{"id":146555,"date":"2023-01-31T16:24:38","date_gmt":"2023-01-31T23:24:38","guid":{"rendered":"https:\/\/www.biggerpockets.com\/blog\/?p=146555"},"modified":"2023-08-10T13:12:02","modified_gmt":"2023-08-10T19:12:02","slug":"multifamily-real-estate-is-on-the-brink-of-crashing","status":"publish","type":"post","link":"https:\/\/www.biggerpockets.com\/blog\/multifamily-real-estate-is-on-the-brink-of-crashing","title":{"rendered":"Multifamily Real Estate Is At Risk Of Crashing \u2014 Here&#8217;s Why"},"content":{"rendered":"\n\n      <iframe loading=\"lazy\" frameborder=\"0\" height=\"200\" scrolling=\"no\" src=\"https:\/\/playlist.megaphone.fm\/?e=BIGPOC6559332390\" width=\"100%\"><\/iframe>\r\n  \n\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">I\u2019m worried about a significant decline (or crash) in commercial real estate valuations, specifically including multifamily, in 2023 and 2024. I feel that the red flags are so clear and all pointing in the same direction that I\u2019d be neglecting my duty to this community to fail to make my stance as clear as possible and to defend that stance in great detail.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">In this article, I\u2019ll walk through my thesis, outlining four primary threats to multifamily valuations, following the summary below:&nbsp;<\/span><\/p>\n\n\n\n<ul class=\"wp-block-list\">\n<li><span data-preserver-spaces=\"true\">Part 1: Cap Rates Are Lower Than Interest Rates&nbsp;<\/span><\/li>\n\n\n\n<li><span data-preserver-spaces=\"true\">Part 2: I\u2019m Not Betting On Meaningful Rent Growth In 2023<\/span><\/li>\n\n\n\n<li><span data-preserver-spaces=\"true\">Part 3: I\u2019m Betting On Interest Rates Rising In 2023<\/span><\/li>\n\n\n\n<li><span data-preserver-spaces=\"true\">Part 4: High Interest Rates Put Pressure On Valuations And Debt Underwriting<\/span><\/li>\n\n\n\n<li><span data-preserver-spaces=\"true\">Part 5: News, Anecdotes, And Further Reading<\/span><\/li>\n\n\n\n<li><span data-preserver-spaces=\"true\">Part 6: Ideas To Protect Wealth And Make Money In This Environment<\/span><\/li>\n<\/ul>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Please note that real estate is local. My analysis in this article is reflective of the average across the United States, though I do dive into<\/span> a couple large regions<span data-preserver-spaces=\"true\">.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Lastly, I want to address upfront that I consider myself an amateur in understanding commercial real estate markets, perhaps approaching \u201cjourneyman\u201d status. I am by no means an expert in them. I invite debate and would welcome analysis from any readers ready to present a \u201cbull case\u201d to my points here. Please feel free to provide that in the comments or email me at&nbsp;<\/span><a class=\"editor-rtfLink\" href=\"mailto:Scott@biggerpockets.com\" target=\"_blank\" rel=\"noopener\"><span data-preserver-spaces=\"true\">Scott@biggerpockets.com<\/span><\/a><span data-preserver-spaces=\"true\">.<\/span><\/p>\n\n\n\n<h2 class=\"wp-block-heading\"><span data-preserver-spaces=\"true\">Part 1: Cap Rates Are Lower Than Interest Rates<\/span><\/h2>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">On average, interest rates are higher than cap rates right now in the multifamily space in the United States. Visually, that can be represented as the two lines in the chart below crossing:<\/span><\/p>\n\n\n\n<figure class=\"wp-block-image size-full\"><img loading=\"lazy\" decoding=\"async\" width=\"512\" height=\"348\" src=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2022\/11\/lower-leveraged-returns.png\" alt=\"lower leveraged returns\" class=\"wp-image-145580\" title=\"\" srcset=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2022\/11\/lower-leveraged-returns.png 512w, https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2022\/11\/lower-leveraged-returns-300x204.png 300w\" sizes=\"auto, (max-width: 512px) 100vw, 512px\" \/><figcaption class=\"wp-element-caption\"><em>\u201cLower Levered Returns\u201d \u2013&nbsp;<a href=\"https:\/\/www.greenstreet.com\/\" target=\"_blank\" rel=\"noreferrer noopener\">Green Street<\/a><\/em><\/figcaption><\/figure>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Investors entering commercial multifamily do so because they want to generate a return. Return is&nbsp;<\/span><em><span data-preserver-spaces=\"true\">not&nbsp;<\/span><\/em><span data-preserver-spaces=\"true\">expressed as a <a href=\"https:\/\/www.biggerpockets.com\/blog\/cap-rate-real-estate\" target=\"_blank\" rel=\"noreferrer noopener\">capitalization rate (cap rate)<\/a>, which is more of a metric used to value properties in relation to one another, but rather as an <a href=\"https:\/\/www.biggerpockets.com\/blog\/internal-rate-return-irr\" target=\"_blank\" rel=\"noreferrer noopener\">internal rate of return<\/a> (IRR). One can generate a strong IRR in high and low cap rate environments, just as they can generate a strong IRR in high and low interest rate environments.<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">IRR is dependent on two primary factors: the amount of cash flow the property produces (and the timing of those cash flows) and exit\/sale of the property (and the timing). Increase rents quickly and sell at a premium price, and the IRR soars. Do so slowly and sell at a higher cap rate than at the time of acquisition, and IRR plummets.<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Cap rates have been relatively low in a historical context for the last 10 years. This hasn\u2019t been an issue for folks in generating great IRR because interest rates were so low. In fact, low cap rates, in many ways, make it easier for investors to generate returns because each incremental dollar of NOI added to a property increases the valuation by a greater multiple. Increase NOI by $1 in a 10% cap rate environment, and the property value increases by $10. Increase NOI by $1 in a 5% cap rate environment, and the property increases in value by $20.<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">However, driving IRR becomes much, much harder in a \u201cnegative leverage\u201d situation where cap rates are higher than interest rates. For reasons we will discuss throughout this article, higher interest rates make it harder for buyers to qualify for attractive financing, increasing likely exit cap rates and putting downward pressure on IRR. And, much of the basis for an IRR projection will come from increasing rents quickly.<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">In other words, the market is more dependent today than at any point in the last decade on cap rates remaining low, rents continuing to rise quickly, and\/or a return to the historically low interest rates we saw in the last five years. \u201cNegative Leverage\u201d is the market\u2019s way of communicating that it is \u201call-in\u201d on appreciation or falling interest rates.