Is a 20-25% Crash in Multifamily Asset Values Realistic?
I've been noodling on this for a few weeks, and the more I think about it, the more I'm starting to convince myself that large multifamily is one of, if not the most, riskiest asset classes in America right now.
Here's my premise:
Supply: According to Ivy Zelman, backlogs for new construction in multifamily are at the highest levels since the 1970s. She estimates 1.6M backlog units. Builders will complete this inventory, and they will monetize it. This will put downward pressure on rents, and asset values (upwards pressure on cap rates).
Demand: We think rents are a coin flip in the next 12 months, and that a good forecast is zero rent growth. Vacancy is ticking up, as rents are falling in recent months in the multifamily space. If vacancy is already ticking up, and rents are declining, this kills the thesis for most multifamily value-add with fixed 2-5 year time horizons.
Cap Rates and Interest Rates: Interest rates are higher than cap rates right now. That's really scary. It means that every dollar of debt that you take on in a no or low growth environment reduces returns AND increases risk. The only way you can justify making an investment in an environment like this is if you believe you can rapidly increase rents/NOI, or if for some reason you believe that cap rates will decline still further.
The market is essentially going all-in on rent and NOI growth in the next 12-18 months. Given the massive supply coming online in the next 12 months, and the question marks around rent growth, I think this is really hard for me to believe.
I think that if anything, interest rates are likely to continue rising quickly in the multifamily space, and that NOI has a very good chance of flatlining or remaining stagnant.
Timing and Credit Considerations: The debt market is already starting to tighten, and (I do not have data on this) I believe that most multifamily properties are financed with variable debt with a 5-year Weighted average Life (WAL) in the range of 60/40 to 70/30 debt to equity. I believe that this varies considerably across the industry, and that folks are in all sorts of different positions. But your typical syndicator will finance this way to maximize returns in a growth environment. This puts timing pressure on deals. If I'm right about the 5-year WAL hypothesis, then about 20% of the market that has financed their portfolios will need to refinance or exit in the next 12 months. The pressure will mount by another 20% in the following 12 months.
Value-add: I can already hear some folks arguing that none of this matters if you can find an incredible deal, well below market, and add a ton of value to reposition the asset and increase rents. Fair enough, the value-added deal sponsor still has to consider the likely buyers at an exit. And that buyer will want a return. The end buyer is not likely to purchase a property with little value-add opportunity at a cap rate that is lower than interest rates - it's almost preposterous.
How bad is it and when will it hit?
Massive supply, weakening demand, debt that is so expensive relative to cash flow that it dilutes returns in all but the most aggressive growth forecast scenarios, and a slowly tightening credit market. These are incredibly tough market headwinds. I don't think the question is whether cap rates and multifamily valuations will decline. The questions for me are how much will asset valuations decline by and when will it happen?
First, I believe that multifamily valuations could decline by as much as 20-25%. Take a look at this chart:
How Much will Cap Rates Rise? Cap rates typically hover about 150 bps higher than interest rates. Is it unreasonable to project that cap rates rise in the current environment from ~5% to 6.5%? That is a BIG deal if that happens. It means that a property that generates $500K in NOI drops from being worth $10M to being worth $7.7M. That's a 23% drop in valuation. If you are financed at 60/40 debt/equity, 58% of your equity is wiped out. At 70/30, that's 77% of the equity eliminated.
How Long will this take to come into effect? If you believe that this is a reasonable projection, then the next question is when. When will this rise in cap rates happen? My guess is that the change will be a process, and not an event. I don't see cap rates rising 150 bps overnight. I think it will be a slow ramp over the next 12-18 months as more and more supply comes online, and more and more folks are forced to exit.
Bias in the market? The syndicator pitching an investment deal is perhaps a fine, but definitely a biased, source of information on the market, deal, and opportunities. Remember that syndicators make money in multiple ways on a deal. First, they often charge an acquisition fee - they make money just by buying large investments. A gimme. Second, they typically charge management fees - often a few percentage points of the equity investment in the deal. Third, they often get carried interests - or a percentage of the profits, if any, in the deal. Many syndicators invest nothing or very tiny percentages of their net worth in individual deals. There is no incentive, other than reputation (which I hope is very powerful), to do anything other than raise as much money as possible, and buy as much real estate as possible. If valuations keep climbing, GREAT! HUGE profits via these fees and carried interest. If valuations decline, "Oh well!" - they get acquisition and management fees, and get little/no carried interest. It's their investors who actually have large amounts of capital at risk.
