By Mario Marroquin
The hike in U.S.
interest rates presents a puzzling dilemma for U.S. multifamily investors
amidst a period of historic institutionalization in the sector.
On one hand, public
pensions, endowments and foundations have largely demonstrated a desire to
increase exposure towards real assets and multifamily real estate during the
current spell of heightened inflation. On the other, sustained cap rate
compression (that is, the decrease in the ratio of net operating income to
property value), lagging rent growth and rising interest rates will beset the
multifamily sector for at least another year and likely for longer.
Marcus Frampton, Chief
Investment Officer at the Alaska Permanent Fund Corporation says the fund’s
investments in multifamily have been largely oriented towards new development
and open-end funds in response to the low cap rate environment and inflation.
“From a cap rate
perspective, we like [new development] because we’re maybe building to a 5% or
6% cap rate, and then on stabilizations, [multifamily properties] are worth
4%,” Frampton told Markets Group. “Individual purchases are a very small part
of what we’ve been doing over the last couple of years because the market is so
competitive and pricing is so bad.”
APFC, with $81.9
billion assets under management, will increase its allocation to real estate
from 7% by 1 percentage point over the next three fiscal years. The fund has
deployed between $700 million to $800 million in multifamily every year for the
last few years via joint ventures with developers such as Greystar and funds
like Clarion Gables, Frampton said.
And while AFPC is
investing in apartment development projects in heavily undersupplied markets
that have strong rent growth, Frampton said it is too soon to tell how
inflation and rising interest rates will influence the multifamily
market.
“We have the view that
markets are going to get rocky, and inflation is going to be a persistent
problem – that is how I’m trying to position things,” he said. “We’re very
defensively positioned in the fund right now.”
Frampton and other
experts interviewed by Markets Group agree the magnitude of the incoming
slowdown in the multifamily sector will depend on the actions taken by the U.S.
Federal Reserve in the second half of 2022. But they find little consensus of
what investors will do and should do next.
According to an
analysis by S&P Global Market Intelligence, pension plan sponsors deployed
more capital for real estate investment trusts (REITs) in office, multifamily
and industrial real estate from January to April than in all of 2019.
Multifamily
investments by pension plan sponsors were 47.2% higher from January to April
($14.5 billion) when compared to all of 2019. Sponsors’ exposure to U.S. REITs
in industrial real estate increased 103.4% to $13.8 billion and in office by
19.4% to $12.8 billion over the same period, S&P Global reported.
Multifamily real
estate in the U.S. has remained a target for non-U.S. public pension as well.
Some of the most
notable transactions have included the Canada Pension Plan Investment Board
venture with Lennar Corporation subsidiary LMC to develop 1,371 apartment units
in Boston, Miami and Denver.
“This investment is an
excellent opportunity to meet the strong demand for high-quality multifamily
housing,” Peter Ballon, managing director, global head of real estate at CPP
Investments, said in a prepared statement from February.
CPP Investments owns
approximately 96% of the joint venture, which is set to focus on urban and
suburban communities in major U.S. markets with strong population and job
growth.
“In the last year and
a half, there’s been a big institutional money shift to hard assets, primarily
commercial real estate as an inflation hedge, but what that does is cause
higher demand and low returns and lower cap rates,” Joseph Ori, the executive
managing director of commercial real estate at advisory firm Paramount Capital
Corporation, said. “The rise in interest rates is going to make deals tougher
to price out, so loan-to-values will have to come down.”
Ori says rising debt
servicing costs as a result of increasing interest rates, and the liquidity and
demand for multifamily keeping returns on apartments low, has yielded negative
leverage in the sector. Tight cap rates and high demand pushed multifamily
owners to raise rents in some of the hottest markets in the country, including
the Miami metro, where overall rents increased by 60% since the start of the
pandemic.
Raising rents,
however, may not be as easy as before given the shape – and direction – of the
economy. Rents cannot go up forever, Ori said. Eventually, renters will double
up, move back home or move down to cheaper apartments.
