Costar sees signs of multifamily trouble: Multifamily cap rates rising
Looks like investors finally starting to demand real cap rates and multifamily will begin trading on present performance and not future rents.
Here in PHX, I am getting calls from many brokers. Most are recommending clients postpone sales and some will not consider listings. One broker is pulling forward listings and throwing up everything they can hoping and preying that someone steps in. They are looking for someone to backstop deals that are falling apart. The official communist party line is "don't expect distressed deals, prices are fine". But talk to these guys on a friendly man to man basis and they will tell you there is already distress. Class A already offering concessions and price cuts. Anyone underwriting a new deal must consider rent growth dead for 2020 and probably 2021. I am underwriting a 20% economic vacancy to account for an increase of bad debt to 7% and concessions to 3%. This may not be conservative enough.
There's a common misconception that cap rates move up so prices move down, or cap rates move down so prices move up. The reality is the opposite. Cap rates don't move prices, prices move cap rates. So if prices don't adjust in response to cap rates, what do they adjust in response to? Assumptions.
Up until a month ago, the assumption in many markets was that revenues would increase as a result of rent growth, continued low vacancy rates, continued robust collections, low concessions, and renovations. Rent growth and vacancy rates were fairly easy to underwrite to, as there are several providers of forecasts for those statistics by economists.
Now, things have changed. Any rent growth forecast published more than a couple of weeks ago is no longer reliable, and any forecast made now or in the near future is suspect at best, or just a guess at worst. A conservative buyer is likely to assume flat rent growth for a year, maybe for two. Bad debt and concessions are the big unknown, but what is most likely is both will rise in the near term. That means less income.
Then there is the cost to borrow. Interest rates are up.
Adding fuel to the fire, lenders are lowering loan-to-value ratios, maximum debt service coverage ratios, and in some cases instituting a mandatory debt service reserve. All of those things mean that you have to bring more cash to the deal to close it.
If you set your offer price by solving for an acceptable investment return (which is what you should be doing it), bringing more cash to the deal, even with all else being equal, means that returns go down. The only way to bring the return back up is to lower the price.
A growing income stream is worth more than a level income stream, or a shrinking income stream.
Putting this all together: Income streams are shrinking, even if just temporarily. The future of most income streams are uncertain, and likely to grow less than previously thought. The cash needed to close is higher. The only way to solve for a desirable investment return is to pay lower price than you could have if all of these factors weren't in play.
Just don't expect a big drop, or for a long-lasting one, unless this situation remains uncontrolled for a long period of time.
@Serge S. locally we are in a bit of a wait and see mode. Depends how long this goes one. I think once there is some clarity the market will dictate if cap rates will go up, stay about the same, or (unlikely) go down.
I suspect that MF will start to trade more based on current performance, but that's going to be somewhat based on the asset and if it has a lot of value add or not.
However supply is also still much lower than demand. So unless that changed dramatically I wouldn't expect a huge shift. I have seen a couple more seller finance opportunities from people that have main businesses being impacted by the business shut downs and they need to sell buildings to raise some cash.
For most of the major western United States markets, everything seems to be on hold. There’s still a lot of money out there but buyers are looking for what seems to be an automatic 10% discount and sellers are willing to wait 30-60 days to not sell at that discount.
Opportunities could probably be found in situations where sellers have liquidity concerns, but there won’t be many. At least not until April and possibly May collection are known. There was a lot of 75-80% levered debt funds deals at 5-6% interest rates and 4% cap rates the last year. Many that projected 6% rent growth plus renovations. Being in PHX, you probably saw this as prices increased significantly over just the past 18 months. If economic loss is 20-40% for two months, the number of opportunities will increase.
Costar sees signs of multifamily trouble: Multifamily cap rates rising
Looks like investors finally starting to demand real cap rates and multifamily will begin trading on present performance and not future rents.
Here in PHX, I am getting calls from many brokers. Most are recommending clients postpone sales and some will not consider listings. One broker is pulling forward listings and throwing up everything they can hoping and preying that someone steps in. They are looking for someone to backstop deals that are falling apart. The official communist party line is "don't expect distressed deals, prices are fine". But talk to these guys on a friendly man to man basis and they will tell you there is already distress. Class A already offering concessions and price cuts. Anyone underwriting a new deal must consider rent growth dead for 2020 and probably 2021. I am underwriting a 20% economic vacancy to account for an increase of bad debt to 7% and concessions to 3%. This may not be conservative enough.
It's too early to tell the exact depth and breadth of this situation. A lot will depend on financing which is all over the map. Deals are both falling apart and still getting done. The effects will not be the same in every market but when Freddie and Fannie changed the rules mid stream on current deals in process things dropped off quite a bit. Bottom line is there will be some distress and many owners who will not be able to hang on. Others will be fine. We will know a lot more in 3-4 weeks.
There's a common misconception that cap rates move up so prices move down, or cap rates move down so prices move up. The reality is the opposite. Cap rates don't move prices, prices move cap rates. So if prices don't adjust in response to cap rates, what do they adjust in response to? Assumptions.
Up until a month ago, the assumption in many markets was that revenues would increase as a result of rent growth, continued low vacancy rates, continued robust collections, low concessions, and renovations. Rent growth and vacancy rates were fairly easy to underwrite to, as there are several providers of forecasts for those statistics by economists.
Now, things have changed. Any rent growth forecast published more than a couple of weeks ago is no longer reliable, and any forecast made now or in the near future is suspect at best, or just a guess at worst. A conservative buyer is likely to assume flat rent growth for a year, maybe for two. Bad debt and concessions are the big unknown, but what is most likely is both will rise in the near term. That means less income.
Then there is the cost to borrow. Interest rates are up.
Adding fuel to the fire, lenders are lowering loan-to-value ratios, maximum debt service coverage ratios, and in some cases instituting a mandatory debt service reserve. All of those things mean that you have to bring more cash to the deal to close it.
If you set your offer price by solving for an acceptable investment return (which is what you should be doing it), bringing more cash to the deal, even with all else being equal, means that returns go down. The only way to bring the return back up is to lower the price.
A growing income stream is worth more than a level income stream, or a shrinking income stream.
Putting this all together: Income streams are shrinking, even if just temporarily. The future of most income streams are uncertain, and likely to grow less than previously thought. The cash needed to close is higher. The only way to solve for a desirable investment return is to pay lower price than you could have if all of these factors weren't in play.
Just don't expect a big drop, or for a long-lasting one, unless this situation remains uncontrolled for a long period of time.
I agree with @Brian Burke and @Greg Dickerson very cogent arguments, and that it's just too early to know what the impact is on the market.
I do hope this represents an opportunity, even if for a short period of time, for well capitalized investors to help distressed sellers unload their properties at a time when cash is in short supply.
I am actively looking for all cash deals at the moment, hoping to parlay liquidity into a strong negotiating position and access to better deals. If nobody is coming to the table, well then that's their choice. But I suspect some out there will be getting pinched very soon.