I'd have a very hard time ESPECIALLY with investing through a syndicator who was not investing a material portion of their net worth in their deals at this point in the market.
What should I do to make money?
- If you have money in current syndications, pray.
- If you are considering investing in a syndication, make sure it is a huge winner even in a no rent growth environment, and one where cap rates rise at least 150 bps.
- Consider getting on the debt side, via a debt fund or private lending - the interest rates are higher than the cap rates! Might mean better returns with lower risk.
- Consider investing in a syndication that uses no leverage at all - as this might yield higher cash flows, and come with less risk - if there is a low growth or no growth environment, it will also yield better returns.
This is a super bold post. I'd appreciate any feedback here before I post these thoughts to the main blog and/or state these forecasts any podcasts!
I'd especially like to know about any mitigating factors - what would soften any price declines in this market?
Quote from @Brian Burke:
Great post, @Scott Trench! Yes it’s bold to post all of this negativity. But your post is well thought out and your points are solid.
Thankfully my team and I saw some of this coming, and even more thankfully we were bold enough to act on it and sell 75% of our multifamily portfolio at the peak of the market (2021 to early 2022). And we were bold enough to not buy anything in 2022, for all of the reasons you’ve set forth here. It’s also why it might be a while before we jump in again.
Addressing each of your points with my thoughts:
Supply: I see some risk here, but it is market dependent. Some markets have no new supply coming. Some submarkets have building moratoriums for multifamily. Some areas have a ton of supply coming, yet not enough to keep up with inbound migration. Some markets will be awash in new construction and struggle with absorption. And some of these projects will see delays due to cost of construction and financing constraints. I see a mixed bag here.
Demand: I agree on the coin toss. I look at rent growth forecasts going out four years, and while these forecasts can be nothing more than highly educated guesses, it’s interesting nonetheless. Three months ago there were 50 out of 151 major markets with double-digit rent growth forecasted for 2023. Now a forecast by the same economists predict double-digit growth in exactly zero markets in 2023, and growth above 9% in only three markets. When I saw the earlier forecasts, I didn’t believe them. Some buyers apparently did, however, because I still saw some overpriced trades happening. I just can’t quantify what will happen with rents. And I think eventually the economists will catch up and the forecasts will continue to come down. Without reliable data, nor my own sense of direction, the safer play for me is to watch the game from the grandstands.
Cap Rate / Interest Rates: Cap rates can be lower than interest rates and massive profits can be made, IF there is massive rent growth. But I highly doubt we will see that, so cap rates will have to rise in order for deals to pencil unless rent growth goes up and/or interest rates come back down. I don’t have confidence in either of those events materializing any time soon, so another reason to stand aside.
Timing and Credit: For the last several years I’ve watched countless buyers acquiring with high leverage short term bridge debt. Yikes. I know that a large percentage of the assets I sold were financed with risky debt. And I know that some of those buyers are already under stress. This problem is likely to get worse before it gets better and will likely breed opportunity in the next 2-3 years.
Value Add: The typical syndication-size deal is pretty large, and the larger the property, the more perfect the market, thanks to the sophistication and capitalization of the buyers in that space. Market imperfections that yield “incredible deals” are needles in haystacks. Most of what is purported to be an “incredible deal” is really just a calculation or modeling error on behalf of the syndicator. You are right that the next buyer has to be able to underwrite to a profit, so all acquisitions need to carefully consider exit cap rate assumptions. This is the third major variable that I can’t confidently quantify (along with rent growth and interest rates) which is keeping me in “watch and wait” mode.
How Bad Is It: Compared to what? In some markets, prices are already down 20% compared to trades in March of this year. In some markets (Phoenix, for example) this was like a light switch. Stuff that was trading for $300K/unit went to $250K/unit almost overnight in late Q2, and has trended down since. But compared to pricing two years ago, they are still up. Even compared to 18 months ago many markets are flat to up, yet down sharply from early Q2 trades. Despite having dropped 15-20% already, I think prices need to drop another 15-20% before buying again makes sense (absent other systemic shifts).
How Long Will This Take: See above about the light switch. But to fully play out we need another year or two, most likely.
Bias: The mechanism in which syndicators make money is a legitimate business practice, but it also introduces a variety of conflicts of interest that require a high degree of ethics to manage. I wrote a whole chapter on this in The Hands-Off Investor…if you haven’t seen it it’s worth the read. This is one reason why I’ve so consistently advocated that sponsor selection is the most critical decision a passive investor will make. Sponsors will handle the responsibility of managing the inherent conflicts of interest differently, and this is all about the sponsor’s moral character, their experience, and financial stability. Choosing a partner that has all three will produce better results than qualifying them based on the metric of how much of their own money they have in the deal. Remember—an unscrupulous or financially unstable sponsor can drain the bank accounts to recoup their investment before fleeing and leaving the other investors holding an empty bag.