<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">&nbsp;<\/span><span data-preserver-spaces=\"true\">And, as I will spell out, I think either outcome has a low probability.<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">While it\u2019s all about IRR for the asset in question in the end, I find it interesting that even without having to run the numbers on a specific deal or a marketplace of deals, we can already make a simplistic observation about commercial real estate just by examining the historical spread of cap rates vs. interest rates (which includes all real estate, not just multifamily in isolation \u2014 but note that multifamily cap rates are typically lower, on average, than other types of commercial real estate).<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Unless one has a stronger thesis for rent growth and\/or interest rate reduction than has been the case for the past decade or so, a spread between interest rates and cap rates of about 150 bps is the norm. That implies cap rates rising from 5% to 6.5%. While that may not seem like a big deal, if this were to normalize quickly, it\u2019s equivalent to about a 23% reduction in asset values.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">That looks like this forecast provided by CBRE:&nbsp;<\/span><\/p>\n\n\n\n<figure class=\"wp-block-image size-full\"><img loading=\"lazy\" decoding=\"async\" width=\"1046\" height=\"536\" src=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2023\/01\/Screenshot-2023-01-31-at-5.13.59-PM.png\" alt=\"historical cap rates\" class=\"wp-image-146558\" title=\"\" srcset=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2023\/01\/Screenshot-2023-01-31-at-5.13.59-PM.png 1046w, https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2023\/01\/Screenshot-2023-01-31-at-5.13.59-PM-300x154.png 300w, https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2023\/01\/Screenshot-2023-01-31-at-5.13.59-PM-1024x525.png 1024w, https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2023\/01\/Screenshot-2023-01-31-at-5.13.59-PM-768x394.png 768w\" sizes=\"auto, (max-width: 1046px) 100vw, 1046px\" \/><figcaption class=\"wp-element-caption\"><em>Historical Cap Rates &amp; Forecast (2012 &#8211; 2024) &#8211; <a href=\"https:\/\/www.cbre.com\/\" target=\"_blank\" rel=\"noreferrer noopener\">CBRE<\/a><\/em><\/figcaption><\/figure>\n\n\n\n<h2 class=\"wp-block-heading\"><span data-preserver-spaces=\"true\">Part 2: I\u2019m Not Betting On Rent Growth In 2023<\/span><\/h2>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">To understand how rents might be impacted this year, we have to think about both supply and demand. I have bad news on the supply front and a mixed bag for demand.<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Let\u2019s start the discussion by looking at supply.<\/span><\/p>\n\n\n\n<h3 class=\"wp-block-heading\"><span data-preserver-spaces=\"true\">Supply<\/span><\/h3>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Backlogs for new construction in multifamily are at the highest levels since the 1970s. Backlogs for&nbsp;<\/span><a class=\"editor-rtfLink\" href=\"https:\/\/www.mortgagenewsdaily.com\/data\/homes-under-construction\" target=\"_blank\" rel=\"noopener\"><em><span data-preserver-spaces=\"true\">total homes under construction<\/span><\/em><\/a><span data-preserver-spaces=\"true\">&nbsp;are at the highest levels we have data for:<\/span><\/p>\n\n\n\n<figure class=\"wp-block-image size-full\"><img loading=\"lazy\" decoding=\"async\" width=\"1266\" height=\"908\" src=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2023\/01\/Screenshot-2023-01-31-at-5.15.41-PM.png\" alt=\"under construction by structure\" class=\"wp-image-146559\" title=\"\" srcset=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2023\/01\/Screenshot-2023-01-31-at-5.15.41-PM.png 1266w, https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2023\/01\/Screenshot-2023-01-31-at-5.15.41-PM-300x215.png 300w, https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2023\/01\/Screenshot-2023-01-31-at-5.15.41-PM-1024x734.png 1024w, https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2023\/01\/Screenshot-2023-01-31-at-5.15.41-PM-768x551.png 768w\" sizes=\"auto, (max-width: 1266px) 100vw, 1266px\" \/><figcaption class=\"wp-element-caption\"><em>Under Construction By Structure (1970 &#8211; 2022) &#8211; <a href=\"https:\/\/www.mortgagenewsdaily.com\/data\/homes-under-construction\" target=\"_blank\" rel=\"noreferrer noopener\">Mortgage News Daily<\/a><\/em><\/figcaption><\/figure>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Experts like Ivy Zelman take the stance that developers will monetize this inventory as soon as it is completed \u2014&nbsp;<\/span><a class=\"editor-rtfLink\" href=\"https:\/\/www.youtube.com\/watch?v=2lA_bQHbKXw&amp;t=1631s\" target=\"_blank\" rel=\"noopener\"><span data-preserver-spaces=\"true\">essentially, come hell or high water.<\/span><\/a><span data-preserver-spaces=\"true\">&nbsp;The holding costs and bridge debt (similar to hard money loans for commercial development) builders use to finance projects are very expensive and thus are a powerful incentive to finish construction and refinance or sell as soon as possible.<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">As Brian Burke of Praxis Capital mentioned on our&nbsp;<\/span><a class=\"editor-rtfLink\" href=\"https:\/\/www.youtube.com\/watch?v=AoXNNRasXTw\" target=\"_blank\" rel=\"noopener\"><em><span data-preserver-spaces=\"true\">On the Market<\/span><\/em><span data-preserver-spaces=\"true\">&nbsp;podcast<\/span><\/a><span data-preserver-spaces=\"true\">, development takes time and will impact various regions differently. Some markets may not see much new supply. Some markets will see a ton of supply come online but have so much new demand that there will be no struggle with absorption. And some markets will see supply come online and struggle to fill the units, putting downward pressure on rents as vacancies increase.