- Apartment complexes attracted record investment in 2021, but rising rates could spoil the party this year.
- Buyers and sellers drift away from building valuations, stalling deals.
- An investor expects deals to emerge later this year as some investments tumble.
Rising interest rates sparked debates about a decline in US house prices. For apartment buildings, the darling of institutional investors last year, the results may already be there.
The multi-family market has grown by leaps and bounds over the past year, with rapidly rising rents and low interest rates attracting $240 billion in investment from investors including the world’s largest landlord, Blackstone, and Adam Neumann, founder and former CEO of WeWork. A heady mix of record rental growth and cheap debt has attracted capital from savvy investors and neophytes alike.
Apartment buildings, the story goes, would be the most effective hedge against an inflationary economy, as rents are expected to rise for years to come. For the first time since at least 2009, demand for them exceeded that of office buildings, which faced an uncertain future as employees took advantage of the work-from-home opportunities that have grown during the pandemic, according to Savills.
But the party is over, at least for now. As interest rates rise, those with cash want to buy properties at a discount from the high prices of just a few months ago, as borrowing costs affect property valuations. commercial real estate. Sellers scoff, saying their rental income looks as good or better than it’s ever been, which boosts values.
This stalemate can be a speed bump as the market readjusts to a new reality or a sign of serious upheaval, especially if high funding costs persist and lending stagnates. Regardless of the end result, industry leaders are feeling the heat, Manus Clancy, senior managing director of Trepp, a company that analyzes real estate debt, said on the company’s podcast last week.
“Over the past 10 days, there has been a sea change in that sentiment from people who have contacted me,” said Clancy, whose data is used by executives in the commercial real estate industry.
He said the gist of the complaints was: “Liquidity hasn’t dried up, but it has tightened significantly.”
Indeed, many of the eight multi-family investors and experts who spoke with Insider about the changing winds shared these views. Most still viewed multi-family properties as the safest part of commercial real estate, as rising interest rates made it harder for homebuyers, increasing demand for rentals. But the risk, some say, is that a recession hits, dampening rent collection and perhaps forcing financially strained landlords to dump their holdings.
One investor, Adil Hasan, head of Yieldstreet, is bracing for fire selling, expecting increasingly expensive debt to capsize some deals. He said he was not alone, with many capital-rich investors needing to be deployed. Yieldstreet, a crowdfunding platform, has raised over $640 million for real estate transactions.
Many multi-family purchases in recent years have been made with short-term loans funded in the commercial mortgage-backed securities market, a favorite of bond investors looking for a little extra yield in an environment of low interest rate. According to the Mortgage Bankers Association, easy access to these loans — created when prevailing rates were much lower — helped push global debt on multifamily properties to a record $287 billion by the end of 2019. Last year.
Rising rates and higher yields demanded by bond investors have yet to upset the market, which is still supported by rising rents. Many market participants believe that Hasan is waiting for what will never happen. But rapidly changing borrowing costs have at least put the market on pause at best, or paralyzed at worst.
“Absent any change in macro conditions, we are likely to see a cooling of the market in terms of transactions and new developments,” Bradley Tisdahl of Tenant Risk Assessment, which analyzes commercial real estate, told Insider. .
Indeed, investors who need to grow their money find few opportunities lately. Hasan, who helps oversee Yieldstreet’s portfolio, estimates multifamily trading volume has fallen 90% in recent weeks.
Coincidentally, the market for cheap short-term loans seized up.
Since the July 14 episode of Trepp’s podcast, the issuance of commercial real estate-backed loan bonds, the complex bonds that fund loans, had completely dried up, with no transactions having taken place. place this month so far. Secured loan obligation deals totaled $24 billion across 23 deals in the first six months of 2022, with nearly half of the volume realized in January alone.
The change affects the value of buildings, at least as far as buyers are concerned. This month, multi-family property values are likely down 5-10% in most markets, Lonnie Hendry, head of commercial real estate advisory at Trepp, said on the podcast. Clancy predicted they could drop as much as 15%, a view he said prompted audible gasps during a private call sponsored by an investment bank.
Valuation disagreements have escalated so much in recent weeks that Tides Equities, which claims to be the third-biggest buyer of apartment buildings this year and second-biggest last year, ‘dropped’, Sean Kia, its co-founder and director, told Insider. His business has gone from closing at no less than two deals a week to nothing in the past six.
“We’ve been extremely active,” Kia said.
It has “curbed” borrowing for commercial property-backed loan obligations, where lenders have sharply raised interest rates and the amount of equity they require from borrowers, and is instead seeking financing from banks and so-called agencies. , like Freddie Mac. He told Insider that companies like his expect some borrowing rates to double from last year’s lows of 7% in the coming months.
Investors who thought they had significant funding a few months ago have had a rude awakening. Lenders are busy canceling these deals or forcing borrowers to make bigger down payments and pay higher rates.
“Some of the deals that are circulating in the market right now are deals that were signed two or three months ago,” Yieldstreet’s Hasan said. “People are going back to sellers and re-evaluating every offer.”
Could a frozen tundra turn into fire sales?
There are early signs that affordability issues could slow rental growth, while the economy is still warm enough to warrant further interest rate hikes by the Federal Reserve.
Hasan doesn’t think rents will go down but expects their growth to slow significantly, he said. For some buildings financed with riskier underwriting — like lower debt-service coverage ratios — falling revenue could push landlords into a corner, triggering sales.
“There’s no way they can meet all the debt obligations because of rising interest charges,” Hasan said. “So they’re going to be a forced seller of their assets over the next three to six months. Those are kind of the interesting opportunities that we’re going to be waiting for, and I think we can get some really remarkable deals at really good prices. prices.”
Adam Deermount, a partner at RanchHarbor Capital, which manages about $150 million in real estate assets, said falling rents relative to the cost of debt won’t be enough to threaten borrowers’ investment.
“If you look at COVID, you had people who couldn’t or wouldn’t pay,” Deermount told Insider, referring to the effects of rising unemployment as the pandemic unfolded. “You never had an incentive to sell, which means your lenders and financial partners were willing to work with you and make capital available.”
During the last financial crisis, there was both housing distress – caused by a deep recession – and reason to sell as liquidity dried up. Currently, funding has dried up, but multi-family properties continue to be cash cows for their owners. According to the Urban Institute’s rent collection tracking system, most tenants continue to make monthly payments even if their rents go up.
“I’m not sure there’s going to be much distress unless a recession lasts much longer or net operating income starts to suffer,” said Deborah Smith, CEO and co-founder of the real estate investment bank CenterCap Group. , said Insider.
John McNellis, an investor and developer, recalled countless times that investors were salivating for struggling opportunities that never materialized. There was a big one, but it was under much more extreme conditions: when the government auctioned off properties seized during the savings and loans crisis from 1989 to 1995.
Additionally, multi-family homes tend to be the most stable commercial real estate assets and would be an unlikely source of sales, McNellis said.
“Everyone knows that. If you’re going to go out and try to get a good deal, multifamily is probably the last place you’ll find one,” McNellis told Insider.