t get the strategy now.  I can’t figure out what these guys are thinking.

[Robert C.]

@Scott Trench, @Brian Burke

Follow up question. What are your thoughts on a tug of war between all the aforementioned potential crash indicators vs. sticky inflation? How much of any upcoming crash is just dealing with "pandemic hangover", and where will we be when we return to an equilibrium but after having gone through (and maybe continuing to go through) several years of higher inflation? 

Isn't the whole concept of living through a high inflationary period that, when all's said and done, both rents AND valuations will be generally higher. Except as multifamily owners, it just won't FEEL like we are making more money because everything has become more expensive (or said another way, our dollar has lost more of it's value). I believe most economy-watchers agree that we aren't likely to just fall straight back to 2% inflation. There could even be additional spikes in inflation like in the 80's, right? 

In terms of supply, I get that some regions of the country will have a glut from in-progress projects. But once that gets worked through, I can't imagine much new construction happening subsequent to that without more catalysts. Construction costs have gone so out of whack, that it's hard to even put together an estimate with any confidence at the moment. Either replacement costs have to fall enough to pencil with drops in rents, or rents (and therefore valuations) have to be pulled up in order to motivate the developers. Hasn't the mantra among all real estate gurus been that rents go up with inflation? Not to mention, every little repair you're doing when a unit turns or to keep your tenants happy is hacking away at your bottom line more than ever. 

Hopefully I'm making some sense - there's a lot of upward pressure, too, in this environment. 

It seems to me that the way things will play out after an initial shock are a little foggier than just everything going on sale. Maybe after the dip, having cash is king, but you can only buy 75% of the amount of properties with your money than if you'd stayed invested. When I hear stories from older investors who lived through the 70's/80's, I don't tend to hear about people who made it rich in the early years, as inflation was going up. What I do hear a lot of is about people who didn't get wiped out and held on past the end of the period, and then became super wealthy. That happens to coincide with the historic peak in interest rates followed by many decades of the rates going in basically one direction - down. 

[Chris Seveney]

@Robert C.

One thing I will add is we already have seen the run up in home prices and rents from the $6T of money we put into the economy.

Here is a great video from 45 years ago that still holds true today

https://youtu.be/F94jGTWNWsA

[Jay Hinrichs]

Quote from @Robert C.:

@Scott Trench, @Brian Burke

Follow up question. What are your thoughts on a tug of war between all the aforementioned potential crash indicators vs. sticky inflation? How much of any upcoming crash is just dealing with "pandemic hangover", and where will we be when we return to an equilibrium but after having gone through (and maybe continuing to go through) several years of higher inflation? 

Isn't the whole concept of living through a high inflationary period that, when all's said and done, both rents AND valuations will be generally higher. Except as multifamily owners, it just won't FEEL like we are making more money because everything has become more expensive (or said another way, our dollar has lost more of it's value). I believe most economy-watchers agree that we aren't likely to just fall straight back to 2% inflation. There could even be additional spikes in inflation like in the 80's, right? 

In terms of supply, I get that some regions of the country will have a glut from in-progress projects. But once that gets worked through, I can't imagine much new construction happening subsequent to that without more catalysts. Construction costs have gone so out of whack, that it's hard to even put together an estimate with any confidence at the moment. Either replacement costs have to fall enough to pencil with drops in rents, or rents (and therefore valuations) have to be pulled up in order to motivate the developers. Hasn't the mantra among all real estate gurus been that rents go up with inflation? Not to mention, every little repair you're doing when a unit turns or to keep your tenants happy is hacking away at your bottom line more than ever. 

Hopefully I'm making some sense - there's a lot of upward pressure, too, in this environment. 

It seems to me that the way things will play out after an initial shock are a little foggier than just everything going on sale. Maybe after the dip, having cash is king, but you can only buy 75% of the amount of properties with your money than if you'd stayed invested. When I hear stories from older investors who lived through the 70's/80's, I don't tend to hear about people who made it rich in the early years, as inflation was going up. What I do hear a lot of is about people who didn't get wiped out and held on past the end of the period, and then became super wealthy. That happens to coincide with the historic peak in interest rates followed by many decades of the rates going in basically one direction - down. 

AS it relates to sticky inflation I totally concur with that.. in my little sand box the only thing in construction that has really come back down hard is Lumber.. everything else prices have stuck and or are going up.. Like we just got a notice that our concrete is going up 15 bucks a yard jan 1. 10% increase.  So U have to back everything off of land prices.. so for us who bought land and developed it in the last 3 to 5 years our land costs are already sunk into the deal .  for us small home builder our profits tend to be 10 to 20% Net on Gross sales price.. so if new construction falls 10 to 20% your going to have what is happening now.. builders will simply not build until land prices start to fall .  so we are right back to 2010 with builders that cant hold lot inventory and have to liquidate at a loss.. now keep in mind many builders are very cashed up now and dont have debt on their dirt so they can ride it through..  But new projects going forward at elevated dirt prices and elevated build costs its exactly right on point to your thought if rental rates come down  or vacancy then everything has to back down from there.