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">The South and West are at the highest risk of seeing massive new supply coming online:<\/span><\/p>\n\n\n\n<figure class=\"wp-block-image size-full\"><img loading=\"lazy\" decoding=\"async\" width=\"1266\" height=\"908\" src=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2023\/01\/Screenshot-2023-01-31-at-5.59.41-PM.png\" alt=\"under construction by region\" class=\"wp-image-146560\" title=\"\" srcset=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2023\/01\/Screenshot-2023-01-31-at-5.59.41-PM.png 1266w, https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2023\/01\/Screenshot-2023-01-31-at-5.59.41-PM-300x215.png 300w, https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2023\/01\/Screenshot-2023-01-31-at-5.59.41-PM-1024x734.png 1024w, https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2023\/01\/Screenshot-2023-01-31-at-5.59.41-PM-768x551.png 768w\" sizes=\"auto, (max-width: 1266px) 100vw, 1266px\" \/><figcaption class=\"wp-element-caption\"><em>Under Construction By Region (1970 &#8211; 2022) &#8211; Mortgage News Daily<\/em><\/figcaption><\/figure>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Note that while you may have heard about permits or&nbsp;<\/span><a class=\"editor-rtfLink\" href=\"https:\/\/www.reuters.com\/markets\/europe\/us-housing-starts-fall-september-building-permits-rise-2022-10-19\/\" target=\"_blank\" rel=\"noopener\"><span data-preserver-spaces=\"true\">housing starts<\/span><em><span data-preserver-spaces=\"true\">&nbsp;<\/span><\/em><span data-preserver-spaces=\"true\">declining<\/span><\/a><span data-preserver-spaces=\"true\">, remember that development takes time. Permitting and development projects that were started in late 2021 and early 2022 will come online in 2023 and 2024. Projects can take years or even decades to permit, start, and finally complete. A lack of new housing starts does little to stem the onslaught of new inventory already underway that is about to hit the market. The effects of this new construction boom are just getting started.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">And it doesn\u2019t take a big stretch of the imagination to extrapolate that this glut of new housing will put downward pressure on real estate prices of all types, as well as downward pressure on rents, as more housing stock is competing for the same pool of renters.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Let\u2019s talk about demand next.&nbsp;<\/span><\/p>\n\n\n\n<h3 class=\"wp-block-heading\"><span data-preserver-spaces=\"true\">Demand<\/span><\/h3>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">The biggest demand question, in my opinion, is around household formation. 1.6M new units coming online is no big deal if we are expecting 1.6M new households to form, right? That allows for those units to be rented or occupied (absorbed) without any type of pricing shock. And everyone\u2019s been talking about a massive housing shortage for years, right?<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">And it\u2019s true \u2014 America typically adds households at a faster rate than we add inventory. And there is<\/span><em><span data-preserver-spaces=\"true\">&nbsp;<\/span><\/em><span data-preserver-spaces=\"true\">a housing shortage. That\u2019s why real estate prices and rents have skyrocketed over the past few years. There are just two problems with this position as a defense of rising rents going forward:<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">First, household formation data was thrown way off during the pandemic, with over a million Covid-19-related deaths and a huge reshuffling of households. This makes it really difficult for any economist to predict household formation.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Second, the housing shortage has&nbsp;<\/span><em><span data-preserver-spaces=\"true\">already been priced in<\/span><\/em><span data-preserver-spaces=\"true\">&nbsp;to current rents and home prices. The shortage, coupled with low interest rates, led to nearly 40% appreciation in home prices and a 26% increase in rents during the pandemic.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Diving deeper into household formation. During the pandemic, we see that&nbsp;<\/span><a class=\"editor-rtfLink\" href=\"https:\/\/www.yardeni.com\/pub\/hseholdform.pdf\" target=\"_blank\" rel=\"noopener\"><span data-preserver-spaces=\"true\">millions<\/span><em><span data-preserver-spaces=\"true\">&nbsp;<\/span><\/em><span data-preserver-spaces=\"true\">of \u201chouseholds\u201d apparently formed:<\/span><\/a><\/p>\n\n\n\n<figure class=\"wp-block-image size-full\"><img loading=\"lazy\" decoding=\"async\" width=\"1802\" height=\"1091\" src=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2023\/01\/Screenshot-2023-01-31-at-6.09.43-PM.png\" alt=\"number of households united states\" class=\"wp-image-146562\" title=\"\" srcset=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2023\/01\/Screenshot-2023-01-31-at-6.09.43-PM.png 1802w, https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2023\/01\/Screenshot-2023-01-31-at-6.09.43-PM-300x182.png 300w, https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2023\/01\/Screenshot-2023-01-31-at-6.09.43-PM-1024x620.png 1024w, https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2023\/01\/Screenshot-2023-01-31-at-6.09.43-PM-768x465.png 768w, https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2023\/01\/Screenshot-2023-01-31-at-6.09.43-PM-1536x930.png 1536w\" sizes=\"auto, (max-width: 1802px) 100vw, 1802px\" \/><figcaption class=\"wp-element-caption\"><em>Number of U.S. Households in Millions (2000 &#8211; 2024) &#8211; <a href=\"https:\/\/www.yardeni.com\/pub\/hseholdform.pdf\" target=\"_blank\" rel=\"noreferrer noopener\">Yardeni Research<\/a><\/em><\/figcaption><\/figure>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">What\u2019s going on here?&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">The answer is not clear to me, and I haven\u2019t found a particularly compelling assessment of the situation from an economist I like. I\u2019d appreciate it if a commenter could point me to a study or analysis that makes sense and allows us to extrapolate the future well.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">In the absence of a quality analysis that I can access, my guess is that people simply moved around. I think this distorted the data in ways that we don\u2019t fully understand yet. People moved back in with Mom and Dad. Perhaps folks who live and work in places like New York City, San Francisco, and Los Angeles kept paying their leases but also moved out of the city to a second home, and perhaps this was counted as a second household formation. Perhaps divorces and breakups spiked, and when a couple splits up, that magnifies \u201chousehold\u201d formation (two people each needing a place to live, each head of household, instead of one family unit).<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">But it&#8217;s obvious that we didn\u2019t actually see millions<\/span><em><span data-preserver-spaces=\"true\">&nbsp;<\/span><\/em><span data-preserver-spaces=\"true\">of new households form. My bet is that we have an artificially high estimate of the number of current households in this country right now, and that scares me when trying to project rent growth next year.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Furthermore, note that even without the craziness in this metric, household formation data can wax and wane with the economy. In good times, folks may buy multiple houses and move out from shared apartments with roommates or move out of their parent\u2019s basement. In recessions, folks can move back home with Mom and Dad or bring in roommates again. \u201cHousehold\u201d formation can decline quickly.