By Taylor Williams
First things first: By most objective metrics and standards, multifamily assets in major Texas markets still represent strong investment propositions relative to certain other commercial sectors, as well as to the stock market, the other long-term vehicle to which real estate investments are most commonly compared.
But as we cross the midpoint of 2022, the U.S. economy finds itself awash in a unique combination of challenging and extreme circumstances. Mainstream news coverage increasingly includes the word “record” in reports on inflation, one-off interest rate hikes and movement in the 10-Year Treasury yield. The yield on two-year Treasury notes recently eclipsed that of the 10-year, creating the “inverted curve” that has historically been an indicator of an upcoming downturn. Rumblings of an imminent recession grow louder by the day. Fear is contagious, and some markets are already showing signs of hunkering down in anticipation of a downturn.
The expectation of recession, let alone the materialization of it, impacts even the strongest of markets, including multifamily assets in Texas. Investors and brokers who specialize in the property type recognize that certain factors — net in-migration of hundreds of thousands of people per year, exceptional corporate relocation activity, and supply chain disruption that limits the new supply coming out of the ground — can still buoy the appeal of the asset class. But with the economy clearly slowing and lacking in future directional clarity, prices of these assets are in for a period of adjustment. There’s simply no way around it, according to various industry professionals.
“The market is less competitive relative to several months ago because sellers’ expectations are still high, and buyers are having to deal with the new economics of the capital markets,” explains Jon Krebbs, managing partner at The Multifamily Group (TMG), an investment sales brokerage based in Dallas. “We were selling B and C class multifamily properties at 4 percent cap rates, but interest rates have gone up, and all-in floating and fixed interest rates are now above 5 percent. That’s created a disconnect that’s kept some buyers away from the table.”
“You’re seeing a slowdown as folks try to determine what’s happening in the marketplace,” concurs Ammanuel Metta, senior director of acquisitions in the Dallas office of Los Angeles-based investment firm TruAmerica Multifamily. “Nobody wants to be caught holding the bag. Investors are trying to find equilibrium between debt and making sure there won’t be an additional runup that impacts their returns.”
“In other words, they’re in a waiting period,” he continues. “Come fall, we should see an uptick as investors try to meet their allocations for capital deployment. So it’s a bit of a recalibration, which sometimes is just a chance to reeducate the investor base when debt pricing and asset pricing have moved.”
Second-quarter data on the multifamily sectors of major Texas markets was not available at the time of this writing. But sources agree that the 90-day period between mid-March and mid-June was marked by change. The observable adjustments in the market include an expanding bid-ask spread, a shift in the preferred type of debt for new acquisitions and a retooling of entry and exit strategies by a variety of investment firms. The only question is just how far markets are into their adjustment periods, or if there’s still more ground to cover.
Part of the issue is that prior to late February/early March — when Russia invaded Ukraine, inflation proved to be anything but transitory and the Federal Reserve announced its regimen of rate hikes — multifamily prices in Texas had been on an absolute tear. Fueled by outsized rent growth that was playing catch-up after essentially being frozen during the first year of the COVID-19 pandemic, valuations skyrocketed throughout the space.
“The fourth quarter of 2021 and first quarter of 2022 were the hottest markets we’ve ever seen,” says Patton Jones, vice chairman at Newmark’s Austin office. “We saw the lowest cap rates, the highest level of interest and cheap debt that was readily available. But as the 10-Year [Treasury yield] increased and subsequently the cost of debt increased, we hit an inflection point in late April, and buyers started to get priced out.”
The 10-Year Treasury yield, which represents the return that bondholders can get on a risk-free, 10-year investment, stood at 3.21 percent on June 28, up nearly 100 percent from the start of the year. Investors typically flock to this security when skeptical about the long-term health of the economy, which traditionally causes the yield to compress. But in the current climate, severe inflation is causing the prices of new bonds that are sold to remain high, thus ensuring that the yield that investors require at those prices continues to appreciate.
