As inflation, the looming recession, escalating price of capital and tightening of underwriting criteria all conspire to slow transaction and development activity in the multifamily market, how is the industry responding?
A trio of in-house multifamily and housing experts — executive VP of research and securities Ivy Zelman, executive VP of investment sales Kris Mikkelsen, and senior managing director of capital markets Aaron Appel discussed the topic during the firm’s “State of CRE” webcast.
The level of uncertainty in the multifamily market doesn’t mean that transaction activity is at a standstill. What has changed is the profile of the players involved, which has narrowed significantly despite multifamily sales volume that has surpassed 2021’s record-setting totals through the first three quarters of 2022 – before the abrupt slowdown. “The institutions that we're transacting with are operating almost exclusively in closed-end vehicles that are not subject to quarterly mark to markets, or they're operating with separate account capital,” Mikkelsen affirmed. “Since June 1, 2022, we've awarded well over 100 transactions, and not a single transaction has been awarded to an open-ended fund or perpetual life vehicle of any kind. And I would include the non-traded REITs in that (statement).”
Mikkelsen said that what is largely clearing in the multifamily market today is what he refers to as “able-to sellers” — those with de-risked assets that can be sold to very well-capitalized private groups and closed-end funds that can operate with lower leverage. He added that the multifamily market has changed dramatically in just six months. “You went from merchant developers basically finding buyers and committing to deals six months before they were complete, to now having them recognize that they have to deliver those assets, execute on the business plan, de-risk the rent roll, and then it's ready to take to market.”
The lack of available capital has been one of the primary deterrents to activity on both the transaction and development fronts. Banks, particularly money center banks, have dramatically cut back on commercial lending since mid-August 2022. Appel said that while commercial banks are still willing to write one-off loans for their best customers, there isn’t a lot of liquidity in the development space, so developers are having difficulty getting construction financing for new projects. He added that if a sponsor doesn't have a substantial enough balance sheet to be able to guarantee completion of the project or partners that could guarantee to provide liquidity for the construction lender on those loans, “we just don't think those loans are going to get capitalized right now. But for good developers with well-located real estate, there is some financing available; it's just not particularly attractive.”
Appel pointed out that the lending environment has changed substantially since the beginning of 2022. In Q1, all that was required of borrowers was a completion guarantee and a carrier guarantee, but no principal recourse. Then, it was possible to borrow at 65% of cost, generally 275 to 300 basis points over SOFR. “Today, that same loan is now in the 50-55% of cost range and is in the mid-threes to upper-threes over SOFR. And you're looking at a SOFR that's now roughly 400 basis points,” says Appel. “So, you're talking about a decrease in leverage of 10-15% and an increase in the cost of funds of about 500 basis points. So that makes a lot of these deals not work. It's challenging, but projects that have a low enough land basis or some sort of creative mechanism to make the deal work and still get financing.”
One such creative deal was a mixed-use project in Brooklyn, The Axel, a 30-story 280,000-square-foot tower with 284 apartments and 60,000 square feet of retail space. Appel and his team recently secured $204 million in loan proceeds from MF1 Capital to refinance the building. “The (project) had a condominium component, and the deal on its own wouldn't work from a return perspective. Some condominium sale proceeds were used to recoup some of the equity in the transaction, so there was a more attractive yield on cost for a rental development.”
As difficult as dealmaking may be in this challenging environment, multifamily still typically provides the most reliable returns of the asset classes, particularly when one considers the current office and retail markets. Appel predicts that multifamily — which has historically made up 35–40% of the investment sales market — is eventually going to comprise 50% of the marketplace on a permanent basis.
With inflation a top of mind concern for many right now, Appel reminded the panel that commercial real estate has always been a “fantastic hedge” against inflation. “Unfortunately, right now, with the swiftness of rate increases, we're going through a bit of a reevaluation period across the board against all asset classes, and it's all getting reevaluated based on just the cost of funds,” he said. “Once that reevaluation takes place and stabilizes, and we have a base set on where rates are going to be…so long as you can hold on, the beauty of real estate is that it will protect you against inflation. And the rents historically will always go up because the Fed is always going to print more money. As long as you buy quality assets in good markets, and the city that you're investing in is not collapsing and losing massive amounts of population, theoretically speaking, those assets should always increase in value.”
For a deeper dive into the state of the multifamily market, watch the “State of CRE 2023” Walker Webcast in its entirety.