I know we are talking MF which is not anything I really know but it does correlate to development and SFR in a broad sense. So in markets that rely on new builds for a lot of their economic growth and houses to put people into.. in the next year or two there is going to be a massive shortage and a ton of layoffs in the trades.. My subs are calling me wanting to know whats next.. I am like there is no next..  We are still getting some presales and have not had to discount but we are not doing volume we pivoted into semi custom and cash buyers or those who already sold and are renting and want out of rentals.. So my forecast for 2023 is volume down by 50% but profits actually per unit up compared to 2020.  Other wise we simply don't build and we paid most of our dirt off so we can hold.  its the over leverage company Or should i say company that runs on max leverage and those builders that have to go to private money instead of banks and  there are a lot of them so not only do they have the debt but its high priced debt. Not to get into the tulle's but there is a big difference in borrowing from a local community bank ( rate wise) and also if things go wonky the work outs are quite different than from Private money who maybe sells their notes off through outlets like Peer st.  And workouts become very tough.

But its not if  its happening  I was talking to  one of my Engineers yesterday and one of his buddies has a construction company that focuses just on  dig outs for  SFRs for the bigger production builders and he was doing 60 or so starts a month for many years here .. the switch was thrown and last couple  months its down to less than 20. and he had to layoff a good portion of his 50 person employees.. plus now you buy the Iron to do the work and it sits idol.   You can see where this all leads..  

Some markets in the MF new builds are still going to be OK because of a mass shortage of housing but choose wisely.   markets that are HEAVILY dependent on new construction for jobs are going to be affected just like 08 to 2011  Not as drastic of course but there will be an effect and rents in those markets could soften as subs layoff and labor is no unemployed and looks to relocate for work etc.

[Larry Turowski]

@Scott Trench Thank you! This is such a great post, courageous and with great points. Great replies too!

As someone contemplating getting into multifamily investing this was timely. I had not really thought about industry trends with respect to interest rates and cap rates.

There was a BP podcast (I can't find it now) where this family sold their billion dollar business and were investing in large multifamilies. The guest mentioned they were buying at 3% cap rates! That made no sense to me and it never came out as to how it might make sense.

[Gaudys Rivas]

Excellent analysis , Thanks for sharing

[J. Mitchell Bernier]

The multifamily space will feel the most pain over the next 12-18 months and maybe longer. I looked this up recently and in the 5 years prior to the pandemic, 2015-2020, only 7 times were there more than 500K construction permits on 5+ units. That is 7 months out of 60....

Since January 2020-October 2022, 22 months, every month but 1 has had over 500K in construction permits for 5+ units. The 3-5 million in inventory that everyone has been saying is need is coming. Just going to be apartments and not houses. 

New Privately-Owned Housing Units Authorized in Permit-Issuing Places: Units in Buildings with 5 Units or More (PERMIT5) | FRED | St. Louis Fed (stlouisfed.org)

[J Scott]

While I agree with much of what you wrote, I'll add some of my own rambling thoughts and some additional considerations... (TL;DR at the bottom for those not interested in the rambling :)

Let me start with the fact that I’m just guessing here and I certainly don't have a crystal ball. I've been wrong more than I've been right the past few years...

That said, while I agree with you that we could see a decent (additional) drop in multifamily housing values, I still believe multifamily maintains the best risk adjusted returns of any housing related asset class. And maybe any asset class. 

In fact, I transitioned to multifamily back in 2018, as I expected a recession to occur around 2020 and I decided that during an economic downturn, multifamily was my asset class of choice -- both as an operator and an investor. And while I might be biased as a multifamily operator, my partners and I have put over $3 million of our own money into our deals just this year, so we certainly do put our money where our mouths are.

Okay, here some of my more detailed thoughts, going off your format...

Supply

Let's assume we start with that 1.6 million units of backlog you mentioned. Add to that 1.7 million new household formations projected each year, with at least a third of them becoming renters. (It's probably a lot higher than a third for the demographic of new households, but with almost exactly two thirds of households currently owning a home, I think one third is conservative.)

Multifamily housing starts for 2022 will total around 500,000 units, and let's pretend that the next several years will be around the same, and also let's pretend that all these units can magically come online immediately. (Between inflated costs of labor, moratoriums, and interest rate increases, I’d argue that delivered units will be much lower than expected, but again, let’s just be conservative and say 500,000 units per year will be delivered.)

