Turning Bullish on Multifamily

When a once-controversial view becomes conventional wisdom, it often pays to take the other side. Recent examples include the ‘22 (now ‘23) recession/spike in unemployment, crypto (both up and down), negative interest bonds, and last year’s dollar strength. The latest collective fear, predictions of a meltdown in commercial real estate (CRE), may offer a similar opportunity.

But in a heterogeneous asset class like real estate, it's important to differentiate within sectors (office vs. multifamily), acquisitions vs. development, markets, submarkets, and specific deal structure. Even if macro factors like interest rates and access to credit affect the entire sector, the range of outcomes differs significantly by opportunity.

For the first time in a while, I’m more constructive and think it’s time to actively look for investment opportunities in the multifamily sector.

I thought it might be helpful to share my views as someone who actively invests in multifamily real estate. But first, a few caveats. I’ve written this piece for a general audience. It’s not comprehensive, and I fully accept that I could be completely wrong. And most importantly, this certainly shouldn’t be considered investment advice.

I acknowledge the risk of a major financial crisis with commercial real estate lending at the center. The Fed's most recent Financial Stability Report highlights this concern. The sudden and dramatic shift in Fed policy has left the financial system in a fragile position - look no further than recent bank failures to see how quickly capital can be destroyed.

Over the coming months, it seems likely that many individual investors and institutions will face losses on existing investments, which I’ll mention below. More loan defaults will inevitably occur in office and in multifamily. But that’s different from expecting an imminent collapse of the entire asset class. In fact, better opportunities may exist specifically because of that risk and the potential to acquire distressed assets.

Why this Risk Matters

For context, the CRE asset class is massive. According to Nareit and Costar, commercial real estate in the US is valued at more than $20 trillion. That's roughly half as large as the entire US equity market cap. And because most of these assets are acquired with leverage, losses could have far-reaching consequences. In the midst of a banking crisis, of course, people are concerned about CRE.

The Problem: When Weak Operating Results Meet a Financing Event

As a framework, I consider two separate but related issues: operating and financing. Over longer holding periods, it’s normal to have periods of weaker fundamentals and times when capital is less available. Risks become existential when both of those conditions occur simultaneously. The day of reckoning comes when new capital is required (a debt maturity that requires refinancing) or when existing debt cannot be serviced (a default).

Currently, the flashpoint is primarily in the office segment. It’s truly a perfect storm: high vacancies (WFH + layoffs) + higher interest rates + banking crisis + more conservative lenders. It’s reasonable to assume we’ll see more high-profile defaults as an estimated $92 billion in loan maturities come due, many of which will occur at underperforming properties. But not all of this will default.

Multifamily Fundamentals Solid

In contrast to the office sector, multifamily fundamentals are reasonably solid. Occupancy is roughly 95%, and rents have stopped falling in most markets. The job market, particularly at lower wage rates, hasn’t been better in generations. Also, despite higher deliveries this year, the structural supply-demand imbalance hasn’t disappeared; there’s still a housing shortage, especially in relatively affordable options like apartment rentals.

On the fundamentals, the primary headwind comes from higher operating costs across the board. Jay Parsons of RealPage, Inc. has done a great job highlighting these trends here on LinkedIn.

Better operators will mitigate cost inflation by leveraging technology, centralizing operations, and self-performing where possible. As COO of Circa , a rent payment platform that centralizes the rent collection process, we see operators laser-focused on operating efficiency. With rents increasing modestly at best, expect margins to be under pressure in the near term.

Back to my framework, periods of underperformance should be expected over longer holding periods. For many operators and investors, this year will likely be one of those periods we’ll need to work through with patience and an aggressive focus on operations.

That alone hardly spells a doomsday scenario for the asset class.

For specific deals, underperforming operations become problematic if you simultaneously face a financing event. That may be enough to force sales or defaults.

For example, consider deals purchased during the frenzy of late ‘21. Many older B/C class value-add deals were priced at 4% cap rates with aggressive underwriting assumptions that required short-term bridge debt. I saw lots of those deals and passed on all of them. Many of those will soon face maturities.

If debt financing is available, the terms will certainly be more expensive and may require additional equity. In many cases, that capital will not be available. More experienced operators with access to capital should find many opportunities in the months ahead.

In recent years, plentiful access to cheap money and persistently falling cap rates saved a lot of bad deals. Those days are over.

Grounds for Optimism

Here’s why I’m getting more upbeat about investing in multifamily for the first time in over a year. Keep in mind that I’m currently focused on B/C Class apartment acquisitions of 50-200 units in the mid-Atlantic. These buildings typically offer some of the more affordable market-rate housing options in their respective markets and are, therefore, relatively defensive.

• The market is opening again?- According to a recent report by 戴德梁行 , “Our V&A [valuation and appraisal] business has seen a meaningful uptick in bid activity, reflecting a thawing lending market.?Our pipeline is up 115% over the fourth quarter.?In April alone, the team received 800+ Multifamily RFPs across the US, which is 5x higher than September of 2022.” My conversations with brokers active in our market corroborate the pick-up.
• Valuations more reasonable?- With transactions closing, cap rates have finally adjusted higher to reflect higher interest rates and higher risk. Anecdotally, I’ve recently seen pro forma cap rates in the high-single digits using broker price guidance for some marketed deals. That compares to pricing I've seen for 7-year term agency debt available for ~6% at 80% LTV, which means you can find positive leverage again.
• Interest rates?- The bond market, as reflected in the yield curve, and the Fed’s commentary suggest we may have seen the peak in this rate cycle. If accurate, that would be supportive of the CRE market.
• Dry Powder?- Multiple?surveys?indicate institutions and family offices have substantial cash on the sidelines targeting CRE, especially multifamily assets.
• Publicly traded CRE-related stocks?- Apartment REITs like Camden Property Trust, UDR, and Mid-America all seem to have stabilized and are off their March lows. They’re all roughly flat YTD, which seems inconsistent with an impending apartment meltdown. Also, the homebuilders are flying, with bellwethers like Pulte and Lennar hitting 52-week highs.

My Approach

Currently, I’m reviewing opportunities deal by deal. If the underwriting supports positive leverage and yields a mid-teens pro forma IRR, then my partners and I will seek financing terms and submit offers that work for our investors and us.

As I mentioned up front, the risks are still significant. Investors will want to consider diversifying and sizing investments appropriately for their risk tolerance. Picking the bottom is impossible, especially in a slower-moving, less liquid market like private real estate. For some, scaling into the right exposure over time may be the best course of action.

In the short-term (12-18 months?), multifamily investors in existing deals should be prepared for disappointing operating performance, reduced distributions, capital calls, and even some defaults. The road ahead will be challenging but potentially fruitful for those operators and investors able to work through it.

We can expect to see more scary headlines about CRE. But with the risk/reward for multifamily investments looking more reasonable, I plan to be more actively hunting for new opportunities.