&nbsp;<\/span><\/p>\n\n\n\n<h3 class=\"wp-block-heading\"><span data-preserver-spaces=\"true\">The potential offset \u2014 rents could rise again in 2023<\/span><\/h3>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">There are always multiple variables in any important economic metric, and rent is no exception. While I am fearful of the downward pressure from massive rental increases over the past two years, supply growth, and the question marks around household formation, I do want to acknowledge that there is a major tailwind (upward pressure) to rent prices: interest rates.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">With mortgage rates doubling in a 12-month period, affordability in purchasing homes, the alternative to renting for millions of Americans, has spiked. One study from ATTOM concluded that just a year ago, it was more affordable to own than to rent in 60% of U.S. markets, a stat that has flipped with the 40-50% increase in monthly payments due to higher interest rates. That affordability switch will put upward pressure on rents.<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">It\u2019s because of this pressure that I think rents are a coin flip in 2023. I don\u2019t trust any economic forecasts about rent growth right now. And, without the upward pressure on rents from high interest rates, I\u2019d be willing to make a meaningful bet that rents would decline on average across the country.&nbsp;<\/span><\/p>\n\n\n\n<h2 class=\"wp-block-heading\"><span data-preserver-spaces=\"true\">Part 3: I\u2019m Also Not Betting On Interests Rates Declining In 2023<\/span><\/h2>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Remember, cap rates are lower than interest rates. That means that for investors to make money, rents have to grow (quickly), or interest rates have to fall. As I mentioned, I think there are a lot of reasons to be skeptical about any rent growth projections nationally in 2023 and every reason to think that rents are a coin flip with a significant potential downside.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Now, it\u2019s time to turn our attention to interest rates. A reversion of commercial rates to the historic lows of the last few years would bail out many commercial real estate and multifamily syndicators and their investors.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Is that likely? I don\u2019t think so. Here\u2019s why.<\/span><\/p>\n\n\n\n<h3 class=\"wp-block-heading\"><span data-preserver-spaces=\"true\">The \u201cspread\u201d (vs. the 10-year Treasury) explained<\/span><\/h3>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">When banks, institutions, or individuals lend money, they want to be compensated for the risk they\u2019re taking. How much they charge in interest can often be thought of as a \u201cspread\u201d against a low-risk alternative.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">It\u2019s widely accepted in the lending space that the U.S. 10-year Treasury bill is a great benchmark to measure \u201cspread\u201d against. Other benchmarks include the London Interbank Offered Rate (LIBOR) and the Secured Overnight Financing Rate (SOFR).&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">In fact, a lot of private commercial debt comes with rates that are pegged to SOFR plus a spread, not the Treasury. But, the 10-year U.S. Treasury bond is the standard that most people compare spreads to and is the biggest influence on multifamily financing.<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Many institutions consider lending money to the U.S. government to be the lowest-risk investment in the world. Lending to anyone else comes with more risk. Therefore, everyone else should be charged with higher interest.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">But how much more? That\u2019s where the idea of a \u201cspread\u201d comes in.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Just how much \u201cspread\u201d a lender charges depends on the lender, the economy, and the demand for loans. In some markets, such as 30-year mortgages for homebuyers, this spread is very well established. For example:<\/span><\/p>\n\n\n\n<figure class=\"wp-block-image size-full\"><img loading=\"lazy\" decoding=\"async\" width=\"1125\" height=\"815\" src=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2023\/01\/Screenshot-2023-01-31-at-6.08.20-PM.png\" alt=\"30 year fixed mortgage vs 10 year treasury yield\" class=\"wp-image-146563\" title=\"\" srcset=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2023\/01\/Screenshot-2023-01-31-at-6.08.20-PM.png 1125w, https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2023\/01\/Screenshot-2023-01-31-at-6.08.20-PM-300x217.png 300w, https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2023\/01\/Screenshot-2023-01-31-at-6.08.20-PM-1024x742.png 1024w, https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2023\/01\/Screenshot-2023-01-31-at-6.08.20-PM-768x556.png 768w\" sizes=\"auto, (max-width: 1125px) 100vw, 1125px\" \/><figcaption class=\"wp-element-caption\"><em>30-Year Fixed-Rate Mortgage vs. 10-Year Treasury Yield (2016 &#8211; 2022) &#8211;  <a href=\"https:\/\/wolfstreet.com\/\" target=\"_blank\" rel=\"noreferrer noopener\">Wolfstreet.com<\/a><\/em><\/figcaption><\/figure>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">This is clearly a really strong correlation, to the point where we can take it for granted that if the 10-year Treasury goes up, mortgage rates go up, and vice versa. However, it\u2019s not a perfect correlation, and sometimes, the spread does, in fact, change.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Today is one of those times. The spread between the 10-year Treasury and 30-year mortgage rates is relatively high,&nbsp;<\/span><a class=\"editor-rtfLink\" href=\"https:\/\/www.urban.org\/urban-wire\/why-have-mortgage-rates-gone-so-much\" target=\"_blank\" rel=\"noopener\"><span data-preserver-spaces=\"true\">as you can see below<\/span><\/a><span data-preserver-spaces=\"true\">:<\/span><\/p>\n\n\n\n<figure class=\"wp-block-image size-full\"><img loading=\"lazy\" decoding=\"async\" width=\"1081\" height=\"597\" src=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2023\/01\/Screenshot-2023-01-31-at-6.08.34-PM.png\" alt=\"10-Year Treasury vs. Primary Mortgage Spread (2000-2022)\" class=\"wp-image-146564\" title=\"\" srcset=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2023\/01\/Screenshot-2023-01-31-at-6.08.34-PM.png 1081w, https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2023\/01\/Screenshot-2023-01-31-at-6.08.34-PM-300x166.png 300w, https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2023\/01\/Screenshot-2023-01-31-at-6.08.34-PM-1024x566.png 1024w, https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2023\/01\/Screenshot-2023-01-31-at-6.08.34-PM-768x424.png 768w\" sizes=\"auto, (max-width: 1081px) 100vw, 1081px\" \/><figcaption class=\"wp-element-caption\"><em>10-Year Treasury vs. Primary Mortgage Spread (2000-2022) &#8211; <a href=\"https:\/\/www.urban.org\/urban-wire\/why-have-mortgage-rates-gone-so-much\" target=\"_blank\" rel=\"noreferrer noopener\">Urban Institute<\/a><\/em><\/figcaption><\/figure>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Many pundits expect 30-year mortgage rates to decline in 2023 because of this high spread. They believe that if the spread between the 10-year Treasury and 30-year mortgage rates were to normalize to the historical average of roughly 180 bps, then mortgages could come back down closer to the 5.5% range instead of 6.3%, where we are at the time of this writing.