Commercial Real Estate Market Recap & Q2 Investment Outlook

All too often during the past cycle, we have seen the multifamily space painted with a broad brush. “It’s a 5% cap rate – that’s above market!” and “The Sun Belt is a strong investment!” Sophisticated investors recognize that not all 5% cap rates are created equal, and not all markets in the Sun Belt will perform in lock step with each other. As we see some headline distress in our space, it is important to not make broad generalizations, and get back to fundamentals.

Despite headline reports of market-specific hyper-supply, the nation remains vastly under-supplied of attainable housing at the macro level. Higher interest rates have further widened the gap of rent vs own affordability, and the Fed appears unmoved to lower interest rates in the short-term. This has impacted consumer behavior by disincentivizing homeowners with low, long-term mortgage rates from relocating, lowered the number of available listings for sale, and ultimately created additional renter demand for those who cannot afford to buy a home.

In the multifamily space, we have seen a more nuanced performance across the sector. Class A assets in strong locations have seen thinner bidding competition, but have not seen price erosion as institutions with strong balance sheets have looked to capitalize on investments below replacement cost. In fact, cap rates for Class A deals have remained stubbornly low despite new debt bringing negative accretion to the returns.

Similarly, build-to-rent (BTR) communities remain the darling of many institutions and developers and have seen strong performance and investment activity. While this asset class lacks the long-term data of garden style apartments, there is plenty of evidence that BTR residents renew at much higher rates, which keeps turn costs down and occupancy high. Data also shows that renters are likely to pay between 15-20%* more per month, on average, for BTR product over traditional multifamily apartments.

We have seen significant distress in the Class C syndicated deal space, often with aggressive first-time sponsors who paid top of market pricing, used floating rate bridge debt, and are now navigating predictable property management challenges on older assets. Unfortunately, there are no easy answers for these investments, as the sumtotal of the distress means the asset is potentially no longer worth the debt.

We expect rents to increase modestly at the macro level over the rest of this year, while specific markets with significant recent deliveries will remain flatter as they continue to absorb the excess supply. It is important to note that most of these markets, like NW Florida, Austin, Nashville, Huntsville, and many others, saw hyper-supply driven by incredible demographics and job growth. We believe that the rent declines today might actually be a great opportunity if you can acquire below replacement cost.

Our forecast for occupancy is similarly nuanced. Generally speaking, we expect Class A and Class B to remain strong, in the 94-95% range, but just like rental rates, this can be very different in the face of submarket new supply absorption. For Class C, we see more distress on the operational side, as well as functional obsolescence for many assets built in the 1970’s and older. For that reason, we expect Class C occupancy to perform worse than the macro market over the next year.

While many news outlets choose to focus on the new supply that is being delivered today, it is important to recognize that new starts are significantly diminished in the wake of higher building costs, higher interest rates, and tightened lending practices. In 2 years, we will predictably be reading headlines of just how few deliveries have been completed, which will only serve to exacerbate the affordability crisis. For these reasons, DLP is bullish that projects breaking ground in 2024 will be “the only game in town” when they deliver in 2026-27, and have the potential for asymmetric rent growth.

“Higher for longer” has been the refrain for most of this year, and Treasury rates have been on a steady incline since early 2022. We believe moderation will begin later this year with 1 or 2 Fed rate cuts before the election cycle.

DLP OUTLOOK

For all the headwinds in the capital markets, first position debt remains a favorable risk-adjusted position, and we anticipate funding $300-350M in loans in Q2; we remain confident in achieving our goal of $1.5 billion for the year. We are also expecting to invest around $500M in deals as equity investor in 2024. This might come in many roles in the capital stack: as developer, buyer preferred equity provider, or rescue capital provider. Due to the dislocations across asset classes, we expect this to be primarily on newer assets (2015+) in which we can invest at a significant discount to the replacement market, in markets we really believe in.

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Sources:

* https://www.costar.com/article/1475634112/with-billions-invested-build-to-rent-brings-changes-to-apartment-industry