Conservatively, given the 1.6M backlog and the 500K new renters per year, we're still 6-7 years away from housing supply catching up with presumed demand.

But here's the more important point that the supply discussion always seems to miss. The idea of absorption rate: just because lots of supply is available doesn't mean it matches the demand.

For example, adding a million efficiency apartments in a typical suburb isn't going to impact market rents because those units will never be absorbed -- there isn't any demand for these types of units in most suburban locations.

Most of these new 500,000 units that are coming online each year will be priced to compete with the Class A units on the market. Given inflation in rents over the last couple years, many of these new units will likely not get absorbed quickly. And, they likely won't impact demand nearly as much for non-Class A units.  In other words, Class B and Class C units will be impacted much less than the number of new units delivered might indicate.

Long story short, while I agree that market rents are likely to flatten, and even decline in some markets, rent impact will be much less a function of supply than other factors. And, by the time supply these issues are fixed (again 6-7 years), I suspect we’ll be well past this current recessionary period.

Demand

My partners and I have some disagreements here, and they can make some very strong cases for why demand in many markets will continue to be strong, driving both occupancy and rents.

But, personally I agree with your sentiment that rents will likely remain mostly flat throughout much of the country for the next year or two. And while I think there will be some select locations that see large rent reductions, I believe these will be the exception to the rule.

This is where good location choice for multifamily owners really matters. In markets where we're likely to continue to see population growth, employment growth and employment diversity, I expect we'll continue to see rent growth, even if it's just 1-2% per year. And, with single family housing likely to remain unaffordable for the foreseeable future, I don’t think we’re going to see large occupancy drops either.

Long story short, I see NOIs leveling off, but in many areas where people are buying multifamily, I don't expect NOIs to fall. Not to mention, anybody that's had a property for more than a year or two has probably already gotten several years' worth of rent and NOI growth since Covid, so even if there is a drop in NOI, this isn't going to cause a crisis for most operators who have likely been outperforming their projections for the past two years.

Cap Rates and Interest Rates

I think this is where my views diverge from yours the most.

I believe that the bulk of the interest rate hikes that we’re likely to see have already happened (inflation hasn’t subsided much, but based on how trailing data math works, it’s going to look like it has, which will slow the Fed down with their rate hikes). More importantly, volatility has driven up the delta between the Federal Funds Rate and 10-year Treasury rates and between 10-year Treasury rates and MBS rates.

With the inflation numbers looking better last month (again, artificial, but that’s what people think), we're already seeing lower volatility and a drop in these deltas, resulting in lower mortgage rates.  Since the last 75 bps rate hike, mortgage rates are down about a 100 bps.  In other words, the delta has decreased by about 175 bps in just the last few weeks.

A couple months ago, when interest rates were over 7%, my prediction was that we'd be back to 5% interest rates by the end of the year (and people were laughing at me).  We may not get that low, but as volatility drops, and the Fed acts more dovish, the more likely we are to see the spread between the Fed's interest rate and mortgage rates drop. Fed rates will keep increasing, for sure.  And mortgage rates may increase a bit into next year, but I don’t believe it will be significant.

As for cap rates, they are already up about a half point in most of the markets that we watch, and while we may get a bit more expansion, I don't think they're going too much higher.

There's a simple reason for this... Historically, as we get deeper into a recession, money starts to flow out of other asset classes and into real estate (yes, 2008 was an exception). This is why real estate tends to hold up well during recessionary periods (again, 2008 being the exception).

And I expect the same thing to happen this time around. When unemployment spikes, as it most certainly will, and investors start to get really scared, they'll be moving their money to risk-free investments and, I suspect, to real estate. As money moves into real estate, there will be downward pressure on cap rates.

Between the upward pressure from rising interest rates and this downward pressure from new investment, I expect cap rates not to move much over the next year.

In summary, I believe NOIs are likely to stay about where they are and cap rates are likely to stay about where they are, and therefore, values are likely to stay about where they are.

I’m not saying there won’t be some desperation selling, but unlike with single family, where comps can have a big impact on values, any desperation selling isn’t going to have effect on the values of other multifamily properties.

Timing & Credit Considerations

You’re absolutely right that there’s a lot of short-term, floating-rate debt out there, and there will be a some desperate sellers over the next year or two. In fact, it’s even worse than that – even those who aren’t facing an expiration of their loan may be facing an issue where the insurance that their lenders require to avoid interest rates going too high is getting ridiculously expensive (this insurance is called a “rate cap”).

Rate caps a couple years ago were on the order of $10-20K per year (nobody thought rates were going to spike, so the insurance was cheap). These days, those same insurance policies can cost hundreds of thousands – or even a million or more – dollars per year. If a lender requires this insurance, it can literally eat up all the free cash flow from a property.