<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">This makes sense in theory, except for two problems.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">First, the 10-year Treasury yield is currently depressed because investors think we are in or are about to be in a recession. This is commonly expressed by saying that the yield curve is inverted. The progression towards an inverted yield curve is represented very well in this&nbsp;<\/span><a class=\"editor-rtfLink\" href=\"https:\/\/www.visualcapitalist.com\/cp\/visualizing-and-understanding-an-inverted-yield-curve\/\" target=\"_blank\" rel=\"noopener\"><span data-preserver-spaces=\"true\">outstanding visualization from Visual Capitalist.<\/span><\/a><span data-preserver-spaces=\"true\">&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Folks are fleeing to safer investments like 10-year treasuries out of recessionary fears. It is highly likely that as the economy starts to recover, the yield curve will normalize, and the 10-year Treasury rate will increase.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Second, the Fed is clearly signaling that they intend to increase rates throughout the year in 2023. Betting that rates will come down is a bet against the official stance of the Fed. The only way I see rates coming down and staying down is if there is a recession that is so deep and bad that the Fed is forced to reverse course quickly.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">In other words, rates are going to increase for real estate investors (and anyone else who borrows money using debt that tracks to the 10-year Treasury) unless there is a terrible recession where millions of people lose their jobs.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">So, let\u2019s flip a coin:&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">If it\u2019s heads (a major recession), jobs are lost, rents decline, and commercial multifamily real estate values decline.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">If it\u2019s tails (a brighter economic outlook), interest rates rise quickly, and commercial multifamily real estate values decline.<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">This is not a very fun game.<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">While it\u2019s possible that you see mortgage rates bounce around and temporarily plunge as low as the mid-5s, I\u2019d bet we end the year with rates even higher than where they are today, again, unless there is a deep recession.&nbsp;<\/span><\/p>\n\n\n\n<h3 class=\"wp-block-heading\"><strong><span data-preserver-spaces=\"true\">Aren\u2019t commercial loans different than residential loans? Why aren\u2019t we talking about them specifically?&nbsp;<\/span><\/strong><\/h3>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">While there are all sorts of nuances to commercial lending, right now, most folks are likely to be using Freddie Mac loans to purchase small to medium-sized apartment complexes, the asset class I am discussing in this article.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">If they can qualify for a Freddie Mac loan, investors are likely to use them. Freddie Mac loans are the easy button for multifamily investors because they have low interest rates, 30-year amortization, and five, seven, or 10-year terms. Right now, the interest rates on a Freddie Loan can be&nbsp;<\/span><a class=\"editor-rtfLink\" href=\"https:\/\/apartmentloanstore.com\/content\/apartment-loan-rates\" target=\"_blank\" rel=\"noopener\"><span data-preserver-spaces=\"true\">south of 5%!<\/span><\/a><span data-preserver-spaces=\"true\">&nbsp;It\u2019s the multifamily equivalent of the conventional loans that millions of real estate investors and homeowners use to buy single-family homes insured by Fannie Mae.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Freddie Mac\u2019s rates are tied to the 10-year Treasury. So, these apartment loans don\u2019t see the same rising spread against the 10-year note that we are seeing in the residential (conventional mortgage) space. That leaves them with&nbsp;<\/span><em><span data-preserver-spaces=\"true\">even more<\/span><\/em><span data-preserver-spaces=\"true\">&nbsp;risk, in my view, to rise if the yield curve normalizes compared with 30-year Fannie Mae mortgages. It also explains why rates are so much lower in multifamily than in single-family housing right now.<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">While there is a private market for commercial real estate debt that was perhaps more commonly used a few years ago, that appears to have dried up to a large degree. It\u2019s either a government-sponsored enterprise (GSE) like Fannie Mae or Freddie Mac or bust for most syndicators right now.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">But, the real difference between commercial debt and typical single-family debt is the <a href=\"https:\/\/www.biggerpockets.com\/blog\/dscr-loans-what-are-they\" target=\"_blank\" rel=\"noreferrer noopener\">Debt Service Coverage Ratio<\/a> (DSCR). We\u2019ll get into why this is so important in the next section.<\/span><\/p>\n\n\n\n<h2 class=\"wp-block-heading\"><span data-preserver-spaces=\"true\">Part 4: High Interest Rates Put Pressure On Valuations And Debt Underwriting<\/span><\/h2>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Commercial debt, including Freddie Mac Apartment Loans, as discussed earlier, isn\u2019t quite the same as conventional lending in the single-family residential space. A typical Freddie Mac loan, for example, might have a 30-year amortization schedule, but with a balloon payment \u2014 the balance comes due after five, seven, or 10 years. This isn\u2019t an issue for investors in typical markets. They can simply sell the asset after a few years to pay off the loan or refinance with a new loan and start the process all over again.