I’m 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’d 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.
In this article, I’ll walk through my thesis, outlining four primary threats to multifamily valuations, following the summary below:
- Part 1: Cap Rates Are Lower Than Interest Rates
- Part 2: I’m Not Betting On Meaningful Rent Growth In 2023
- Part 3: I’m Betting On Interest Rates Rising In 2023
- Part 4: High Interest Rates Put Pressure On Valuations And Debt Underwriting
- Part 5: News, Anecdotes, And Further Reading
- Part 6: Ideas To Protect Wealth And Make Money In This Environment
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 a couple large regions.
Lastly, I want to address upfront that I consider myself an amateur in understanding commercial real estate markets, perhaps approaching “journeyman” status. I am by no means an expert in them. I invite debate and would welcome analysis from any readers ready to present a “bull case” to my points here. Please feel free to provide that in the comments or email me at [email protected].
Part 1: Cap Rates Are Lower Than Interest Rates
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:
Investors entering commercial multifamily do so because they want to generate a return. Return is not expressed as a capitalization rate (cap rate), which is more of a metric used to value properties in relation to one another, but rather as an internal rate of return (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.
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.
Cap rates have been relatively low in a historical context for the last 10 years. This hasn’t 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.
However, driving IRR becomes much, much harder in a “negative leverage” 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.
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. “Negative Leverage” is the market’s way of communicating that it is “all-in” on appreciation or falling interest rates.
And, as I will spell out, I think either outcome has a low probability.
While it’s 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 — but note that multifamily cap rates are typically lower, on average, than other types of commercial real estate).
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’s equivalent to about a 23% reduction in asset values.
That looks like this forecast provided by CBRE:
Part 2: I’m Not Betting On Rent Growth In 2023
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.
Let’s start the discussion by looking at supply.
Supply
Backlogs for new construction in multifamily are at the highest levels since the 1970s. Backlogs for total homes under construction are at the highest levels we have data for:
Experts like Ivy Zelman take the stance that developers will monetize this inventory as soon as it is completed — essentially, come hell or high water. 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.
As Brian Burke of Praxis Capital mentioned on our On the Market podcast, 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.
The South and West are at the highest risk of seeing massive new supply coming online:
Note that while you may have heard about permits or housing starts declining, 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.
And it doesn’t 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.
Let’s talk about demand next.
Demand
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’s been talking about a massive housing shortage for years, right?
And it’s true — America typically adds households at a faster rate than we add inventory. And there is a housing shortage. That’s 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:
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.
Second, the housing shortage has already been priced in 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.
Diving deeper into household formation. During the pandemic, we see that millions of “households” apparently formed:
What’s going on here?
The answer is not clear to me, and I haven’t found a particularly compelling assessment of the situation from an economist I like. I’d appreciate it if a commenter could point me to a study or analysis that makes sense and allows us to extrapolate the future well.
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’t 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 “household” formation (two people each needing a place to live, each head of household, instead of one family unit).
But it’s obvious that we didn’t actually see millions 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.
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’s basement. In recessions, folks can move back home with Mom and Dad or bring in roommates again. “Household” formation can decline quickly.
The potential offset — rents could rise again in 2023
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.
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.
It’s because of this pressure that I think rents are a coin flip in 2023. I don’t trust any economic forecasts about rent growth right now. And, without the upward pressure on rents from high interest rates, I’d be willing to make a meaningful bet that rents would decline on average across the country.
Part 3: I’m Also Not Betting On Interests Rates Declining In 2023
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.
Now, it’s 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.
Is that likely? I don’t think so. Here’s why.
The “spread” (vs. the 10-year Treasury) explained
When banks, institutions, or individuals lend money, they want to be compensated for the risk they’re taking. How much they charge in interest can often be thought of as a “spread” against a low-risk alternative.
It’s widely accepted in the lending space that the U.S. 10-year Treasury bill is a great benchmark to measure “spread” against. Other benchmarks include the London Interbank Offered Rate (LIBOR) and the Secured Overnight Financing Rate (SOFR).
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.
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.
But how much more? That’s where the idea of a “spread” comes in.
Just how much “spread” 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:
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’s not a perfect correlation, and sometimes, the spread does, in fact, change.
Today is one of those times. The spread between the 10-year Treasury and 30-year mortgage rates is relatively high, as you can see below:
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.
This makes sense in theory, except for two problems.
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 outstanding visualization from Visual Capitalist.
