Walker Webcast: State of CRE 2023 - 4 Big Takeaways

As 2023 gets underway, there are clearly some troubling signs for investors in the multifamily market space. In addition to an unexpected drop in demand for apartments in the third quarter of 2022, multifamily lenders are tightening lending criteria and the cost of capital has skyrocketed since the first quarter of 2022.

However, there are still positive signs emerging in some corners of the multifamily market, as Walker & Dunlop in-house 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 – shared during the firm’s “State of CRE” Walker Webcast.

Despite Clouds, Some Potential Bright Spots Emerge

“The overall underwriting has definitely significantly changed; it’s more stringent and uses much more conservative rent assumptions,” said Zelman. “And obviously the demand side is being hurt by the elevated cost of capital, (to the point where it) feels like the transaction market has come to a bit of a halt. But the good news is that with the ten-year treasury rallying (from a high of 4.25% in late October to hovering around 3.5% in December 2022) and the cost of debt coming down, I think that there might be some signs of price discovery and maybe some indication there's a slight increase in interest.”

Price Discovery Finding Floor

On the transaction front, Mikkelsen stated that there are encouraging signs as the year begins. Multifamily sales were somewhat modest during October and November 2022, with Walker & Dunlop awarding approximately 40 transactions at an average price of $55 million. But following a low point in mid-October when the ten-year treasury spiked to 4.25, there have been encouraging signs, particularly in terms of price discovery. Mikkelsen’s team recently priced about a dozen assets and it appears a floor is beginning to form on pricing. Buyer interest is gaining momentum, he said, evidenced by the growing numbers on bid sheets. “We've been successful at really making markets and getting some price discovery within the last two to three weeks (late November, early December) that we frankly weren't able to find 45 days ago.”

Financing Still Available for Quality Assets

GSEs like Freddie Mac and Fannie Mae are still lending, but the aforementioned conservative underwriting and cost of capital are causing a drag on acquisitions in the multifamily market. Lending for apartments decreased by 16% year-over-year in the third quarter of 2022, according to the Mortgage Bankers Association’s Quarterly Index of Commercial/Multifamily Mortgage Bankers Originations. But Appel said that there is financing available for well-located quality assets.

“For core plus value-add multifamily assets, there's plenty of liquidity; it just costs more,” said Appel. “So, I think it's a cost funds issue relative to what the value is or what people are willing to pay.” Appel and his team recently secured $204 million in loan proceeds from MF1 Capital to refinance The Axel, a 29-story mixed-use multifamily and commercial asset with 284 multifamily units located in Brooklyn for sponsor Hope Street Capital.

“It's a property that's (currently) 50% leased, and there's a small commercial component to it. When it stabilizes, it (should have) a $13.5 million-dollar net operating income on a $200 million loan. So, it's about a 7-ish-% debt yield. That asset today is probably worth about a five and a quarter cap, so there's a good spread for the lender in terms of value versus their loan amount.”

He added that there was significant interest in financing the asset, with approximately 10 groups interested in the deal. That number was eventually whittled down to three that were willing to meet the market in terms of the amount of leverage they were willing to provide, before the deal was awarded to MF1 Capital.

Rent Growth Will Remain Strong for the Near Term

Following a torrid period of sustained rent growth of 22 percent between January 2021 and October 2022 (according to Yardi Matrix), rent growth has been slowly decelerating, and the national average asking rent fell $9 to $1,719 as of November 2022. However, the current 7% rent growth is still a strong number from a historical perspective.

Multifamily units

“Overall rent growth is actually (doing well) on the renewal basis,” said Zelman, who is also CEO of the housing industry research and advisory firm Zelman & Associates, a Walker & Dunlop company. “I think that the new move-ins are definitely moderating at a faster rate, but they're capturing loss to lease today, and there's no question renewals are stickier. In our forecast right now, we see a moderation in blended rent growth (moving) more into the historic range – a little bit above four and a half percent and then continued moderation in ‘24 to more like a 2% growth rate. But I think that overall, the renewals are stickier and holding up better than new move-in rates.”

It should also be noted that rent growth may vary by region, with Freddie Mac expecting the best performing markets to be predominately smaller southwestern and Florida markets. A recent Walker & Dunlop Insight also speculated that there may be room for growth in some markets based on rent-to-median-family-income ratios. While nationally that ratio is 26%, the Great Lakes region – which encompasses major markets like Chicago, Columbus, Detroit, Grand Rapids, Indianapolis, Milwaukee, and Minneapolis – averages 19%, potentially leaving room for rents to run.

The SFR Market Remains Strong

Despite some slight hiccups that the SFR/BFR market is experiencing, scarce home inventory, high interest rates, and record-high home prices are keeping the market strong.

“There's a lot of people within a class A multifamily asset that might not be interested in living out in the (suburbs) and looking at a single-family rental for a three-bedroom home,” said Zelman. “But I also think it's also clear that affordability is stretched in the for-sale market and that builders are actually turning to the rental market….They're continuing to move forward on their overall plans and strategies to develop more lots for the rental market. So our expectations will continue to rise in 2023.”