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">But, as mentioned earlier, there is another underwriting test with these loans: the Debt Service Coverage Ratio. A DSCR is multifamily\u2019s version of a debt-to-income test that many homeowners need to pass when qualifying for a home mortgage.<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">If the cash flow of the business or apartment complex is exactly equal to the principal and interest (the debt service) of a loan, then the DSCR would be 1.0. Lower, and the cash flow produced by the business is not sufficient to cover the loan. Higher, and there is excess cash flow.<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Freddie Mac Loans typically require a DSCR of 1.2 to 1.25.<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Commercial debt negotiated between lender and borrower privately, with debt that is not backed by a GSE, may have more strict covenants like higher DSCR ratios or debt covenants that require borrowers to maintain a DSCR ratio throughout the life of the loan.<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">While Freddie Loans can size to up to 80% LTV, in practice, many get coverage constrained in underwriting to 65% to 75%.<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">In normal markets, these items aren\u2019t an issue. But let\u2019s examine what happens when interest rates rise quickly like they did this past year.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Imagine an investor bought a property with a $1,000,000 Freddie Mac Loan in late 2021. The loan has a 3% interest rate. The principal and interest on 30-year amortization is $4,216 per month, or $50,592 per year. Fast forward to today. This same loan would come with a loan at 5.5% interest. That higher interest rate would increase the debt service on a $1M loan to $68,136, an increase of 35%.<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Now, our investor used a Freddie loan (and an estimated two-thirds of the market uses fixed-rate debt) and likely won\u2019t run into real pressure for 5-10 years, depending on their loan term. But, it is important to acknowledge that if that investor were to reapply for that same loan today, they likely would not qualify. They\u2019d likely have to bring significantly more cash to close the deal (reducing LTV), or else they would have to pay less for the property.<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Even more problematic, there is a sector of the market that uses variable rate debt and other types of creative finance like bridge debt (similar to hard money loans) to finance multifamily and other commercial real estate. <\/span><a class=\"editor-rtfLink\" href=\"https:\/\/www.wsj.com\/articles\/rising-interest-rates-hit-landlords-who-cant-afford-hedging-costs-11673900169\" target=\"_blank\" rel=\"noopener\"><span data-preserver-spaces=\"true\">According to the Wall Street Journal<\/span><\/a><span data-preserver-spaces=\"true\">, about one-third of the market uses variable interest rate debt, and some (unknown) percentage of that cohort uses bridge debt and other non-agency debt.<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">These borrowers will face increasing pressure to make their payments with higher interest rates. Going back to our example from earlier, imagine that the property generated $62,500 (5% cap rate at acquisition) in NOI with $50,592 in debt service at a 3% interest. Today, those payments are, again, $68,136. This fictional borrower is now going to have to cover the difference with funds other than those generated by the property.<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Many of these variable-rate loans have rate caps in place (often required by their lenders) that temporarily prevent interest rates on their debt from rising too high. However, the cost of renewing these rate caps is skyrocketing, by as much as 10X, in light of rising rates. This is already starting to put pressure on borrowers who often have to set aside funds for this insurance every month.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">As I mentioned, Ben Miller, CEO of <a href=\"http:\/\/fundrise.com\" target=\"_blank\" rel=\"noreferrer noopener\">Fundrise<\/a>, has termed this phenomenon the \u201cGreat Deleveraging\u201d \u2014 a turn of phrase that I feel sums up this problem very succinctly.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Listen to&nbsp;<\/span><a class=\"editor-rtfLink\" href=\"https:\/\/www.biggerpockets.com\/blog\/on-the-market-65\" target=\"_blank\" rel=\"noopener\"><span data-preserver-spaces=\"true\">his appearance on&nbsp;<\/span><em><span data-preserver-spaces=\"true\">On the Market<\/span><\/em><\/a><span data-preserver-spaces=\"true\">&nbsp;and hear some of the examples that are already hitting the commercial real estate world (starting with retail and office).&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Brian Burke says that this problem has the potential to be acute with development loans, where re-margin requirements may force borrowers to pay the loan balance down if the lease-up isn\u2019t hitting targets.<\/span><\/p>\n\n\n\n<h3 class=\"wp-block-heading\"><span data-preserver-spaces=\"true\">Is a panic possible?<\/span><\/h3>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">When operators can\u2019t meet their loan covenants, they may default and hand the asset back to the bank (a foreclosure). In these situations, the creditor will liquidate the property, selling it as fast as possible. Some folks may tout a liquidated property that sells for far below market value as a \u201cbuying opportunity\u201d \u2014 and it may well be.<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">But it also sets a comp for assets just like it. In addition to DSCR covenants, multifamily properties are appraised, just like houses. If appraisals don\u2019t come in, buyers need to bring more cash to closing.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">If pressure mounts over 2023, comps for multifamily complexes could be driven lower and lower by distressed foreclosure sales, making borrowing harder and harder in a negative feedback loop.<\/span><\/p>\n\n\n\n<h2 class=\"wp-block-heading\"><span data-preserver-spaces=\"true\">Part 5: News, Anecdotes, And Further Reading<\/span><\/h2>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">What I\u2019m discussing here is not news to industry insiders.&nbsp;<\/span><a class=\"editor-rtfLink\" href=\"https:\/\/www.barrons.com\/articles\/reits-brutal-year-simon-property-bargain-51671209220\" target=\"_blank\" rel=\"noopener\"><span data-preserver-spaces=\"true\">REIT valuations plunged 25% in 2022<\/span><\/a><span data-preserver-spaces=\"true\">. Rents are falling in many major cities like Minneapolis and Chicago, where&nbsp;<\/span><a class=\"editor-rtfLink\" href=\"https:\/\/www.rd.com\/article\/will-rent-prices-go-down\/\" target=\"_blank\" rel=\"noopener\"><span data-preserver-spaces=\"true\">rent prices are down 9% and 4%, respectively<\/span><\/a><span data-preserver-spaces=\"true\">, year-over-year.