The 2008 financial crisis sent ripples throughout the world economy and the effects of the changes in individual and institutional behavior can still be felt today. There has been a steady decline in homeownership since that time (after a peak in 2004). Millennials, riddled with student loan debt and traumatized by the worst economic crisis since the Great Depression, both prefer and, to some extent, are forced to rent. This has led to a booming multi-family market across the nation with seemingly no end in sight to development in major urban areas and downward pressure on market cap rates; prime conditions for a bubble. No one saw an end to the booming housing market in the early to middle 2000s or if they did, it did not stop the majority of people from continuing to engage in the same behavior that led to the largest market correction in living memory.
Multi-family refers to apartment buildings of 4 or more units where Fair Housing laws apply. The amount of properties in this asset class pales in comparison to the number of single-family homes in the country and thus a correction does not have the ability to impact the economy to the same level; however, unsound investment principles do have their consequences. In this article, I will explain what is going on in the multi-family investment market and how the assumptions upon which investment decisions are being made are likely to lead to a correction.
One of the great things about multi-family properties is that everybody needs a place to live. Technology has created disruption in traditional commercial real estate asset classes. Companies are taking less office space, allowing employees to telework, opting for open/collaborative layouts, etc.; making office properties less attractive as an investment class. Vacant office properties trade for less than they’re “worth” and fully leased properties trade for more. I put “worth” in quotations because market value is what an asset sells for in the open market in an arm’s length transaction. What this means is that there is a significant impact on the value of a property/asset class based on the perceived risk associated with it.
Amazon’s impact on the retail market has been significant. Because products can be purchased online and delivered, many product-based retailers are having trouble competing with their online counterparts due to the added cost of leasing retail space. This has increased the prevalence and desirability of more service/experience-based tenants. Big box stores are at particular risk because of the lack of potential tenants that could/would re-lease such a large amount of space. The one benefactor has been industrial assets, as companies like Amazon require storage and distribution centers for their products, and due to the exponential growth of digital information, data centers are increasing in number, need, and desirability as a stable tenant/business.
As two of the most commonly traded asset classes struggled to adapt to life in the 21st century, investors saw multi-family properties as solid and safe investments with the potential for significant appreciation. Many people lost their homes as a result of the housing crash. The damage to their credit and net worth forced many to become renters. For millennials graduating with tens of thousands of dollars of student loan debt, renting was not only a necessity due to financial reasons but was also a choice brought about by a lack of faith in the housing market and the desire to be in more urban, work-live-play environments. As a result, investors and developers rushed to satisfy the demand of America’s largest generation.
Multi-family assets are classified as A (trophy), B, and C properties. I will touch on B & C class apartments in another article, but it is the newly-built, class A properties that are the focus of this discussion because they are the most susceptible to a potential crash. As millennials graduated college and moved to job centers in primary markets, developers hastened to increase supply of high-rise, hundred-unit plus apartment buildings with each seeking to outdo the other by providing the newest and most fashionable amenities. Even though these projects costs hundreds of millions of dollars, developers had no problem financing such projects, as investors needed to “park” their money somewhere and multi-family was seen as a safe investment. This was intensified by Fannie Mae and Freddie Mac offering low interest, non-recourse multi-family loan products. Sound familiar?
This isn’t necessarily bad, at least initially, but as demand increased, it continued to put downward pressure on cap rates. Without going into cap rates in greater detail, the basic principle of supply and demand applies. Development takes time and often fails to keep up with demand. As a result, prices exploded. Multi-family properties in Washington, DC have been trading below a 5% cap rate. A five percent return is not necessarily bad if the investment is considered safe; however, that 5% is based on an all cash purchase. How many investors have hundreds of millions to put toward a single purchase? Some do. As I mentioned, investors need to park their money somewhere, but with the rates being offered by Fannie and Freddie, many investors chose to finance the investment thereby taking advantage of the effects of positive leverage to increase their return.