Although there are some troubling headwinds in the multifamily market, it remains real estate’s most sought-after asset class, due to its relative stability and predictability for investors. For deeper insight into the multifamily properties market by the industry’s leading experts, watch the Walker Webcast & Dunlop “State of CRE 2023” in its entirety.

Webcast Transcript

Willy Walker: Good afternoon and welcome to another Walker Webcast. It is my great pleasure to have my three colleagues, Ivy Zelman, Kris Mikkelsen and Aaron Appel join me today once again to try and give our listeners some insight into what's going on in the commercial real estate markets. I have to say that we have typically not, if you will, brought W&Ders on to the webcast to try and look for a third-party insight to give our listeners sort of outside perspectives. At the same time, I have the great privilege of working with these three professionals every single day. I must say that they are as insightful and as understanding of where the markets are as any three people that I come in contact with. That is the only self-promotion and pitch I will give today, and I will then move to my three guests so they can actually live up to the expectations.

Let me also, just as a quick intro. Ivy Zelman really needs no introduction. Over a decade ago she has been one of the leading research firms as it relates to the housing industry, most particularly in the single-family market, then moving into the multifamily market and then covering extensively the single-family rental and built for rent markets over the past several years. Kris Mikkelsen runs investment sales at Walker & Dunlop and has responsibility for our entire multifamily investment sales platform, which last year sold over $20 billion of properties across the country. Aaron Appel runs our New York Capital Markets Group, as well as our institutional capital markets efforts across the country, working with large institutions on the financing, as well as the equity and sale of institutional quality properties, commercial real estate in every asset class office, retail, hospitality and multifamily.

So let me start here: Ivy, your most recent publication, did a survey of multifamily investor sentiment, and there were two headlines that really jumped out at me. The first one is the cost of capital and uncertainty is hurting buyer demand in the multifamily market. And your survey came back with some pretty depressing numbers, quite honestly. And then the other one was from an underwriting standpoint, the underwriting assumptions that many multifamily investors are making have gotten as negative as you've ever seen. Can you talk through those two surveys and what the general survey came back with?

Ivy Zelman: Sure, and thanks for having me on the webcast with you. Overall, our transaction survey, the metrics were across 12 years of data. Probably some of the worst metric results that we've seen. The overall underwriting has definitely significantly changed, as you indicated, in terms of much more stringent underwriting and using much more conservative rent assumptions. And obviously the demand side being hurt by the elevated cost of capital that, you know, feels like the transaction market has come to a bit of a halt. But good news is that with the ten-year rallying and the cost of debt coming down in the ten-year now in the three and a half percent range, I think that there might be some signs of price discovery and maybe indication there's a slight increase in interest. But we'll have more to say after we survey our November overall respondents. But the October numbers were, no question, pretty ugly.

Willy Walker: Kris, you're seeing the transaction market every single day. Is that negative sentiment being seen pretty much across the board?

Kris Mikkelsen: My hope is that the October numbers that came out in the sentiment survey might have a little bit of a trailing effect to them. It's been an exceedingly challenging six months, as I think everyone that's listening to this call knows. But I would agree with some of the findings from Ivy's report, particularly around a couple of things. One, the seller supply index is very, very low right now. We are transacting and we've awarded about 40 transactions over the course of the last 60 days – the average transaction size is around $55 million. So, we absolutely are getting things done. And I would say, Willy, if you asked me that question on October 15th with a ten year and the four and a quarter range feeling like it was never going to stop until 5 to 5 and a half versus what we see today, which just over the last two to three weeks, we've priced about a dozen assets and we've started to see a little bit of a floor forming and pricing. I've looked at a number of bid lists that have 10 to 15 names on the bid sheet. We recognize that in most of these groups, you'll see 60 to 70% of those groups crowded around a two to three% kind of band. You see a couple of groups, 10% off that, but you see a few that are willing to step out two to three% ahead of that pack. And we've been successful at really making markets and getting some price discovery really within the last two to three weeks that we frankly weren't able to find 45 days ago. So, to your question about growth and some of these assumptions, I think back to where we were in the middle of August, where we had some green shoots with some CPI numbers rolling over and some positive job reports and we had some optimism that really got removed in the middle part of September when the tenor from the Fed was such that they were going to remain focused on a hawkish stance until they saw the hikes show up in employment figures. I think the biggest difference for us over the course of the last 60 to 90 days, when we look at our expectations of value and when we go make a market, is the reining in of those growth assumptions has created some issues over the course of the last 60 to 90 days that have taken time to work through the system and that's really caused probably another let down in value. But that was really kind of a September, October situation. And we feel like as we sit here on December 6, we feel like we might be finding a little bit more consensus today.

Willy Walker: Aaron, both Ivy and Kris talked about capital availability as far as being one of the key drivers of why there's been both conservative underwriting as well as sluggish demand for the acquisitions market. We just rate locked today a $47.3 million floating rate loan with Freddie Mac at a 5.83% coupon rate. So, the GSEs are still lending. Is the market in any way, you know, transacting or is finding financing just like pulling teeth?