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Landlords are also starting to offer more&nbsp;<\/span><a class=\"editor-rtfLink\" href=\"https:\/\/www.rd.com\/article\/will-rent-prices-go-down\/\" target=\"_blank\" rel=\"noopener\"><span data-preserver-spaces=\"true\">\u201cconcessions\u201d to renters<\/span><\/a><span data-preserver-spaces=\"true\">, in the form of one month\u2019s rent free, or free parking, to entice new tenants. These concessions hit the bottom line for apartment investors in the same way that vacancy or lower listing price rents would, but may mask the degree to which rent declines may be reported in certain markets.<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">The institutional clients of large private equity funds have been withdrawing funds to the point where those funds are bumping up against&nbsp;<\/span><a class=\"editor-rtfLink\" href=\"https:\/\/www.wsj.com\/articles\/blackstones-hefty-concession-is-a-warning-to-investors-11672840068\" target=\"_blank\" rel=\"noopener\"><span data-preserver-spaces=\"true\">withdrawal limits for their investors<\/span><\/a><span data-preserver-spaces=\"true\">, starting with the most famous non-traded REIT in the world: Blackstone.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Brian Burke discusses this topic at length in&nbsp;<\/span><a class=\"editor-rtfLink\" href=\"https:\/\/www.youtube.com\/watch?v=AoXNNRasXTw\" target=\"_blank\" rel=\"noopener\"><em><span data-preserver-spaces=\"true\">On the Market<\/span><\/em><span data-preserver-spaces=\"true\">\u2019s \u201cThe Multifamily Bomb is About to Blow\u201d<\/span><\/a><span data-preserver-spaces=\"true\">&nbsp;episode with Dave Meyer. He believes that we are on the cusp of \u201crepricing\u201d in the sector and that there is a massive bid\/ask spread between buyers and sellers. The few deals being done, for now, are by 1031 exchange participants and those who have raised large funds and have to deploy those assets quickly. These folks are motivated to move fast, and with many sellers holding on for dear life for now, prices remain elevated.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">This won\u2019t last much longer. Sellers who were highly levered with variable rate debt will be forced<\/span><em><span data-preserver-spaces=\"true\">&nbsp;<\/span><\/em><span data-preserver-spaces=\"true\">out by their DSCR compliance issues. And, there will be steady mounting pressure for investors to refinance their balloon debt, pressure that will increase with each passing month as more and more of the market is forced to act by either selling, refinancing, or bringing significant chunks of cash to reduce debt balances and avoid foreclosure.&nbsp;<\/span><\/p>\n\n\n\n<h2 class=\"wp-block-heading\"><span data-preserver-spaces=\"true\">Part 6: Ideas To Protect Wealth And Make Money In This Environment<\/span><\/h2>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Cap rates are lower than interest rates. Rent growth and interest rate relief are each a coin flip. Pressure is mounting on the debt side for a sizable chunk of the market, and underwriting new deals is much harder at last year\u2019s prices.<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">This is a tough environment, but there is still a number of strategies that may make sense for savvy investors who still want to participate in the multifamily and other real estate sectors. Here are some of the things I\u2019m considering:<\/span><\/p>\n\n\n\n<h3 class=\"wp-block-heading\"><span data-preserver-spaces=\"true\">Lend<\/span><\/h3>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Interest rates are higher than cap rates. That means more cash flow, at least in the first year(s), for the lender per dollar invested than the equity investor, with lower risk. Let someone else take the first 20-30% of the risk. I\u2019m personally considering investing in debt funds that do hard money lending, as I like the short<\/span><strong><span data-preserver-spaces=\"true\">&#8211;<\/span><\/strong><span data-preserver-spaces=\"true\">term nature of those loans and feel that the single-family market is more insulated from risk than the multifamily market.&nbsp;&nbsp;<\/span><\/p>\n\n\n\n<h3 class=\"wp-block-heading\"><span data-preserver-spaces=\"true\">Buy with zero leverage<\/span><\/h3>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">If your goal is truly to own multifamily for the long haul, and near-term risk is not something that bothers you, consider simply not using leverage at all, if you have the means. This reduces risk and, again, because interest rates are higher than cap rates, will increase cash flow. You can always refinance in a few years if you want to put more capital to work.&nbsp;<\/span><\/p>\n\n\n\n<h3 class=\"wp-block-heading\"><span data-preserver-spaces=\"true\">Wait and watch<\/span><\/h3>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">This is timing the market and is not my style. But, if you believe this analysis, we could see prices shift considerably in 2023. Sitting on cash for 6-12 months might put some savvy buyers in a position to acquire assets at a great bargain, especially if a panic drives the cap rate very, very high.&nbsp;<\/span><\/p>\n\n\n\n<h3 class=\"wp-block-heading\"><span data-preserver-spaces=\"true\">Review the terms of any investments you are in<\/span><\/h3>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">Some syndicators have the right to make capital calls. If a DSCR covenant is broken on a deal, the syndicator may have very unattractive options of selling at a huge loss, getting foreclosed on, or bringing a huge pile of cash to the table to prevent foreclosure.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">The terms of your syndication investment may allow the syndicator to require investors to put in additional capital or risk dilution of their shares. While the power is likely in the sponsor\u2019s hands, it is at least within your control to understand if this is a possibility in your deal or not and to prepare your cash position accordingly. Don\u2019t be blindsided.<\/span><\/p>\n\n\n\n<h3 class=\"wp-block-heading\"><span data-preserver-spaces=\"true\">Bring a healthy skepticism to any new investments<\/span><\/h3>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">I am obviously skeptical of the market in a systemic way, but if presented with a specific deal that was able to intrigue me enough to take a second look, I\u2019d want to be sure that the deal made sense even with a significant rise in cap rates.