Real estate investors make decisions based on projections that are unique to each project. These projections address the four questions posed by the cash flow model: how much money goes into the investment (purchase price), when to buy, when to sell (holding period), and how much money comes out of the investment (sales price and after-tax sales proceeds). Some investors choose to buy and hold, but many base projections on holding periods of 5 years. This is because most commercial loan terms are 5-years at which point the property can be refinanced or sold. This has created a virtual game of hot potato where the last investor to hold the property gets burned.
Decreasing cap rates means that the return on each dollar of NOI goes down. The spread between the all cash return (cap rate) and the interest rate (cost of financing) creates positive leverage; allowing investors to increase their return above the cap rate. As that spread narrows due to rising interest rates, the actual return these properties generate decreases. If interest rates increase to the point where they exceed the all cash return, financing becomes undesirable. This will eliminate investors that cannot afford to purchase assets in cash thus eliminating a substantial portion of demand for such assets thereby decreasing their value. Interest rates have been kept artificially low for over a decade and have only one way to go… up. Interest rate risk is one of the greatest dangers affecting the multi-family market.
Another risk facing the class-A multi-family market is oversupply. As stated previously, supply cannot keep up with demand in real time. The development process can take multiple years during which time demand may have waned and/or supply may have caught up with or overtaken demand. This is what we’re seeing in DC and its surrounding submarkets. Deliveries of thousands of units each year has led to a concession war between owners. Tenants can move from one apartment building to the next an enjoy 1-2 months of free rent as landlords compete for occupancy. This has also caused stagnation in rental rates. Many owners based their projections on annual rental escalations; leading to an increase in NOI over the holding period. If rents remain relatively flat the NOI for the property in the year of disposition will be below projections and without a decrease in market cap rates to increase the value, owners may not be able to achieve the return that they based their acquisition decision on.
Here is an example that will put these concepts in practice. A 100-unit apartment building was built in 2010 and sold fully-leased to an investor in 2015 at a 6% cap rate for $18,000,000. The units lease for $1,500/month and the NOI for the building was $1,080,000. The new owner was able to achieve financing at 4.5% and projected that rents would increase by 3% per year over the 5-year holding period resulting in an NOI of $1,215,549.51. Because of increasing demand this owner was able to sell the property in 2015 at a 5.25% cap rate for a sales price of $23,153,324.09 and netting a healthy profit as a result. The new owner was able to obtain financing at a slightly higher interest rate of 4.75% and based their investment decision on a 5-year holding period with the same annual rental increases of 3%. They also project that cap rates will continue to decrease and that they will be able to sell in 5 years at a 4.75% cap rate for another healthy profit.
Fast forward to 2020. Due to increased supply, rental rates remained relatively flat over the holding period leading to an anemic increase in NOI to only $1,227,705.01. On top of that interest rates increased to 5.75%; increasing the cost of money. When money is more expensive, there are fewer buyers and the remaining buyers cannot afford to pay as much for the same asset. As a result, cap rates saw a slight increase to 5.5%. What does this mean for the owner?
Based on their initial projections the owners expected to sell the property at the end of the holding period for $28,802,351.32; however, market conditions will result in an actual sales price of $22,321,909.27 and a loss. Because interest rates are higher than the unleveraged return of the property the owner will be unable to refinance without contributing additional capital to the investment. While some large, institutional investors can weather such a storm it becomes increasingly difficult as deal size and interest rates increase and (rates of) returns and rents decrease (or remain flat).
Millennials will eventually grow up and while increased interest rates will make home ownership less affordable (and renting more prevalent as a result), it’s naïve to think that this generation’s preferences will not change. Nearly 60% of homes in the country are owned by people over the age of 50. As baby boomers pass away there will not only be a huge transfer of wealth but also of supply. Home prices should decrease as a result; finally making homes relatively affordable.
Everyone wants to make hay when the sun is shining, but the decision making regarding multi-family acquisitions is decreasingly defensible based on fundamental investment principles. As investors are willing to pay less and less for the NOI a property produces, they are opening themselves up to interest rate risk, supply risk, etc. They are leaving less and less room for error if anything adversely impacts their projections. Just like we saw in the years leading up to the housing crash, we will continue to see this game of musical chairs continue until the music stops and just like then the best thing to have is cash so you can benefit from the poor and irresponsible decisions of others.