Aaron Appel: No. I mean, I think it depends on what you're doing. So, for core plus value-add multifamily assets, there's plenty of liquidity, it just costs more. So, I think it's a cost funds issue relative to what value is or what people are willing to pay. People have a certain expected return, and they want to achieve that return. And, if they're borrowing costs have increased substantially, then, they need to pay less for the asset ultimately, unless the revenues are going up and clearly revenues seem to have frozen in most markets.

Willy Walker: Yeah. So, for instance, you just did a $204 million bridge loan on a property in Brooklyn. I think the 70% LTV cap rate was four and a half, but the coupon was, I think, 840. Am I correct on that?

Aaron Appel: Yeah. So, it's a $200 million loan. It's a property that's 50% leased. There's a small commercial component to it. When it stabilizes, maybe it has $13.5 million-dollar net operating income and it's a $200 million loan. So, it's about a 7-ish% debt yield. The asset today in New York is probably worth about a five and a quarter cap. So, there's a good spread for the lender there in terms of value versus their loan amount. And that priced in the low fours over SOFR. So SOFR’s 380 and it's got a level four handle spread on it, that's a deal that at the beginning of this year would have priced at 250 to 275 over SOFR and SOFR was zero. So, you're talking about a 500 plus basis point increase in cost of capital.

Willy Walker: How many lenders showed up for that? In other words, is that a group of one or five different lenders who showed up to be able to write that loan?

Aaron Appel: So, at the proceed level on that particular transaction, there were three groups that showed up and then there were another seven or eight that were maybe 5 to 10% off the market terms of the amount of leverage they were willing to provide.

Willy Walker: So, Ivy, the negative leverage we've been seeing in the market has been something that has obviously been of concern to many buyers. Your survey has been looking at rent growth and a lot of people have been saying, well, I can buy with negative leverage. I have this outsized rent growth that many people were proforming back in the summertime of 6-8% rent growth on an annualized basis. Are we seeing rent growth hold up at that level or we see that collapse with everything else?

Ivy Zelman: You know, I think that overall rent growth is actually holding up at those levels on the renewal basis. I think that the new move-ins are definitely moderating at a faster rate, but they're capturing loss to lease today. And so, there's no question renewals are stickier. And I think we're in the kind of seven plus percent range. And our forecast right now, although we're updating our forecast for ‘23 to ‘24 and we do that quarterly is that we just see a moderation in blended rent growth more into the historic range and actually a little bit above four and a half percent and then continued moderation in ‘24 to more like a 2% growth rate. Now, that's subject to change as we update our forecast, but I don't think we're as bearish as some with respect to their assumptions. Kris and I chatted about it and there's some that are looking for a sort of flat line. Now, if we have a hard landing, I think it could be obviously we could be too optimistic. But I think that overall, the renewals are stickier and holding up better than new move-in rates.

Willy Walker: Ivy, how does the supply of single-family and sort of the distress we're seeing in the single-family market play into those assumptions? In other words, I think there are a lot of people sitting there going: there hasn't been an overhang of single-family impacting rents on the multifamily side of things. But if prices get cut and single-family inventory starts to move again, does that pull away from the rent rolls and therefore put downward pressure on those rents?

Ivy Zelman: I think from the multifamily versus single-family, we do think that shelter is shelter. And yet there's a lot of people within a class A multifamily asset that might not be interested in living out in the tertiary and looking at a single-family rental for, you know, a three-bedroom home. But I do think that more competition, whether it be supply coming on from the build-for-rent operators or investors selling SFR in the existing market and overall, more supply in multifamily that's going to be delivered with completions. Our expectation will continue to rise in 2023. I think that the competitive environment could put pressure more and that's what we're reflecting in our expectation for rents to decelerate and we're seeing that right now. But I think it's also clear that affordability is stretched in the for-sale market and builders are actually turning to the rental market as an outlet to sell units on a scattered basis or whole communities. And I think that they're continuing to move forward on their overall plans and strategies to develop more lots for the rental market. So I would anticipate there's going to be a lot more competition in the single-family rental market and overall that could have some impact on multifamily, but not as much as crossover depending on, you know, suburban class-A that might be more the area where you start to see people reconsider if they were in the market and they wanted to own and they've been renting and now the builders are offering them a much more attractive pricing it might compel them to buy today because the pricing in some markets have come down pretty sharply and incentives are pretty compelling. And they're offering substantial mortgage rate buy downs and base cut rate reductions as cancelation rates are also surging. So, they're sitting on inventory that they need to move.

Willy Walker: Kris, you were going to jump in with something.

Kris Mikkelsen: Well, Ivy mentioned their base case rent growth forecast that I think is really pretty spot on. I think we've observed a similar phenomenon where renewals seem to be holding up very well. There's been a moderation of rent growth on new move-in rates. But still, when you're taking a look at those rental rates relative to what's in the rent roll, it is still positive. I was sharing with Ivy as we were catching up before this call, my frustrations with some of the other third-party providers. We took a look at an asset in a growth market in the Southeast just yesterday where one of the third-party providers that a lot of institutional acquisition officers really need to take their assumptions and put them in their underwriting models because that's what research groups rely on. Took this asset in the market from a four-year rent growth CAGR, so not cumulative growth but per year annual rent growth of seven and a half percent in March and they've revised that assumption down to a sub 1%, four-year growth CAGR. So just do nothing else other than follow this third-party data provider, solve for the same returns, use the same residual cap rates at the end of your hold. That's a 30% correction to value.