“Rent growth has been
the justification to buy an apartment deal or any deal at three or four cap
rates,” he said. “If you’re buying commercial real estate at three or four cap
rates, that’s like buying a tech stock at a 100 P/E ratio.”
The U.S. Bureau of
Labor Statistics reported an 8.6% increase in the consumer price index in May –
the largest increase in the CPI since 1981 – and reported a 34.6% increase in
the energy index and a 10.1% increase in the food index on a year-over-year
basis.
Research from
Realtor.com indicates median rent in the 50 largest metropolitan areas
increased 15.5% in May on a year-over-year basis.Joe Berner, senior economic
research analyst at Realtor.com, said the 15.5% increase constitutes a 26.6%
increase in median rent over May 2019.
Realtor.com found the
following metropolitan areas saw the largest increases in rent from May 2021:
· Miami-Fort Lauderdale, Fla. – 45.77%
· Orlando-Kissimmee, Fla. – 28.4%
· Providence-Warwick, R.I.-Mass. – 23.8%
· Austin-Round Rock, Texas – 21.9%
· San Diego-Carlsbad, Calif. – 22.7%
· Tampa-St. Petersburg, Fla.– 22.4%
· Nashville-Davidson, Tenn. – 20.6%
· Las Vegas-Henderson, Nev. – 20.2%
Downstream Effects
Slowing rent growth
and increasing debt servicing costs are already manifesting on the housing
lending market, according to Nitin Chexal, CEO of Palladius Capital Management
of Austin, Texas.
Palladius Capital
Management, a real estate investment manger with debt and equity strategies,
and its affiliates have deployed over half a billion dollars since its launch
in 2021, according to Chexal.
“Cap rates have been
inching higher, but they are certainly not moving in lockstep with interest
rates,” Chexal told Markets Group. “You have a tremendous amount of capital
that has been raised for real estate that’s sitting on the sidelines – and some
of that capital has made the decision to take the summer off – but ultimately
that capital is going to move back into the market.
“Some of that capital
is going to be willing to accept lower returns on some of these investments
simply to get the capital put to work.”
Chexal says the
Covid-induced collapse of interest rates (and correspondingly cap rates)
coincided with the mass migration towards Sunbelt markets such as Miami,
Phoenix, Denver, Austin, Nashville and Las Vegas.
As interest rates have
risen, prices have started to fall across asset classes, including multifamily,
Chexal said.
The actions of the Fed
will determine the level of the slowdown, he said. In the short-term, however,
distressed opportunities are likely to increase.
“You can make money at
any point in the economic cycle, you just have to be cognizant about where you
are in that cycle,” he said. “For a fair number of real estate investors, they
have only seen an up market in the last nine years, which has been a bull
market, so they only know that.
“When you’re in an
economic pullback like this, you will start to see meaningful differentiation
between the quality of sponsors that are out there.”
Justin Kennedy, a
managing partner and co-founder of balance sheet lender 3650 REIT in Miami,
echoed Chexal’s sentiment that the Fed will be the one to determine the
magnitude of the slowdown in U.S. multifamily, but also said regional
fundamentals will play a factor in the slowdown.
3650 REIT, which
originated $1.45 billion in loans in 2021, lends towards construction, bridge
and value-add strategies and has seen an increase in inquiries and closings
during this rising interest rate cycle, Kennedy told Markets Group.
The cofounder said he
expects 3650 REIT to deploy more capital this year than last year, though he
did contend a slowdown in multifamily is on the horizon.
“In the case of many
multifamily and industrial properties, cost of debt can be materially higher
than going-in cap rates, which is clearly not sustainable, except in situations
where very high rates of rent growth are expected,” he said. “Many transactions
[even in the best asset classes] will need to be restructured to accommodate
materially higher lending rates across all markets.”
As benchmark rates
rise in response to the Fed, lenders such as 3650 REIT will continue to raise
interest rates on fixed and floating rate debt, Kennedy said.
In light of the
continuing inflation pressures, Kennedy said he expects the Fed tightening to
bring the secured overnight financing rate (SOFR) up to 3.25% by the end of
this year and a largely flat to slightly inverted curve out to 10-year
Treasuries.