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.