So, you know, I would say kind of shame on you if you were taking lock, stock and barrel that seven and a half percent revenue CAGR assumption over the course of the next four years back in March. But it's hard to look at these in-migration markets and say rents today are going to be the same in the end of 2025 and early 2026, where they seem to have really kind of overcorrected to.

Willy Walker: So, Aaron, you've been funding a bunch of construction loans, I think surprisingly over the past month or two. You just did a multi construction loan in Salt Lake City and then you also did a very large mixed use construction loan in Brooklyn with what I saw as a very reasonable coupon. Who's still writing construction loans and what are some of the assumptions that you're seeing in those types of deals?

Aaron Appel: Yeah. I mean, look, commercial banks for their best clients will still go out and write it a loan on a one-off basis. You know, there's not an abundance of liquidity in the development space whatsoever and there's a lot of construction loans that are in the market right now and developers are looking for construction financing. And there's you know; we would take on a lot more than we're currently working on right now. I would tell you that a sponsor doesn't have a substantial enough balance sheet to be able to guarantee completion of the project and have the liquidity and financial wherewithal or partners when in their transaction are going to go on a guarantee to provide liquidity for the construction lender on those loans. We just don't think those loans are possible to get capitalized right now. So, we're not interested in working on those. But you know, for good developers with well-located real estate, there is some financing available. It's not particularly attractive.

I'll give you a couple of examples or anecdotes. Beginning of the year for a loan that was just required to have a completion guarantee and a carrier guarantee, but no principal recourse. You could borrow at 65% of cost at roughly 275 basis points to 300 basis points over SOFR. Today, that loan is somewhere in the call it 50 to 55% of cost range and is in the mid threes to up or threes over SOFR. And you're looking at a SOFR that's now, 400 basis points roughly. So, you're talking about a decrease in leverage of 10%-15% and an increase in the cost of funds of, call it, 500 basis points that makes a lot of these deals not work. So, 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 finance.

So, in that deal in Utah, we sold the fee to below the proposed building to Safehold which is iStar’s fee purchasing vehicle and rolled that capital back, sale proceeds back, into the deals additional equity and then did a leasehold construction loan and credit metrics worked well for the leasehold construction lender and the return metrics worked well for the sponsor.

And the deal in Brooklyn had a component, a condominium in it that the deal on its own wouldn't work from a return perspective, it's just a multifamily development to justify the investment. So, you're using some condominium sale proceeds to sort of recoup some of the equity in the transaction. You wind up at a more appropriate or more attractive yield on cost for a rental development. So that's why that happened.

But we have some stuff going on in South Florida, we have some transactions in Nashville, other markets that do work, and then we have deals in other markets where development just doesn't work right now. Where you can't make the math work based on inflation costs and cost of increased funds and return requirements.

Willy Walker: On that big deal you did in Brooklyn, the $300M plus construction loan, you also brought in almost $90M of equity. What kind of return was that $90 million of equity looking for?

Aaron Appel: It was over $200 million, but the first tranche was funded as land acquisition. And we had a second tranche that was funded at the closing. But I mean, they're looking for, call it close to a 20 IRR (internal rate of return) and a two on multiple ultimately on that deal. What I will say that I find to be very interesting and call it the 100 meetings we've had in the last two months is, you know, I'll point out two things. Number one, I had lunch with a lender yesterday and everyone said he's in charge of a big mortgage REIT and he said they're cost to borrow. So, they would write loans, write transitional loans on assets. And they used to borrow on just take multifamily, for example. They would go and they borrow at LIBOR or SOFR plus 150 and they put out money at LIBOR or SOFR 275. And today their cost to borrow is SOFR plus 300 and they're putting out money at 350 to 375. So well, on an all-in relative return, they're getting a better return on their money because SOFR is going from 0 to 400. And on a spread basis, they're making a lot less than they were. That gap is only 50 or 75 basis points. So, I thought that was interesting. I find it to be very, very interesting in the marketplace. I'm curious, Kris, to know what you have to say about this. Call it the senior capital that's in the marketplace on anything sort of non-fully stabilized wants to make roughly seven and a half to 8% on their money right now with where SOFR is and then the subordinate capital in the marketplace from everybody we talk to, pretty much wants to be rescue capital or some sort of distressed angle coming in and filling a capital stack that's maybe short or someone paying down a loan that doesn't have all the capital and they want 15% and they want to attach somewhere in the 60, 65, 70% range, and they want to go to anywhere from 75 to 85. So those guys want 15 or 16, the equity, theoretically speaking, should want 25, right? And therein lies the problem in the marketplace right now.

Kris Mikkelsen: Makes it hard to figure out how to sell 4caps.

Aaron Appel: Yes, it does.

Kris Mikkelsen: So, what I would say to that, Aaron, is, first off, very few of those deals are getting done right now.

Aaron Appel: Agreed.