What Should I Do To Make Money: If you have money in a syndication, I hope it isn’t financed with short-term high leverage debt. If you are considering investing in one, I’m less concerned with how much the cap rate rises, but far more concerned on the exit cap rate assumption that was made, interest rate assumption, and rent growth assumption. It’s funny that you mention buying real estate debt, Scott. That’s exactly what I’m doing along with my investors. It feels safer to have someone else’s equity in the first-loss position. And rising rates play right into our strategy. We are also contemplating buying properties all cash. You nailed this one.
Mitigating Factors: The only thing that will soften price declines will be high rent growth and lowering interest rates. The housing market is fundamentally strong—there is demand for housing, many areas have varying degrees of shortage of it, employment is still relatively strong (although there are now some cracks appearing in the foundation), and wages are growing. But inflation of goods and services is competing for tenant’s surplus dollars, leaving them with less capacity to absorb runaway rent growth on the heels of double-digit growth for multiple years. So high rent growth is unlikely. And with persistent high inflation, lower rates are unlikely, at least to a significant degree in the short run.
But there is no reason to mitigate. Prices were too high and needed to come down. This will present an opportunity for smart investors to earn great returns with their syndication partners that survive the turmoil.
Very in depth post thank you, eye opening for a newbie like me, if you were just getting started like me, what would be your TOP 1-3 data information source you can read up on that will help you make better multifamily rental investment decisions, that will reveal real estate investing forecasts that can alert you of opportunities or potential crashes that could hurt your current or future plans for investments.
Quote from @J Scott:
While I agree with much of what you wrote, I'll add some of my own rambling thoughts and some additional considerations... (TL;DR at the bottom for those not interested in the rambling :)
J - thanks for the wonderful perspective as always. I love the suggestion for preferred equity!
What I just can't understand is how we can project that cap rates remain flat for two years, in an environment where cap rates are lower than interest rates and NOI growth is flat. The lender and perhaps the preferred equity investors win in that scenario.
But common equity sees little/no growth, and is exposed to huge risks in an environment like that. Interest rates would have to come down very materially from the ~5%+ they are currently at in the commercial space for this to make sense. That feels hard for me to believe, even though I completely agree that the Fed will slow the pace of rate increases heading into next year.
I'm not yet convinced that we will have a particularly deep recession next year or in 2024. I think that too many household and corporate balance sheets became extremely well-fortified during the pandemic. I think that it will take a long time before large pockets of the country are forced to reduce their standard of living. Inflation will likely slow, as will rate hikes, in 2023, but I am not convinced we are about to have a deep recession that forces the fed to whiplash rates back down again very quickly. Could be way off on that.
In other words, if the Fed is able to avoid a deep recession as I think they will, interest rates don't fall by much (they just rise more slowly) and cap rates return to a reasonable spread vs interest rates. If the Fed is not able to avoid a deep recession, we have a deep recession, with interest rates coming down quickly. This is bad news for everyone, and multifamily will be impacted heavily, like everyone else, likely in an environment of severe rent declines and high vacancy.
Either way, I don't see the good news for multifamily valuations. Multifamily valuations should, in my view, in a reasonably rational market, increase or remain very high only when rent growth prospects are strong. Cap rates should only remain close to or below interest rates when rent growth prospects are really strong.
Lastly - I am curious about where you are citing the household formation number of 1.7M. Household formation data has seen absolutely wild variations over the past few years, and I think that formation is really anybody's guess next year. Yes, there are more people, but there is also a lot of COVID craziness (millions and millions of new "households" formed during COVID - is that real, or is that just people getting some more living space during the lockdowns?). I'm really concerned that demand could be extremely volatile, in the event that there IS a mild or even deep recession (although again, I think that a mild one is more likely). Furthermore, retirement portfolios got hit pretty hard between stock market, bond market, REIT, and other asset declines in the context of very high inflation - is that yet more downward pressure on household formation, with older generations moving in with younger ones?
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Quote from @Lee Yoder:
I believe the variable that is often misunderstood is the demand for housing. Demand for housing can change much quicker than people realize.
Too many investors only consider population growth instead of considering household formation. Household formation is a choice and it can be very cyclical. If the economy weakens, unemployment rises, and people start to fear the future, they'll make very different decisions when it comes to housing. Young people will live with their parents for an extra year or two. Older folks will finally sell their home and move in with family. Young people will share an apartment instead of having their own. When people start making these decisions, the demand for housing can drop dramatically, and quickly, even if population is increasing.