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.
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.
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.
So, let’s flip a coin:
If it’s heads (a major recession), jobs are lost, rents decline, and commercial multifamily real estate values decline.
If it’s tails (a brighter economic outlook), interest rates rise quickly, and commercial multifamily real estate values decline.
This is not a very fun game.
While it’s possible that you see mortgage rates bounce around and temporarily plunge as low as the mid-5s, I’d bet we end the year with rates even higher than where they are today, again, unless there is a deep recession.
Aren’t commercial loans different than residential loans? Why aren’t we talking about them specifically?
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.
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 south of 5%! It’s 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.
Freddie Mac’s rates are tied to the 10-year Treasury. So, these apartment loans don’t see the same rising spread against the 10-year note that we are seeing in the residential (conventional mortgage) space. That leaves them with even more 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.
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’s either a government-sponsored enterprise (GSE) like Fannie Mae or Freddie Mac or bust for most syndicators right now.
But, the real difference between commercial debt and typical single-family debt is the Debt Service Coverage Ratio (DSCR). We’ll get into why this is so important in the next section.
Part 4: High Interest Rates Put Pressure On Valuations And Debt Underwriting
Commercial debt, including Freddie Mac Apartment Loans, as discussed earlier, isn’t 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 — the balance comes due after five, seven, or 10 years. This isn’t 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.
But, as mentioned earlier, there is another underwriting test with these loans: the Debt Service Coverage Ratio. A DSCR is multifamily’s version of a debt-to-income test that many homeowners need to pass when qualifying for a home mortgage.
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.
Freddie Mac Loans typically require a DSCR of 1.2 to 1.25.
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.
While Freddie Loans can size to up to 80% LTV, in practice, many get coverage constrained in underwriting to 65% to 75%.
In normal markets, these items aren’t an issue. But let’s examine what happens when interest rates rise quickly like they did this past year.
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%.
Now, our investor used a Freddie loan (and an estimated two-thirds of the market uses fixed-rate debt) and likely won’t 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’d likely have to bring significantly more cash to close the deal (reducing LTV), or else they would have to pay less for the property.
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. According to the Wall Street Journal, 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.
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.
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.
As I mentioned, Ben Miller, CEO of Fundrise, has termed this phenomenon the “Great Deleveraging” — a turn of phrase that I feel sums up this problem very succinctly.
Listen to his appearance on On the Market and hear some of the examples that are already hitting the commercial real estate world (starting with retail and office).
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’t hitting targets.
Is a panic possible?
When operators can’t 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 “buying opportunity” — and it may well be.
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’t come in, buyers need to bring more cash to closing.
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.
Part 5: News, Anecdotes, And Further Reading
What I’m discussing here is not news to industry insiders. REIT valuations plunged 25% in 2022. Rents are falling in many major cities like Minneapolis and Chicago, where rent prices are down 9% and 4%, respectively, year-over-year.
Landlords are also starting to offer more “concessions” to renters, in the form of one month’s 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.
The institutional clients of large private equity funds have been withdrawing funds to the point where those funds are bumping up against withdrawal limits for their investors, starting with the most famous non-traded REIT in the world: Blackstone.
Brian Burke discusses this topic at length in On the Market’s “The Multifamily Bomb is About to Blow” episode with Dave Meyer. He believes that we are on the cusp of “repricing” 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.
This won’t last much longer. Sellers who were highly levered with variable rate debt will be forced 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.
Part 6: Ideas To Protect Wealth And Make Money In This Environment
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’s prices.
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’m considering:
Lend
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’m personally considering investing in debt funds that do hard money lending, as I like the short–term nature of those loans and feel that the single-family market is more insulated from risk than the multifamily market.
Buy with zero leverage
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.
Wait and watch
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.
Review the terms of any investments you are in
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.
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’s 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’t be blindsided.
Bring a healthy skepticism to any new investments
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’d want to be sure that the deal made sense even with a significant rise in cap rates.
I’d be skeptical about claims of “value-add” (every deal advertised by every sponsor is “value-add”) or that the property is a “great deal” (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 – something meaningful in the context of their net worth. ). I’d 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.
Take a short position on … something?
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’d be very interested in talking through your findings.
Conclusion
This was a long article. If you made it this far, thank you for reading!
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.
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 small multifamily property like a duplex, triplex, or quadplex, as I like to do every 12-18 months.
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.
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 [email protected]. I’d love to hear your take.
