The commercial real estate industry, including the multifamily sector, has experienced a significant slowdown in 2023. This slowdown can be attributed to:
- Rising short and long-term rates affecting the cost of capital, particularly in the debt component.
- A banking crisis impacting regional and community banks, further constricting liquidity.
- Large funds and equity funds pivoting towards senior debt or preferred equity, drawing equity out of the system.
- Sellers' reluctance to transact below peak prices.
This perfect storm combined to cut transaction volume by 80% from peak volume. If you’re a broker of debt, equity, or deals you rely on transaction volume. This likely results in a palpable financial crunch for many. Cushman and Wakefield and JLL – two massive CRE brokerages – have seen their earnings down 90% year over year. CRE is leading the rest of the economy into a recession.
To give some perspective on how ahistorical (in the modern economy) this is: The 10-year yield has surged ~440 basis points (440!!!) from its low in March 2020. Just about every move of this size, all of which were smaller, resulted in some sort of a crisis dating back to the 1980s. Currently, the gap between treasury yields and equity valuations is unfilled. Either equity valuations need to fall or treasury yields need to fall to close this gap. The 10y hit 4.80% this week or the highest since 2001. 30-year yields at 4.95% — in the last 30 years we’ve only really had Fed Funds more than a smidge above 5% in 1995, 2000, and the past few months.
Treasuries and equities selling off at the same time is also incredibly rare. I would not want to bet against these jaws closing:
Equity values in commercial real estate have already fallen much sooner than other industries. REITs are down significantly more than the S&P as a whole. Multifamily as an asset class has remained relatively shielded from the impacts observed in office spaces, thanks to steadfast demand in residential and influential demographic forces. In office, it is not just that equity is impaired but the value of the debt is taking a significant haircut. This means an impaired value of 50% or more. In 2005, Wells Fargo bought a building in the heart of San Francisco's financial district for $108M. Roger Field's of Peninsula Land & Capital just bought the building last month for just over $40M, or $114 per SF - less than 1/2 of what it was worth in 2005. As much as multifamily is in a better position than office, multifamily is facing challenges other than rates including rising insurance, utility, and payroll costs. It is definitely the most challenging operating environment the industry has seen since post-GFC. Purchasing and refinancing is incredibly difficult in this environment.
Part of the reason we're so adamant about doing value-add projects is the ability to increase revenue and earnings protects capital even when cap rates are rising (multiples falling). Working to protect capital in the face of market volatility and adversity is a core tenant of our investment thesis. If you bought a property at bought for $20M at a 5% cap with $1M NOI and didn't do anything to improve this, today is currently sitting worth ~16.5M at a ~6% cap. Compare this to a building you bought with the same basis, but increased NOI by $300k. In this scenario your building is worth $21.6M – not a homerun, but certainly a good result in this environment.
"Greedy when others are fearful"
While it's simpler to adhere to the old adage when the market is booming, we firmly believe that the current market dislocations and challenges present significant opportunities. The multifamily deals that are finding a bid are down 20-30% off of peak pricing, but given the rent growth that’s happened in this time, the distress we are seeing in the marketplace tends to be spot-level distress and nothing widespread. The new discounts will provide an incredible opportunity for those who can capitalize their deals because in real estate investing you marry your basis and date your debt. Basis is forever. Debt is a temporary instrument.
“You marry your basis and date your debt.”
Of course, for GP’s with normal LP’s it can be a huge challenge to go to LP’s who are likely invested across ~10-20 different deals that are down on equity values and ask them to put money in when they’re not sure if we’re at the market bottom. The GP/LP relationship is a partnership and it’s important to partner with the right types of investors who don’t believe in the ability to precisely time the bottom and will invest through market cycles pouring more capital in when cyclically you’re “around” the bottom. Cyclically, we believe over the next 12-18 months we’ll see some of the best vintage of deals over a 10 year rolling basis.
Some of the world's wealthiest families in the world believe the same thing. A prime example of this trend is Chicago’s luxurious 727 West Madison tower, which has a new owner, billionaire Amancio Ortega, founder of Zara, who purchased the property for $232 million. This deal follows similar investments, such as Israeli billionaire Eyal Ofer’s acquisition of a 57-unit building near Manhattan’s Gramercy Park. Additionally, wealthy families from Latin America and firms backed by global investors like David Rubenstein are also exploring opportunities in the multifamily building sector, seeking to capitalize on the current real estate market dislocations.
The fundamentals have not changed in America with workforce housing supply for the $50k to $70k income household which represents the majority of this important market. While a lot of multifamily construction has been built, in order for development deals to be profitable developers either needed to build Class A multi which is unaffordable for this sector OR they needed to build "Affordable Housing" which comes with tax breaks in exchange for only renting to folks under a certain household income. On top of this, supply pipeline has fallen off a cliff as apartment construction has hit a lull with the cost of capital being so high so there will be a few years at least with very few deliveries to absorb.
We are starting to see more deal flow than we have over the past 12 months. As debt maturities begin to hit, sellers come to terms with the new market, and the summer ends, a confluence of factors is starting to loosen up the transaction market. We are also hearing consistently from the broker community that BOV's (broker opinion of value) are drastically up indicating additional future deal flow.
We underwrite about 2000-3000 deals a year depending on the year and are actively in the market targeting debt maturity off-market deals so we feel we are well poised to begin acquiring some assets targeting an acquisition late in this quarter and early next quarter with a chunk of activity for the fund in 2024. We do not have a specific asset identified yet, but our pipeline is robust and we are hopeful something should hit soon – we imagine the first quarter.
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