So, for various reasons, there will likely be desperate sellers out there over the next year or two.

But, again, this isn't single family. And values of similar properties aren't going to be impacted by a fire-sale or two. In commercial, values are driven by NOI and cap rates, and unless there are enough desperation sales to move the needle on cap rates, a property fire-saled next door isn't necessarily going to affect the value of my property, as my NOI hasn't changed.

Value Add

Nothing to add here. Though I will reiterate that anyone who purchased more than a year or two ago has likely already gotten many extra years' worth of NOI through market rent increases, so it's mostly those who purchased in 2021 and early this year who are at most risk of missing their long-term proformas.

How Bad Is It & When Will It Hit

This is where the discussion gets interesting. If you think that many multifamily owners are going to start running into issues over the next year or two, the question becomes, where will interest rates and cap rates (and by extension, values) be in the next year or two?

This is where history is a reasonable guide. Historically, there have been 10 cycles of rate hikes and rate drops over the past 60 years. The average time between the Fed doing their first rate hike, a recession hitting and then the Fed starting to drop rates is 2.2 years. The longest is 3 years.

In other words, if history is any indicator, we should expect rates to start dropping within 3 years of when they were first hiked (March 2022) and more likely within about 2 to 2.5 years. That puts us somewhere in 2024, most likely, to start seeing rates drop. And historically, rates drop much faster than they were hiked.

So, this leads to the question of whether most multifamily operators can figure out how to stay afloat for another year or two. If so, I believe a major crisis will be averted.

Now, if this cycle of rate hikes lasts longer than historical averages, or if multifamily operators have less runway than I believe they have, things could certainly get bad.

How Much Will Cap Rates Rise

I gave my opinion on this one above. I believe we’re pretty close to the top. Maybe another quarter to half point in some markets (and then some crazy markets like Boise and Phoenix perhaps even more), but unless inflation is a lot more stubborn than anyone thinks (requiring a lot more rate hikes than the Fed is currently projecting), I don’t think interest rates or cap rates are going up too much more in most markets.

How Long Will This Take To Come Into Effect

Assuming we go with your 12-18 month projection, I believe the Fed will reverse course in this time and operators will be in a much better position before most of them get desperate.

Bias In The Market

Agreed with all this. When I invest with other operators, I want to see that they are significantly invested in the deal. Lots of bad operators out there, and I think the next year or two will certainly expose some/many of them.

What Should I Do To Make Money

Like you suggested, my partners and I like the idea of investing in debt. Though we do it through a vehicle known as preferred equity (which is similar to debt). It’s basically a way to get paid more like the lender, before all the other investors. And to get paid even if the other investors lose their shirts.

In fact, we’re launching a fund this week that only invests in preferred equity (let me know if you want info… ;)

TL;DR:

• - We’ve already seen values drop 10-20% in a lot of markets, so while I agree that we could see 20-25% value drops, I think much of it has already happened;
• - I believe multifamily still offers the best risk-adjusted returns of any asset class.
• - I expect NOIs to stay pretty much flat for the next year or two, as well as cap rates. Which means values should stay flat as well.
• - I believe there will some desperation selling, but multifamily values aren’t based on comps, so a few of these fire-sales here and there shouldn’t impact overall values very much.
• - I agree that debt is a great place to be right now. In fact, we just launched a preferred equity fund that basically mimics debt, because lower on the capital stack is better.
• - I agree that only investing with operators who align their interests with their investors (e.g., they put a lot of their own money in the deal) is a good criteria for investing.
• - I believe that we still have a year or two before most operators hit major financing issues (they either having to refinance or buy new rate caps), and I expect that over the next two years the Fed will reverse course and drop interest rates in response to the recession. So, I believe that a catastrophe in the multifamily space will be avoided.

[Ezra Henderson]

J’s a pretty smart guy

[Lee Yoder]

I believe the variable that is often misunderstood is the demand for housing. Demand for housing can change much quicker than people realize. 

Too many investors only consider population growth instead of considering household formation. Household formation is a choice and it can be very cyclical. If the economy weakens, unemployment rises, and people start to fear the future, they'll make very different decisions when it comes to housing. Young people will live with their parents for an extra year or two. Older folks will finally sell their home and move in with family. Young people will share an apartment instead of having their own. When people start making these decisions, the demand for housing can drop dramatically, and quickly, even if population is increasing. 

A lot of people didn't think this was possible, especially in these cities where population is increasing so much. But, with the increasing supply, and suddenly slowing, or decreasing, household formation, suddenly housing demand is falling and we're already seeing rent decrease year-over-year.