A lot of people didn't think this was possible, especially in these cities where population is increasing so much. But, with the increasing supply, and suddenly slowing, or decreasing, household formation, suddenly housing demand is falling and we're already seeing rent decrease year-over-year.
our multi genrational floor plan is what is selling best right now.. exactly whats happening mom sells her home kids sell their home they combine and buy one of my new great homes.
Two answers we would need
1) where are rates in 12-18 months?
2) how many floating rate loans are coming due in 12-18 months who dont have reserves for rate caps
https://www.reuters.com/market...
Saw this article just now, and my reaction is that the construction of fewer SFHs is going to exacerbate SFH supply issues.
Might that shift at least some households into all of the multifamily that is being built?
Quote from @Nicholas L.:
https://www.reuters.com/market...
Saw this article just now, and my reaction is that the construction of fewer SFHs is going to exacerbate SFH supply issues.
Might that shift at least some households into all of the multifamily that is being built?
Great question - the issue is one of timing. 5-10 years from now, demand will outpace supply, and we will see price and rent growth long-term, in my opinion.
It's the near-term that scares me. Single family permits are down. But, builders already purchased a ton of land and broke ground on development in both the single family and multifamily housing markets. Supply will hit - because these builders lose money if they sit on the land due to holding costs. So, we will get relief in 18-24 months on the supply side, but in the meanwhile pressure will ramp on single and multifamily as all the projects started in 2021 and 2022 complete.
One has only to look outside their window here in Denver to see the cranes, more abundant than ever, almost exclusively constructing multifamily housing. Or, take a drive out to the suburbs to see tens of thousands of brand new homes being built.
Quote from @Chris Seveney:
Quote from @Scott Trench:
I've been noodling on this for a few weeks, and the more I think about it, the more I'm starting to convince myself that large multifamily is one of, if not the most, riskiest asset classes in America right now.
Here's my premise:
Supply: According to Ivy Zelman, backlogs for new construction in multifamily are at the highest levels since the 1970s. She estimates 1.6M backlog units. Builders will complete this inventory, and they will monetize it. This will put downward pressure on rents, and asset values (upwards pressure on cap rates).
Demand: We think rents are a coin flip in the next 12 months, and that a good forecast is zero rent growth. Vacancy is ticking up, as rents are falling in recent months in the multifamily space. If vacancy is already ticking up, and rents are declining, this kills the thesis for most multifamily value-add with fixed 2-5 year time horizons.
Cap Rates and Interest Rates: Interest rates are higher than cap rates right now. That's really scary. It means that every dollar of debt that you take on in a no or low growth environment reduces returns AND increases risk. The only way you can justify making an investment in an environment like this is if you believe you can rapidly increase rents/NOI, or if for some reason you believe that cap rates will decline still further.
The market is essentially going all-in on rent and NOI growth in the next 12-18 months. Given the massive supply coming online in the next 12 months, and the question marks around rent growth, I think this is really hard for me to believe.
I think that if anything, interest rates are likely to continue rising quickly in the multifamily space, and that NOI has a very good chance of flatlining or remaining stagnant.
Timing and Credit Considerations: The debt market is already starting to tighten, and (I do not have data on this) I believe that most multifamily properties are financed with variable debt with a 5-year Weighted average Life (WAL) in the range of 60/40 to 70/30 debt to equity. I believe that this varies considerably across the industry, and that folks are in all sorts of different positions. But your typical syndicator will finance this way to maximize returns in a growth environment. This puts timing pressure on deals. If I'm right about the 5-year WAL hypothesis, then about 20% of the market that has financed their portfolios will need to refinance or exit in the next 12 months. The pressure will mount by another 20% in the following 12 months.
Value-add: I can already hear some folks arguing that none of this matters if you can find an incredible deal, well below market, and add a ton of value to reposition the asset and increase rents. Fair enough, the value-added deal sponsor still has to consider the likely buyers at an exit. And that buyer will want a return. The end buyer is not likely to purchase a property with little value-add opportunity at a cap rate that is lower than interest rates - it's almost preposterous.
How bad is it and when will it hit?
Massive supply, weakening demand, debt that is so expensive relative to cash flow that it dilutes returns in all but the most aggressive growth forecast scenarios, and a slowly tightening credit market. These are incredibly tough market headwinds. I don't think the question is whether cap rates and multifamily valuations will decline. The questions for me are how much will asset valuations decline by and when will it happen?