Kris Mikkelsen: And I would say, when you look at what is clearing in the market (and this is a multi-family specific comment) but what is clearing in the market is largely clearing what I would just refer to as “able to sellers.” Those able to sellers largely have de-risked assets and they're selling to very well capitalized private groups and closed end funds that can operate with lower leverage. So, they're not gearing up those capital stacks with the type of capital that you just outlined. We were on this call six months ago and we were incredibly active still in the forward transaction market. That space is completely new. You went from merchant developers basically finding buyers and committing to deals six months before they were complete, to now recognizing that they have to deliver those assets, they have to execute on the business plan, they have to de-risk the rent roll, and then it's ready to go take to market. And there might be one or two exceptions to that rule that are very situational and specific, but that is the general rule today. And really that's what you need to be able to go find more reasonably priced senior and an equity that is able to get to a price that works for the seller.

Willy Walker: Kris, I looked through that list of the 40 transactions that have taken place in the last 60 days, and it seemed like a pretty even break between private capital, institutional capital. But it also feels, from having looked at the list, that private capital is transacting more than institutional of late. Is that a fair read of where the capital is coming from and who's actually getting stuff done?

Kris Mikkelsen: I think that's right. I think within the institutional capital description, Willy, I think we should be very specific there. 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. Since June 1st of this year, we've awarded well over 100 transactions. 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 observation.

Willy Walker: Ivy, I want to come to you on a couple of things but let me just say this is a perfect time for us to just dive into the BREIT and SREIT halting redemptions or limiting redemptions in both of those vehicles – that's the news of the last week. What's your read on that, Kris? To the extent that the gates were put in place on purpose, both these vehicles have been great in an up market. Everyone sort of knew in a down market wouldn't be great. My general read of it has been if you look at the publicly traded REITs, they're all off between 20 and 40% in value. If you can go and redeem at par at NAV right now in one of these private vehicles, you can basically get an ARB on where you think the value is going to go on those. And therefore, there are a lot of people redeeming on them right now. Is that a fair read or is that an incorrect read?

Kris Mikkelsen: I would just say that we saw this in 2008 and 2009 with the large open ended core funds, with big redemption queues. Those gates are there to serve a purpose. And I think those gates largely protect shareholders of non-traded REITs and LPs of these open-ended vehicles. Forced liquidations and resetting of values don't help anyone. And so, keeping, that sale activity to create liquidity, to fund those redemptions at an orderly pace so as to not overwhelm the market with product, I think is the responsible thing to do. There was an understanding going into some of those non-traded vehicles that there's a reason why they were non-traded REITs and not public REITs and, you know, daily liquidity. And so, I think what you're seeing right now is a little bit of the result of that.

But in the meantime, while those gates are up, the investors of those REITs should feel very good about the neighborhoods that those groups have been investing in and the cash flow that those assets are generating and their ability to cover those dividends. But whether it's a non-traded REIT or an open-ended fund, Willy, for those groups to come back off the sidelines and start to play offense again – they will have to recognize write downs. They will have to meet the market. They need trades to have the clarity of where the market actually is to accurately reflect today's NAV. But they will have to make some of those realizations and make it attractive for new capital to come in and it'll take some time. But overall, those are still great vehicles with a lot of longevity to them.

Aaron Appel: But I would just point out that commercial real estate has been a fantastic hedge against inflation historically. Unfortunately, right now, with the swiftness of rate increases, we're going through a bit of a reevaluation period of real estate assets. I think we're going through that re-evaluation period across the board against all asset classes. It's all one trade and it doesn't really matter what it is. It's all getting re-evaluated based on just the cost of funds. Once that re-evaluation takes place and stabilizes and we have a base set on where rates are going to be and maybe they do come down, maybe they sort of stay where they are, so long as you can hold on. The beauty of real estate is it will protect you against inflation. And the rents historically will always go up because the Fed is always going to print more money. And so long as you buy quality assets in good markets, that 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. So, the time that you have, you can grow your way out of those problems.

Willy Walker: Can I just jump over Ivy on something here? Aaron was just talking about inflation and inflationary pressures. The big question now is when does the Fed stop raising and when do these inflationary pressures kind of get out of the market? You all track the building products market very closely. Are you seeing any relief on the inflationary pressures that have been seen throughout the building products market starting to kind of ripple their way through to the point where a) construction costs are starting to come down, and b) those inflationary pressures as it relates to goods are seeing some relief?

Ivy Zelman: The trades right now are seeing less work in many of the MSAs that were hot and are recognizing that activity is slowing so that they're being more willing to work with builders and reduce price and some of the front-end part of the cycle. On the back end where there is a lot of inventory that needs to be completed, I think that there's less willingness yet so that it's much more category specific. But I think if you just look at overall expense growth, we've seen moderation in expense growth and overall costs that have moderated but are still elevated.

