When the Downturn is Your Friend…

Welcome to this issue of The Multifamily Memo.

As long-term industry veterans, we did not anticipate another major pricing reset of this scale during our lifetimes.? Resets of this magnitude have only occurred twice over the past 40 years: 1) in the early 1990’s after the savings and loan crisis and, 2) in the wake of the 2008-2009 global financial crisis (GFC).

Our reasoning??? Real time access to big data, that was not readily accessible until after the GFC, would put a governor on the availability of mortgage debt.? Our thinking was, once lenders started to see pricing significantly deviating from its historical norms, they would put the brakes on.

Wow…were we wrong!?

It appears that cyclical behavior exists not only with investors but lenders as well.?? When pricing on multifamily became too frothy for traditional lenders (agencies, insurance companies, etc.), enterprising lenders wanting to keep the party going became very innovative and? Collateralized Loan Obligations (CLOs) were born.? Not surprisingly, this is where the initial distress is beginning to raise its head.? We will expound on CLOs in the Expert Insights section of this issue later.

In previous issues we have covered two fundamentals we believe are vital to understanding today’s multifamily investment market; pricing and market cycles.? The two go hand in hand in understanding how to profit from once-in-a-generation buying opportunities.

While we like the technical aspects to support investment thesis,’ sometimes it is good to layout where we believe the market is in plain English.? Simply put, real estate became overvalued due to a speculative frenzy driven by ultra-low interest rates.? Now that interest rates are back to historical norms, multifamily values will have to adjust downward before the market begins to trade normally.?

This will involve some painful investor and lender losses.? As such, transactions (at levels not seen since 2010) will not pick up until sellers, likely forced by mortgage maturities or regulatory pressure, face the reality of market clearing prices in a normal interest rate environment. ??

As previously mentioned, we believe 2024 will be the year the dam breaks, starting a multi-year deleveraging cycle, ripe with opportunity for savvy investors.? We view this as a rare opportunity as declines of this magnitude occur once every 10-20 years and have historically resulted in outsized returns as illustrated in the chart below.

As an investor, you may be asking yourself “what are the key areas I need to address to position myself to take advantage of once-in-a-generation pricing”?

First, you need ready capital.? The early downturn (where we believe we currently are) is the time to line up capital for opportunistic buys.? Once we enter the full downturn phase, equity and debt is typically harder to come by on attractive terms, if at all.? Investors and sponsors that have amassed a war chest will be well positioned to take advantage of distress and attractive pricing on high-quality assets.

Second, you need an operating platform.? A platform is the compilation experience, expertise, systems, and networks capable of making smart long-term investments in this environment.? An appropriately scaled platform will allow you to identify opportunities early and pursue them proactively.

Third, you may need to align or partner yourself appropriately based on your capabilities.? Downturns are risky for new investors as there is a thin line between seizing opportunity or catching a falling knife.? At the very least, educate yourself in market cycles and how investments are valued.? If you do not have a war chest and platform, you can partner with a capable sponsor as your operating partner.

The landscape of multifamily investing is undergoing a tectonic shift, particularly as transactional values take the lead in shaping the market.? This once-in-a-generation opportunity for multifamily investors is complex, but also exciting.? It is a time to think of “the downturn as your friend.” ?

Expert Insights:?Collateralized Loan Obligations (CLOs) – may be the first shoe to drop

A CLO is an investment structure used to bundle mortgages, that are usually seen as too risky for traditional lenders, into bonds of varying risk and return.? As stated earlier, this is a relatively obscure investment structure used by lenders to keep the party going after multifamily pricing outran conventional mortgages.? Not surprisingly, the CLO market is now facing unprecedented stress as many borrowers are struggling to pay their loans.

CLOs are primarily comprised of short-term, high low-to-value, floating-rate, loans for properties undergoing renovations or expansions.? These loans, typically known as bridge loans, were the only highly leveraged debt product available to support the speculative acquisition prices paid during the 2020-2022 cycle peak.? As interest rates normalized resetting multifamily values, many borrowers? found themselves underwater with their property worth less than their debt.

With their debt service doubling or sometimes tripling, borrowers that were counting on reselling their property before their loan matures have found themselves caught.? Many cannot sell their properties anywhere near where they bought them.

How bad is it?? Hockey stick bad - as the following chart shows.

Three (3%) to five percent (5%) loan delinquencies will bring the regulators down hard on traditional banks.? Research shows that CLO delinquencies topped 10% at the end of the first quarter.

This stress in the market has forced CLO issuers to take unprecedented steps to protect their structures and in some cases their firm’s survival.? As issuers work to resolve these troubled loans, opportunities will present themselves for investors that have positioned themselves as a solution.

That is a wrap for this issue’s Expert Insights. We hope you have found it enlightening and invite you to contact us with any questions or thoughts.? We are always happy to help.

Finally, if you have not already, be sure to Subscribe for more insights gleaned from over four (4) decades of navigating market cycles.? We look forward to bringing you more of the information you need for successful multifamily investing.