The U.S. economy has shown resilience despite the Federal Reserve's efforts to control inflation by raising interest rates. Economic growth in the second quarter exceeded expectations, but still, many multifamily investors are waiting for the market to stabilize. The Federal Reserve's aggressive tightening program has resulted in the highest policy rate in 22 years, causing a 70.6% decline in multifamily transaction volume between H1 2022 and H1 2023. Q2 2023 has shown indications of multifamily sales volume beginning to increase, however.
Fannie Mae and Freddie Mac spreads on U.S. Treasuries have grown YTD, surging the cost of agency debt. The larger spreads indicate a greater level of perceived risk in the market. Nationally, year over year (YOY) rent growth has fallen to 1.2%,and buyers are being more conservative in their underwriting as a result. Midwest and Northeast markets have shown strength over the past 12 months, experiencing only minor declines in YOY rent growth, while Sun Belt markets have seen the most significant slowing.
The US multifamily commercial real estate sector is transitioning from the booming heights of 2022 to a more measured pace in 2023.
• Cap rate differences based on asset quality and vintage are re-emerging, reflecting a return to standard underwriting practices
• Multifamily construction saw a peak in 2022 with almost 1 million units under construction, but this has since declined due to rising costs and oversaturation.
• Vacancies have increased for eight consecutive quarters to a national rate slightly above pre-pandemic levels at 7.5%.
Trends such as increased vacancies, market oversupply, and higher borrowing costs have caused uncertainty in income yields, increasing cap rates in every major U.S. region.
Between 2023 and 2029, the market is facing a significant concern with an unprecedented amount of debt maturing annually, exceeding $100 billion each year. The high interest rate environment adds to the worry, as the new debt is more expensive than existing debt, leading to challenges in refinancing for property owners. The 1-month Term SOFR, which sat at near zero in January 2022, has increased to over 5.32% by August23rd,2023.
• Outstanding multifamily mortgages have doubled over the past decade to about $2 trillion.
• In 2021, investors took out $45.4 billion dollars in CLO floating rate debt compared to $8.7 billion in 2020. Investors are feeling the brunt of this in the short term given interest rates are now significantly higher than when these loans were originated.
• Regional banks have limited lending activity.
Prior to the Federal Reserve's rate hikes in March 2022, investors were drawn to value-add apartment buildings due to rising rents and low borrowing costs, resulting in significant returns. The popularity of short-term floating rate debt surged as investors sought to enter the market. However, few foresaw the extraordinary increase of borrowing costs.
The increase in debt costs has affected owners across the board, as apartment values have fallen 14% in the year ending June. This presents a predicament for sellers, as those who need to sell are faced with the reality of today’s lower pricing.
Demand for non-bank CRE lenders has risen in 2023's first and second quarters. Traditional lenders are more cautious, making it harder to secure financing for multifamily projects. Fannie Mae agency debt approval has become stricter due to market uncertainty and recent bank failures. When refinancing, investors are turning to debt funds and private equity lenders for more flexible credit options compared to traditional sources, often resulting in higher than desirable credit spreads.
Today, market uncertainty stems from a misalignment between sellers holding onto inflated valuations of recent years, and buyer concerns of tightened yield spreads. This is further fueled by properties failing to meet acquisition debt requirements. Going forward, as details of recent property sales become public, new benchmarks for key metrics will be set in each market. Although the market has been experiencing a period of readjustment, higher interest rate environments tend to offer a ground for opportunity. Buyers who remain active can capitalize on higher returns at lower pricing which, in turn, can lead to greater asset appreciation once lending levels stabilize.
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