So, I think that we're definitely seeing a benefit to the slowing, and we continue to expect that those costs are going to come down. I think that Toll Brothers just reported earnings after the close and they indicated that they are seeing some cost relief. And I would expect that that will continue. I think the backlogs for single family right now are still very elevated and a significant portion of that is spec inventory. So, as we see that spec inventory get completed and delivered in the first half of 2023, I think once we start to see less of that benefit from the backlog, you're going to see that all points of the construction cycle from the trades are going to have to be willing to give up price. And we're not seeing as much really price increases from manufacturers and distributors. They're not pushing for an incremental price, they're kind of holding and getting a little stickier as they think about the growth that they know is coming from the backlog. But I do think at the front end of the cycle, you're seeing some benefits.

Aaron Appel: Just quickly, I want to read a text that I received this morning because I'm building a house. I’m building the foundation now. I asked a friend of mine who builds houses in Long Island, he's got a lot of houses under construction. I said to him, “Hey, what are you seeing on the cost side because I'm currently in the process of buying out the job with the contractor and signing on the subs,” and he said: “Materials are down somewhat, but labor is all the same. Subs are especially busy in the high end of the market still. So, we haven't seen any sort of reset in prices due to the labor shortages that are still out there.” So, I think that we will see substantial decreases, but I think you're going to have to wait another six months to see them, personally.

Ivy Zelman: I think the one thing I'd add, though, Aaron, is that where you have very large-scale builders that benefit from scale, they have more negotiation power. So, the smaller the builder, the less likely that they're going to see some relief. But the largest guys are definitely talking with their trades and working together to come up with what would be more attractive pricing, knowing how much leverage they have.

Willy Walker: Yeah, I was going to make the comment, to anyone listening – put a big asterisk next to what Appel just said ‘cuz the labor market in Southampton, New York, and Aspen, Colorado, is very different from Nashville, Tennessee, and Austin, Texas.

Aaron Appel: That's the only one I care about.

Willy Walker: I just want to be clear there. Ivy’s data is a far better benchmark to where the labor markets are than Aaron's anecdote from his builder this morning.

Kris Mikkelsen: Last call we got his color from his guy that bought a million eggs and now we're getting the foundation guy in Southampton.

Ivy Zelman: Though, Aaron, might be right. The luxury market, you know, super luxury, which I put you in there in that category, is definitely still pretty active. And I think that the lower price points were the production builders. Just for the audience, the public homebuilders account for almost 50% of the market and very much a production builder segment. The lowest end of that price point is actually holding up in some markets, despite affordability being so stretched. If you can build in the threes and you're selling townhouses in certain parts of the country, you're actually seeing pretty decent absorption, leading incentives, mortgage rate buy downs. But the middle of the market is where it's most challenged. But even framers are willing to negotiate and drywallers, knowing that they need to work. And so, you are seeing some of those subs willing to offer better pricing to their large-scale builders.

Kris Mikkelsen: And I would just add to the cost conversation, Ivy’s got great insight onto the for-sale side. A number of developers who were able to capitalize their projects get equity on board, keep the construction lender at the table, closing those projects over the last 60 days. We've really heard for the first time that the numbers that they started to carry in the first or second quarter of the year for that development project have held all the way through GMP. And in some of those instances, marginal savings. You know, these are not significant numbers, but getting to the end of the $70 million total capitalization and having an extra million and a half dollars left in the hard cost number once they finally get that GMP from their contractor. So, I think we've seen a little bit of good news there. It's really just a reprieve from what was a 150 basis points per month worth of cost inflation that they've been running with since the middle part of 2020.

Aaron Appel: And I don't think we're going to go back substantially the other way. I think we could go back a bit, though, because I just look at all the projects that we see and we're just a small segment of the market. So many of them we don't think are going to get capitalized that are planned out there. So, it's just a matter of time, we think before depending on the market you’re in and figure it out.

Willy Walker: So, Aaron, on that, Banks have basically, particularly the money center banks, have basically been out of the market since mid-August. What that's done is slow down construction dollars, but more importantly, it's slowed down the liquidity of the secondary market, which has made it so that there's really no buyer in the secondary market of paper, which has made it sort of spreads have gapped out. And so, until the money center banks get back in there and provide that kind of liquidity, it's very hard to think about the general capital markets for commercial real estate getting back up and getting back to where they need to be. Do you think that we get to January 1 and the money center banks step back into the market?

Aaron Appel: So, look, they're not all completely out of the market. You know, we're still able to get things done. But I would tell you, normally in a normalized market, 60% to 70% of capital allocations are contributed, whether it's from investment banks or insurance companies or commercial banks or on the equity side, a variety of different equity investors, they're typically made in the first and second quarter of the year. That's where the plethora of liquidity is. And then it slows in the summer and then people sit there in September, and they try to cherry pick what they're willing to do. And, if they're able to win deals with lighter pricing or paying less great, and if they're not, they sort of will dump that money to the market right around now. Around November as the last gaps to meet their quotas. You know I am very suspect about seeing any new capital come in January ‘23.

