The 2010s saw an unprecedented period of historically cheap debt and economic stimulus, which had a fundamental impact on the global macro economy and the way capital priced risk. Investor capital poured into real estate, which increased competition, spurred more aggressive underwriting, increased the use of leverage, and compressed yields.
But rapidly rising interest rates have caused a significant shake-up, exposing cracks in some investment strategies of the past decade.
As background, over the past decade, risk calculations began to change. Across the multifamily space, investors moved into riskier markets, strategies, and capital structures to increase returns and compete for deals. Firms were rewarded for volatile, high-leverage strategies but, until recently, were not negatively impacted for failing to hedge longer-term risks.
Managers who invested in riskier strategies or assets without sufficient mitigation measures didn’t always seek higher returns for that additional risk. Firms with maturing variable rate debt on high-leverage strategies simply refinanced or extended existing loans without liquidity concerns or much fear of rising rates and many hedged their risk with only short 2-year caps.
However, given the current economic climate of rapidly rising interest rates and lack of credit availability, investors are once again evaluating risk much more closely and demanding managers more accurately assess and price risk to deploy capital in opportunities with more attractive risk-adjusted returns.
Cap Rate Compression
Over the last 10-plus years, investment poured into primary and secondary markets alike. Multifamily saw cap rates drop below 4 percent for the first time. Historically, there was a significant cap rate spread between primary, supply-constrained markets and secondary ones where barriers to entry were lower.
In 2018, this spread began to narrow and disappeared completely in 2021. For the first time, investors largely ignored the additional risk of investing in a secondary market. Similarly, purchasers were not requiring any additional yield for less desirable submarkets within a particular metro. The previously required risk premium for investing in secondary markets or traditionally less desirable submarkets largely evaporated without a corresponding underlying change in the market fundamentals, indicating that managers were no longer demanding to be compensated for that additional investment risk.
In addition to higher-leverage strategies and strategies with more geographic risk, over the past 10 years, firms were not required to actually add value to the real estate to generate strong returns even though the structural changes in the economy and monetary policy, the tailwinds that drove those returns were unlikely to continue. Many were beneficiaries of the “rising tide lifting all boats” phenomenon by taking advantage of cap rate compression and cheap debt. Many managers were simply buying at historically low cap rates and selling at historically lower ones . . . until the tide went out.
Multifamily Fundamentals
Notwithstanding broader market-wide headwinds, multifamily fundamentals remain strong. Unlike other product types like office and retail, multifamily did not undergo a fundamental shift in the way people need and use housing. Renter demand remains strong driven by a fundamental supply/demand imbalance in many markets, leading to continued rent growth and high occupancy rates. Multifamily valuations have taken a hit—and will probably take a greater one—due primarily to capital market factors and high-interest rates as opposed to core fundamentals.
High-interest rates are a double-edged sword for multifamily because while they place downward pressure on valuations, they also boost demand by making it more difficult for renters to leave the renter pool to buy houses. Homeownership costs have risen as mortgage rates have increased by two and a half times from their low in 2021. In addition, for-sale housing inventory remains low as 99 percent of current mortgage holders have a rate lower than 6 percent and have limited incentive to sell only to rebuy a new home at a significantly higher rate.
With less inventory on the market and higher interest costs—and significantly higher monthly mortgage payments—associated with purchasing a home today, renters are more likely to remain renters for longer, increasing demand for multifamily.
These favorable supply/demand fundamentals in many markets remain as the United States still fails to produce and maintain a sufficient inventory to meet the country’s housing demand. The gap between household formation and housing units constructed between 2012 to 2022 was 2.3 million. Moreover, this imbalance will only grow with new construction permits dropping as developers struggle to make deals pencil with rising construction costs, higher interest rates, and the threat of a recession-dampening demand. However, that doesn’t mean that there are not areas at risk of oversupply, or that there won’t be winners and losers in the space.
The housing shortage does not apply equally across markets. New multifamily inventory—particularly in the Sunbelt where it is easier to build—is leading to oversupply in some markets and rents dropping for the first time in years. These markets are at risk of being overbuilt, at least in the short term, with negative projected absorption and a large inventory of product delivering over the next one to two years.
For example, Nashville’s rental unit inventory is projected to grow 7.9 percent this year, 4.9 times the pace of household growth in the four-year period between December 31, 2020, and December 31, 2024. Compare that to a market like Los Angeles, where inventory is projected to grow just 1 percent, which is only 20 percent of the growth needed to replace obsolete housing stock and satisfy household growth.
Near-term oversupply in several markets is already negatively impacting rental rates, rent growth, and creating the need for outsized concessions to win renters. While a U.S. housing shortage still exists in the aggregate, a deeper look shows that the level of this shortage will vary wildly by market. Some markets that have seen large development booms over the past 3 to 5 years may have short-term difficulty absorbing such a high level of new product, while others (often high-barrier-to-entry markets) continue to be significantly undersupplied.
The Return of Alpha
The next era of multifamily real estate will be led by managers that have the ability to produce alpha. The 2010s were defined by a seemingly never-ending bull market. The next cycle will remind investors of the importance of partnering with managers that apply an appropriate risk-reward analysis and have the skill and experience to add value at the real estate level to generate alpha.
Successful managers will be those who return to (or never strayed from) the fundamentals—excellent locations and a focused execution on a strong, value-creating business plan. Staying close to the real estate is going to become even more critical than it has been in the past. Managers with their own in-house development and construction management teams should be able to control costs better, build faster and turn units more quickly. Managers with their own in-house property management firms should be able to understand their customer—the renter—better and will have deeper levels of insight into on-the-ground operations.
In theory, these insights and access to on-the-ground data will give vertically integrated managers an advantage in assessing and underwriting future investments. Experienced managers with local market knowledge also have an edge. Their ability to source, evaluate, and execute projects on a block-by-block basis is likely to lead to outperformance going forward.
In addition to a specialty mindset, resilient strategies that favor maximum optionality for managers coupled with strong business plans, capable operating teams, and contingency plans to account for as many potential risks as possible will be critical to creating alpha through tumultuous or unpredictable economic times.
We have entered a market environment where increasing beta exposure is no longer the avenue to generate outsized returns. Managers’ ability to both recognize the opportunities and challenges going forward as well as execute high-conviction investment strategies with appropriate risk-adjusted returns will be the determining factor as we move forward though more uncertain times.
The next era of private real estate will look very different from the last. The end of cheap debt for the foreseeable future will continue to cause disruption across the real estate space. This is especially true in multifamily, where strong performance over an extended period has increased competition and, subsequently, compressed yields.
SEAN BURTON is CEO of Cityview. RYAN GRAF is an associate of capital raising and investor relations at Cityview.