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">I\u2019d be skeptical about claims of \u201cvalue-add\u201d (every deal advertised by every sponsor is \u201cvalue-add\u201d) or that the property is a \u201cgreat deal\u201d (what sponsor is going to tell you that the deal is not a great one?). My interest would also be piqued if a sponsor committed a significant amount of their own capital &#8211; something meaningful in the context of their net worth. ). I\u2019d want to feel confident that their own hard-earned capital was at risk, alongside mine, not just that they have the opportunity to earn upside from acquisition fees, management fees, and carried interest.&nbsp;<\/span><\/p>\n\n\n\n<h3 class=\"wp-block-heading\"><span data-preserver-spaces=\"true\">Take a short position on \u2026 something?<\/span><\/h3>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">I wonder if there are any public REITs that are particularly exposed to the risks outlined here. A material amount of research could reveal portfolios that are particularly concentrated in markets with low cap rates, massive supply risk, and with a high percentage of variable rate debt or who will be seeing skyrocketing rate cap costs. If anyone decides to go digging here, I\u2019d be very interested in talking through your findings.&nbsp; &nbsp;<\/span><\/p>\n\n\n\n<h2 class=\"wp-block-heading\"><span data-preserver-spaces=\"true\">Conclusion<\/span><\/h2>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">This was a long article. If you made it this far, thank you for reading!<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">As I mentioned in the introduction, I consider myself between an amateur to journeyman in understanding the world of commercial real estate and large multifamily.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">However, what I am able to comprehend makes me fearful for valuations. I feel like there are many risks here, and I plan to be very conservative in 2023. However, I may buy another single-family rental or even a&nbsp;<\/span><em><span data-preserver-spaces=\"true\">small<\/span><\/em><span data-preserver-spaces=\"true\">&nbsp;multifamily property like a duplex, triplex, or quadplex, as I like to do every 12-18 months.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">I hope that, at the very least, this article helps investors make more informed decisions if they are exploring multifamily investment opportunities and do just a bit more due diligence.&nbsp;<\/span><\/p>\n\n\n\n<p class=\"wp-block-paragraph\"><span data-preserver-spaces=\"true\">And again, I am still looking for someone with a bull case for multifamily. If you are reading this, please comment below or email me at&nbsp;<\/span><a class=\"editor-rtfLink\" href=\"mailto:Scott@biggerpockets.com\" target=\"_blank\" rel=\"noopener\"><span data-preserver-spaces=\"true\">Scott@biggerpockets.com<\/span><\/a><span data-preserver-spaces=\"true\">. I\u2019d love to hear your take.<\/span><\/p>\n\n\n\n<div class=\"wp-block-columns is-layout-flex wp-container-core-columns-is-layout-8f761849 wp-block-columns-is-layout-flex\">\n<div class=\"wp-block-column is-layout-flow wp-block-column-is-layout-flow\" style=\"flex-basis:100%\">\n<div id=\"hero-block_62df1a82bfc88\" class=\"first:mt-0 hero-block py-4    has-background has-slate-200-background-color has-text-color has-theme-gold-color\">\n    <div\n        class=\"gap-10 lg:gap-20 flex flex-wrap lg:flex-nowrap max-w-screen-xl mx-auto px-4 relative lg:items-center \">\n\n        <div class=\"relative z-30 lg:w-2\/3 \">\n            <main class=\"py-4\">\n                \n\n<p class=\"has-theme-blue-color has-text-color has-large-font-size wp-block-paragraph\"><strong>New! Updated Rental Market Data\u2013Top 100 US Markets<\/strong><\/p>\n\n\n\n<p class=\"has-text-align-left my-3 md:my-5 lg:my-8 has-slate-900-color has-text-color wp-block-paragraph\" style=\"font-size:16px\">Download Dave Meyer&#8217;s latest dataset that shows median rents and annual and monthly growth rates for the largest 100 markets in the US. <\/p>\n\n\n\n<div x-data=\"frictionlessSignupForm()\" class=\"button-account-type\">\n\n  \n\n  <!-- Guest Button -->\n      <template x-if=\"!$store.wp.isMember()\">              <button x-on:click=\"$store.wp.displaySignupPrompt()\" class=\" btn-shape inline-block no-underline has-background has-theme-blue-background-color has-text-color has-white-color\">Download<\/button>\n          <\/template>  \n  <!-- Free Member Button -->\n      <template x-if=\"$store.wp.isMember() &#038;&#038; !$store.wp.isPaidMember()\">              <a href=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2023\/02\/Rent-Data-January-2023_For-DL-.xlsx\" target=\"_blank\" class=\" btn-shape inline-block no-underline has-background has-theme-blue-background-color has-text-color has-white-color\">Download<\/a>\n          <\/template>  \n  <!-- Pro Member Button -->\n      <template x-if=\"$store.wp.isPaidMember()\">      <a href=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2023\/02\/Rent-Data-January-2023_For-DL-.xlsx\" target=\"_blank\" class=\" btn-shape inline-block no-underline has-background has-theme-blue-background-color has-text-color has-white-color\">Download<\/a>\n    <\/template>  \n  <!-- Frictionless Popup -->\n  <\/div>\n\n            <\/main>\n        <\/div>\n\n                <div class=\"lg:w-1\/3 first:mt-0 relative h-full lg:flex lg:items-center\">\n            <img decoding=\"async\" class=\"object-cover w-full relative z-20 my-0  shadow-xl rounded-md hidden lg:block\" src=\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2022\/12\/State-of-REI.png\" alt=\"\" title=\"\">\n        <\/div>\n            <\/div>\n<\/div><\/div>\n<\/div>\n","protected":false},"excerpt":{"rendered":"<p>I\u2019m worried about a significant decline (or crash) in commercial real estate valuations, specifically including multifamily, in 2023 and 2024. I feel that the red flags are so clear and [&hellip;]<\/p>\n","protected":false},"author":1676,"featured_media":146565,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[8,7119,7357],"tags":[],"class_list":["post-146555","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-real-estate-trends","category-biggerpockets-daily","category-multifamily-real-estate-investing"],"acf":[],"comment_count":0,"_links":{"self":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/posts\/146555","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/users\/1676"}],"replies":[{"embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/comments?post=146555"}],"version-history":[{"count":0,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/posts\/146555\/revisions"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/media\/146565"}],"wp:attachment":[{"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/media?parent=146555"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/categories?post=146555"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.biggerpockets.com\/blog\/wp-json\/wp\/v2\/tags?post=146555"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}