First, I believe that multifamily valuations could decline by as much as 20-25%. Take a look at this chart:
How Much will Cap Rates Rise? Cap rates typically hover about 150 bps higher than interest rates. Is it unreasonable to project that cap rates rise in the current environment from ~5% to 6.5%? That is a BIG deal if that happens. It means that a property that generates $500K in NOI drops from being worth $10M to being worth $7.7M. That's a 23% drop in valuation. If you are financed at 60/40 debt/equity, 58% of your equity is wiped out. At 70/30, that's 77% of the equity eliminated.
How Long will this take to come into effect? If you believe that this is a reasonable projection, then the next question is when. When will this rise in cap rates happen? My guess is that the change will be a process, and not an event. I don't see cap rates rising 150 bps overnight. I think it will be a slow ramp over the next 12-18 months as more and more supply comes online, and more and more folks are forced to exit.
Bias in the market? The syndicator pitching an investment deal is perhaps a fine, but definitely a biased, source of information on the market, deal, and opportunities. Remember that syndicators make money in multiple ways on a deal. First, they often charge an acquisition fee - they make money just by buying large investments. A gimme. Second, they typically charge management fees - often a few percentage points of the equity investment in the deal. Third, they often get carried interests - or a percentage of the profits, if any, in the deal. Many syndicators invest nothing or very tiny percentages of their net worth in individual deals. There is no incentive, other than reputation (which I hope is very powerful), to do anything other than raise as much money as possible, and buy as much real estate as possible. If valuations keep climbing, GREAT! HUGE profits via these fees and carried interest. If valuations decline, "Oh well!" - they get acquisition and management fees, and get little/no carried interest. It's their investors who actually have large amounts of capital at risk.
I'd have a very hard time ESPECIALLY with investing through a syndicator who was not investing a material portion of their net worth in their deals at this point in the market.
What should I do to make money?
- If you have money in current syndications, pray.
- If you are considering investing in a syndication, make sure it is a huge winner even in a no rent growth environment, and one where cap rates rise at least 150 bps.
- Consider getting on the debt side, via a debt fund or private lending - the interest rates are higher than the cap rates! Might mean better returns with lower risk.
- Consider investing in a syndication that uses no leverage at all - as this might yield higher cash flows, and come with less risk - if there is a low growth or no growth environment, it will also yield better returns.
This is a super bold post. I'd appreciate any feedback here before I post these thoughts to the main blog and/or state these forecasts any podcasts!
I'd especially like to know about any mitigating factors - what would soften any price declines in this market?
It is good to see BP posting about some of the realities of what is coming down the pipe in real estate as there are a lot of newer investors on this platform only listening to one side.
I agree with a lot of what you say. Also I saw a post from Jonathan Twombly on Linkedin that noted
"1,457 Multifamily Properties Currently Barely At or Below DSCR Requirements - and What This Means for You
Today it was reported that real estate data provider Trepp has 1,457 multifamily properties in its database that currently do not meet or barely meet the 1.25x DSCR requirement on their loans. That translates into $18.6 billion of debt, and assuming 75% LYV, translates into $23.25 billion of MF property.
What does this mean for you?
It means that bargains are on the way, especially for properties with maturing bridge debt, where the sponsors underwrote an refinancing into permanent debt at pre-2022 interest rates.
The potential is way larger than the mere 1,457 properties identified by Trepp. Some $1 trillion of real estate loans will mature in the 2023 and 2024 across all flavors of commercial real estate, and a substantial amount of this will be in MF. These properties will need to refinance in a much higher interest rate and cap-rate environment than existed when they obtained their original debt.
"Extend and pretend" won't work as well as the last crisis, because interest rates are rising, not falling as they were in the aftermath of the Great Financial Crisis. And many lenders won't want to work with sponsors who did not perform, so many of these sponsors will be forced to sell if they cannot refinance.
This means that, for strong and experienced sponsors, who are not tainted by forced sales or foreclosures, there will be more opportunity to purchase MF at attractive prices than we have seen in a very long time"
I agree with you about syndications, as I am already hearing from some of our investors that they are having cash calls and cannot exit their syndication.People may want to consider funds vs. syndications. Reminder a fund invests in multiple assets not just one, and funds are not strictly multifamily there are debt funds that take on no leverage (cough cough). As noted the returns may not be as exciting as what some SAY they were getting with MF in the past, but in todays market risk aversion is real and people who have not been through a downturn will understand how risk plays out in real estate when you have limited exit options.
That is incredibly insightful! Thank you for sharing this!