Commercial real estate minds have been fixated on the office market crash in the aftermath of the pandemic lockdowns, and justifiably so. Remote work has relegated large swaths of conventional workspace irrelevant and left millions of square feet of office space vacant. There is much less fear surrounding the multifamily sector, which thrived during the pandemic. Yet that is changing.
Skyrocketing multifamily rental growth and cheap debt in 2021 and 2022 fueled a wave of investment in which buyers overpaid for properties. The reasoning behind buying properties with high price tags and minuscule cap rates was the idea that continued rent growth would eventually lead to a handsome payoff. Those assumptions did not consider the dramatic rise in interest rates over the past year and what that might do to the economy.
Now multifamily experts are bracing for distress as borrowers in these so-called negative-leverage deals, in which the cost of debt exceeds the investor’s initial yield on an acquisition, could face difficulties, and not only in making mortgage payments. Refinancing or selling the assets in a higher interest rate environment is also difficult, casting uncertainty over property values. That’s because to fund the transactions, borrowers often tapped short-term floating-rate bridge loans, the bulk of which begin maturing in the coming months. “If you did a deal with 80 percent leverage, the value today could be at a point where it’s below the loan balance,” suggested Kelli Carhart, an executive managing director and leader of U.S. multifamily capital markets at CBRE. “So depending on their capital stack, we could see some interesting decisions being made by apartment owners.”
In a brief report on the National Multifamily Housing Council’s (NMHC) annual conference early this year, real estate location data analytics firm Markerr noted that investors anticipated distressed opportunities emerging in the second half of 2023. While positive, annual apartment rent growth of 4.5 percent in the first quarter of 2023 was the lowest in six quarters and well off the peak of around 15 percent a year ago, according to CBRE. The average vacancy rate also ticked up to 4.9 percent in the quarter, its highest level in six years. Meanwhile, more than 1 million apartment units are under construction in the U.S., according to Greg Willett, a multifamily specialist with Institutional Property Advisors. Developers are expected to deliver about 400,000 units this year, an amount that’s likely to exceed demand, he added.
While that could put more downward pressure on rent growth, the chances of widespread pain are relatively low due to a general shortage of housing, said Caitlin Sugrue Walter, vice president of research at NMHC. “Some properties might struggle a little bit temporarily in markets where we’re seeing new supply come online and a little higher vacancy rate,” she stated. “But we are still seeing positive rent growth. It’s just not the type of rent growth we saw in those abnormal times a year or two ago.”
Still, signs of trouble are already surfacing. In March, mortgage real estate investment trust Arbor Realty Trust foreclosed on four old Houston apartment properties after the owner, Applesway Investment, defaulted. Although some operational issues were reportedly at play, Applesway acquired the lower income assets near the top of the market over several months beginning in the summer of 2021 with the help of $230 million in financing from Arbor Realty.
Additionally, Veritas and a joint venture partner late last year defaulted at maturity on $447.5 million in multifamily commercial mortgage-backed securities (CMBS) floating-rate debt secured by 62 assets in San Francisco. While the joint venture had owned the properties for years, it invested heavily to upgrade them and issued the CMBS debt in 2021 in anticipation that cash flow would increase by 30 percent to $42 million as occupancy increased. But cash flow didn’t increase by 30 percent as expected. Instead, it decreased along with occupancy and remained below what was necessary to service the loan.
To estimate how much potential distress might be on the horizon, the securitized mortgage research firm Trepp analyzed CMBS, Fannie Mae, Freddie Mac, and collateralized loan obligation loans where debt service coverage had dropped below 1.25. Of the $87.7 billion of these “at-risk” loans maturing over the next two years that Trepp identified, multifamily properties secure more than $37 billion. What’s more, some $23.5 billion of those apartment loans have a debt service coverage of less than 1, or insufficient cash flow to pay the mortgage.
Additionally, in a recent report to gauge bank exposure to commercial real estate risk in response to the collapse of Silicon Valley Bank (SVB), Moody’s Analytics estimated that $235 billion in multifamily loans held by banks will come due in 2023 and 2024. Faced with maturing loans where property values do not justify a refinance, banks will have to extend maturing loans with the hope that appreciation accelerates, demand that borrowers plow more equity into the deal, or foreclose on the property.
Exacerbating the risk is the potential for depositors to pull their money out of some institutions to such a degree that banks must sell their real estate loans for 70 or 80 cents on the dollar, said Manus Clancy, a senior managing director and leader of the applied data, research and pricing departments with Trepp. That would further depress property prices especially with the Federal Reserve selling assets as part of its tightening strategy and BlackRock disposing of SVB assets. The market for a rated bond at auction is likely going to be much more liquid than for a one-off multifamily loan, making them more attractive in this market. “Even though we’re not talking exclusively about commercial real estate loans, the market is already awash in assets that institutions are trying to get rid of,” Clancy said. “If you have 40 more banks flooding the market with billions of dollars in loans to offset their deposit reductions, then you’ll have a downward spiral where prices keep going lower and lower.”
Such a scenario would wreak havoc on the value of multifamily properties, even well-performing apartments with low fixed-rate loans that are coming to term soon. It would also serve as a reminder of how quickly aggressive and speculative investment activity ahead of a spike in interest rates can amplify the risk of a crash in a historically strong and relatively safe asset class. Offices have been the focus of much of the speculation about a real estate crash, one that has potential to take the banking system with it. Despite a much less bleak scenario, loans on overpriced multifamily buildings pose a significant risk in the coming months.