Potential trouble brewing in a sector that has been viewed as relatively bulletproof multifamily is concerning. But while stress is very much real, industry participants are quick to point out that the overall foundation for multifamily remains strong. “The cracks that we’re seeing are not structural; they’re superficial,” says Vincent DiSalvo, chief investment officer at Kingbird Investment Management, a family office investment firm specializing in multifamily.
The obvious challenge is higher interest rates. Generally, long-term owners that are holding low leverage, cash flow-positive assets are just fine. The pressure points are hitting developers and investors who have bought or built assets within the last three years and are either holding expensive short-term debt or need to refinance into the higher-rate market.
“The distress that we’re starting to see is in groups that bought into the hype around the demographic shifts and have over-committed themselves to certain geographies,” says DiSalvo. Some investors were buying apartments at very aggressive cap rates of 3 percent or even sub-3 percent in high-growth markets such as Texas and Florida. For some investors, debt service is now 50 to 100 percent higher than what they projected it would be. “So even though you’ve done well on the income side, and you had a business plan you’ve successfully executed, your debt service has become so outsized that it is causing a real problem,” he says.
In some cases, an investor also paid too much for a property and came in with a high basis. So, even if a sponsor is not underwater, they may be treading water and looking to sell out of an asset or assets, adds DiSalvo.
Pockets of stress emerge
Along with more expensive debt, owners and developers are battling higher operating and construction costs, including surging insurance premiums. At the same time, record levels of new multifamily construction are putting pressure on owners to offer incentives, such as free or discounted rents, to attract and retain tenants. “What that does is eat into the profitability of the asset,” says Steven Jacobs, president of Ten-X, an online commercial real estate exchange platform.
Investors that bought multifamily assets in 2020 and 2021 when rates were near historic lows now have three-year loans that are maturing into a higher interest rate environment where debt costs are between 6 and 7 percent. “What’s happening is that the sponsors—the owners—are saying, ‘hey, our debt is maturing, our revenues and expenses are up, and we don’t want to put any money into this asset on a refinance,’” says Jacobs.
For example, Ten-X is working with a developer in Washington, D.C., that is looking to sell a 120-unit development ahead of getting its final certificate of occupancy. Although the developer could get a higher sale price by stabilizing the asset and showing income, they didn’t have the money to complete construction. According to Jacobs, the project fell short of its proforma largely due to higher than expected costs. The developer is not in default on a loan but is looking to sell rather than put more equity into the project.
“There’s a real motivation for some of these sponsors to sell. In some cases, they lose their equity, and in other cases, we’re able to recover some of their equity,” says Jacobs. Those are the types of deals Ten-X is seeing coming to its sales platform. “We haven’t seen a lot of this in the market, but some believe there is a bigger train wreck coming because of market dynamics,” he says.
Foundation remains strong
Higher costs are ill-timed with a surge in new supply, with 420,000 new units completed in 2023 and another 480,000 units set to be delivered in 2024, according to Marcus & Millichap.
The new supply is resulting in some softening in what had been robust fundamentals. According to Yardi Matrix, occupancies that stood at 94.5 percent at the end of January are expected to dip lower, particularly in markets such as Raleigh, Charlotte, Austin, and Miami, that are experiencing an outsized level of new supply relative to current inventory. Rent growth also has cooled. February saw the first increase in seven months with the national average rent growth that was up a slight 0.6 percent year-over-year, according to Yardi.
However, occupancy levels and underlying demand for rental housing remain strong. “I don’t think that with where the operations are right now we’re going to see truly foundational cracks within the multifamily industry,” says John Sebree, senior vice president and director of Marcus & Millichap’s national multi housing group. Some markets will see vacancies increase, and potentially rents that decrease because of the new supply.
The counterbalance to that is that the supply of single-family homes remains constrained, and the volume of new multifamily construction is expected to drop significantly after 2024. “Owners and operators are not concerned about the five-year outlook for the industry. Everybody’s just trying to figure out how to make it through the next 18 months,” says Sebree.
Capital eyes investment opportunities
It’s difficult to measure the scope of the distress that might be ahead. “Anecdotally, we’ve seen stress on the margins and not in a meaningful way,” says DiSalvo. “What I would expect is that if interest rates don’t meaningfully come down inside of the next two years, and the longer that higher interest rates drag on, you’ll start to see more distress and more complicated sources of financing filling gaps.”
So far, stress emerging in multifamily doesn’t appear to be showing up in market data. According to Trepp, the multifamily delinquency rate on CMBS loans for February remained relatively flat at 1.8 percent and well below the rate of 4.7 percent across all property types. However, attention is focused on the maturing volume of debt ahead. Yardi Matrix recently conducted a review of its multifamily database that found that across more than 58,000 properties, there is an estimated $420.6 billion in loans set to mature over the next five years (2024-2028).
It is important to note that there is a big difference in the stress emerging in multifamily and stress in office. Problems in multifamily are related to near-term profitability for certain sponsors. Office is dealing with a bigger issue of changes in the way people are working that, in some cases, means coming up with a whole new business plan for a property.
Another key difference is that there is a lot of capital, both debt and equity, still interested in multifamily assets. In most cases, lenders are working with the sponsor to adjust the loan terms or extend the term. In addition, there is a lot of money sitting on the sidelines held by investors who like the underlying fundamentals and resiliency of multifamily.
So, while there will be some buying opportunities, the capital waiting to acquire assets will make it difficult for buyers to find deep discounts. “The good to great location multifamily assets have no problem selling, even if they’re priced at 4 caps, because people know that market is safe, even if it’s a B property,” adds Jacobs.