I think we're going to see more of this. My personal take, from talking to people, is that the financial system is having an issue right now. The biggest issue in the financial system is the public markets are not working properly. There are no buyers for bonds right now, and specifically commercial real estate bonds. There's a lot of talk that bonds are the best place to be going forward in the next 12 to 18 months. And I think they're a good place to be. But there doesn't seem to be a big demand at all for securitized commercial mortgage bonds right now. And I think that's a big problem. And until the public markets open up and you see some stability and, part of the issue is there's a lot of instability. So, you really don't know what a deal is going to price until the day the bonds sell. And it makes it hard for the banks to write loans also. You need public markets to be open to absorb the large loans. And then some of the stuff that's on bank balance sheets can get off their balance sheets into the public markets where it was meant to be and then you have capital allocation that free up to lend. So, I think that's a big problem. And also, I think that the marks on the treasuries that a lot of these banks hold with customer deposits is also having failed the stress tests and has created downward pressure as well.

Willy Walker: Yeah, I think that you get some clearing of that in the New Year and particularly with budgets for 2023, the ability to kind of move some of that paper that is now underwater. But Ivy, given how depressed the single-family mortgage market is and all these money center banks have massive single family mortgage origination platforms, they're not getting that, they're not writing CNI loans today. Isn't there a sense that they got to earn NIM somewhere and that they're going to have to come back into the markets to some degree starting in 2023? Or is that just wishful thinking on my part?

Ivy Zelman: I think right now the mortgage market is probably the most challenged part of our ecosystem with refi is basically nonexistent and purchases basically originations are down 40 plus percent. We've seen some modest improvement as rates have come down sequentially. We've seen a pickup a little bit, but really just getting less worse, I guess, from a very depressed level. You're right, where are they going to get NIM from? And recognizing that today, you know, our view is that, you know, it's somewhat dependent on what rates do going forward. And I think it's a very challenging environment. And they're not really lending as much. They're much more stringent in underwriting as it relates to any development in the single-family market, as they are in the multifamily market. So, they've pulled back substantially.

Aaron Appel: I would make the case that the cost of capital right now that's available in the marketplace is more expensive than it's ever been. Look, I'm 41 years old, so maybe since the early eighties because even though the coupon is not as high as some of those eye-popping mid-teen coupons, the leverage is just so low relative to historical standards, and historical norms, it's just so conservative. There's such an ungodly fear factor out there that 2008 is going to happen all over again and the marketplace is completely different. The dynamics are completely different. It's skewed so far the other way. You know, when you're talking about 50% leverage, and seven and a half percent coupons to 8% coupons for development. You were borrowing it at that price at 85% - 90% leverage back in 2007 and 2008. Just a titanic difference.

Willy Walker: Kris, your team’s selling a bunch on the build-for-rent front. I just saw a number of prints on some inventory that you've sold there. Has that market corrected as much as the multi market has? Less? More? Ivy, I want to come to you with your outlook on SFR|BFR because that's sort of without a doubt, that was the hottest space in housing. Kind of across the spectrum for the last year or two, has some of the air come out of that? Or is it still holding up pretty well?

Kris Mikkelsen: The capital formation and the capital deployment continues. It's largely centered in the build to core strategy, Willy. You've seen large institutional investors continue to deploy capital. But it's really to build and own this durable income stream for the next 8 to 10 years. The transaction space in build-for-rent in particular was almost exclusively in the forward take out structure because a lot of inventory just hadn't been delivered. So, we went from forward take out structures in the low to mid four stabilized cap rate range in the fourth quarter of 2021 and the first quarter of 2022 to now. Those stabilized yields need to comfortably have six handles on them, if not, you know, into the mid sixes and there's very, very little transaction activity. I made the comment to Ivy earlier. I said, I feel like you've got transactions on stabilized, cash flowing existing communities at market prices and then you've got distressed home builders selling to opportunistic builders in the forward space on the other end of the spectrum and very little transaction activity, acquisition activity in between the middle of those two poles right now.

Ivy Zelman: But we are seeing build and hold continue to move forward. I think that there's a lot of optimism, Willy, that there is a shortage of shelter and therefore, if the developers develop and look forward to the expectation that we have, the need for stretched affordability. There is more of a directional play to go to build-for-rent by many developers that might have been otherwise, considering for sale. So, I think that there's a lot more optimism towards that asset class than the for-sale market right now. Just to put into perspective, but I think the build and hold side is still pretty positive.

Willy Walker: Ivy, remember about a year ago you were talking about the fact that both single-family developers and then also BFR developers were getting a little over their skis as it relates to land. That some of the bidding that was going on to buy land was kind of getting super frothy. That was obviously one of the precursors to the 2008 great financial crisis. Are you seeing any issues as it relates to people having overpaid for land and then some kind of distressed sales going on to the market now? Are people saying, I'm not going to develop this?

Ivy Zelman: Well, no question lot inflation just soared. At the peak, we were seeing lots in some markets doubling in value. Developers were the winners here. Overall, nationally, we do a land development survey quarterly, and we had a lot of inflation approaching 35-40% nationally with, as I said, many markets seeing more doubling of that. And the land developers in our survey indicated that a good 40% of that inflation was due to the build-for-rent capital chasing the asset class. That has since moderated to lot inflation more in the low, let's say ten plus percent. And I think it will continue to moderate, given the weakness in the market. But I do think that comparing it to the GFC, I would just say that at least on the for-sale side, builders have been much more prudent tying up lots via option in smaller bites than they did in the GFC. And just by orders of magnitude, there's a lot on their balance sheets or a lot that's not on the balance sheet that they're retrading now. And so, they're going back and dealing with the developer that they're optioning lots from and they're either walking away and taking impairments on those deposits, those options that they have locked right now. And they're deciding they don't want them or they're retrading them at better values. So, it's really not the GFC in our opinion today. If you told me we're going to have a hard landing and the economy is going to sink into a recession, I think that we're going to see more significant impairments. But right now, they've been fairly modest.

Willy Walker: So, I want to finish with: What's the smart money doing today? And I know that there's a lot of smart money out there that may not have the ability to move right now because of certain capitalization issues, redemptions, things of that nature. But as you sit there today and say, okay, that was a really smart move that someone did either harvest capital, hold on to capital, make a big bet right now that others it's somewhat contrarian. What do you see in the market where the smart money is going beyond just sitting on the sidelines? So let me put that as one caveat on this. I want to know if people are actually doing it, not just sitting on the sidelines. Kris, let me start with you.

Kris Mikkelsen: There was an asset that closed at the end of the week last week, full disclosure we did not work on the project, but it was acquired by what I would generally consider probably one of the savvier opportunistic investors in the market. It was an asset that was put under agreement in the first quarter. Let's say it got put under agreement for a dollar in the first quarter. New construction, core, high growth market. You know, the basis was very attractive. Let's call the basis that $0.50 and this group actually went in and acquired the asset that closed last Friday at $0.65. So, a 35% discount off of peak pricing in March of 2022. I don't think the story is really about how much that value has fallen off. I think it's a reversion to the mean story and a story about how far that value ran from when that development project was capitalized to where the peak pricing was in the first quarter. I have no idea what rents are going to do in that market over the course of the next 3 to 5 years. And candidly, I don't think anyone else really does. It's a great neighborhood. It's a growth market, a ton of in-migration, a ton of employment growth. They just bought a phenomenal basis in the right location, and they've got the ability to hold that asset for the next 5 to 10 years. They did a ten-year floating rate. This group has been doing ten-year floating rate debt and hedging out, swapping the rate for the first five years to get them on the other side of the turbulence in the rate environment. So, I think that's a pretty smart play and they've been ahead of the puck more often than not. So that one caught my eye.

Ivy Zelman: I would just say that M&A activity, as we know across the board, has been pretty much nonexistent. And I think that smart money right now is taking advantage of the weaker players in the market that are not well capitalized. D.R. Horton announced a small acquisition in Fayetteville today, and I imagine they probably got this builder at a pretty attractive price. So, I think that there's no question to capitalize on those companies that are not well positioned, they have too much leverage and take advantage of what would be good locations. It would be what smart money is doing today, I think.

Willy Walker: Aaron?

Aaron Appel: Yeah. I mean, look, historically, multifamily has been somewhere around like 35% maybe 40% of the investment sales market. I think going forward, it's going to be 50% of the marketplace permanently. There's obviously a fundamental issue in a lot of the asset classes within the office sector. And people for years now have been turned off by retail to a big extent. So that leaves you with industrial, multifamily, and a little bit of hospitality, which is not a huge market. And then some of the specialty uses like data centers, life science, or self-storage. But I would say that the smart money should be looking to be able to buy multifamily at break-even leverage based on right around where today's rates are and to lock in what I would deem to be seven-year financing with the ability to get out after five. The Fed may increase rates and bring SOFR above 5% for a period of time or the federal funds rate. But 50% of the outstanding government debt has an average duration of seven years or less. 15% rolls every 12 months. We have $32 trillion in debt; we generate $4 trillion of tax revenue, and we spend a little bit over $6 trillion a year. We're printing two and change a year, $2.2 trillion a year or so regardless, and that's going to continue to increase. The Fed cannot hold rates at a high, high level for an extended period of time. So it's just it's just a waiting game, really, if you can buy it, break even leverage and good rental markets where there is going to be demand drivers and eventual employment drivers back in the horizon and some level of supply constraint, I think you're going to be a huge winner five, six years from now. And that's what you really have to play for. But I think there's a tremendous opportunity there.

Willy Walker: Kris, last word.

Kris Mikkelsen: I would just point out I went back and listened to the archive and six months ago, Appel made a prediction about the Fed's activity that when compared to the guest that you had the week after our call, and I'll say no more than that, other than the fact that he had more letters after his name than I think are in the alphabet – to say that Appel was more directionally accurate, I think would be the understatement of this Zoom call. So, congrats on getting that call correct, Aaron. And hopefully you're correct about the prediction that you just made.

Aaron Appel: I thought you were going to take a shot of me with Bitcoin.

Kris Mikkelsen: Nope.

Willy Walker: Jamie Dimon did that this morning talking about his pet rocks. So, I would just go back to what I said at the beginning – I am so blessed to work with the three of you on a daily basis. Thank you so much for sharing your thoughts and insights on the market. To everyone who joined us today, thank you for tuning in and we will be back next week with another Walker Webcast. I hope everyone has a great day. Ivy, Kris, and Aaron, thank you three for joining me.

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