How We Got Here
As for rent growth that contributed to inflated valuations late last year and early this year, the average asking multifamily rent in Dallas-Fort Worth increased by 17.9 percent between the first quarters of 2021 and 2022, according to data from CBRE. The metroplex’s marketwide occupancy rate stood at 97.4 percent at that time. Austin also finished the first quarter with double-digit year-over-year rent growth and a healthy occupancy rate.
Sources say that even with strong in-migration and stunted supplies of new construction, rent growth of that magnitude was likely not sustainable. Throw in inflationary pressures on operating costs like payroll and repairs/maintenance, as well as the adverse impact of the new interest rate policy on the cost of capital, and the stage was set for price dips.
“We’re already seeing price reductions of 10 percent, and given that more rate increases are coming, we don’t think the adjustment period is over yet,” says Cliff Booth, founder and chairman of Dallas-based Westmount Realty Capital. “Cap rates and interest rates don’t generally move in lockstep, but when rate increases are so significant, cap rate movement will also be significant.”
“Right now the market is going through a period of price discovery, which should translate to fairly low transaction volume for the rest of the summer,” concurs Scott Everett, CEO of Dallas-based investment firm S2 Capital. “We’re also seeing something of a flight to quality. Older assets in secondary locations have likely seen 15 percent reductions in price relative to 120 to 150 days ago. With core product that’s being chased by well-capitalized institutional groups, the bid-ask spread is probably about 5 percent off from where it was.”
Everett adds that he believes that clearly articulated policies and actions from the Federal Reserve can help mitigate the current uncertainty engulfing the U.S capital markets. The Fed’s ability to provide clarity will enable lenders to accurately underwrite loans on new acquisitions and better align the expectations of buyers and sellers. A return to such harmonious market circumstances would also better allow the fundamentals of Texas multifamily markets to play out organically, ensuring that more deals get done.
Multifamily investors and brokers cite lease trade-outs — the difference between the rents paid by a new resident and the previous one — as a bullish indicator for the revenue side of the equation. Jones says that in Austin, owners are typically seeing lease trade-outs of 15 to 20 percent and increases of 10 to 15 percent on renewals. In that particular market, deals on new construction are still being underwritten with double-digit rent growth for the first year or two — a far cry from the historical base range of 3 to 5 percent.
“In an uncertain world, buyers see multifamily as the best and safest investment in real estate and still have a large allocation for it,” says Jones. “There’s no question that our seller clients were getting higher pricing four or five months ago, but overall pricing is still fantastic.”
“From a demand perspective, we’ve seen no slowdown, and fundamentally, apartment investing is still as good as it’s ever been,” adds Everett. “Our rents are still outpacing inflation considerably, and the Sun Belt continues to generate a lot of jobs, so there’s plenty to be excited about. Lack of clarity is bad for business, so as long as the Fed can be crystal clear about the path we’re on, we can get back to accurately pricing multifamily assets.”
“Multifamily, especially workforce housing, is still a great investment,” adds Krebbs of TMG. “Developers aren’t building more of it, and there’s still great population growth in Texas and the surrounding states. There’s pressure on rents as supply stays the same and demand grows increasingly robust.”
The Fed raised the federal funds rate, or the short-term benchmark rate by which commercial banks price loans to one another, by 75 basis points at its June meeting. The nation’s central bank is targeting a range of 1.5 to 1.75 percent but has signaled that more rate hikes of similar magnitude are coming down the pike.
Prior to the release of the monthly Consumer Price Index (CPI) report on June 10, which showed an 8.6 percent year-over-year increase in the average cost of U.S. goods and services, investors had expected a 50-basis-point hike in the federal funds rate at the June meeting. But the severity of the inflation report prompted the Fed to tack on another 25 basis points. For the nation’s central bank, the impromptu move resulted in the single-biggest rate hike since 1994.
Buyer Beware
While multifamily investors of all types love to see exceptional rent growth, some caution against reading too much into such patterns without the proper context.
“If you look at lease trade-outs, they’ve been at historical highs,” says Metta. “But that’s partially because for 15 months, we had zero to minimal rent growth. So there’s been pent-up growth that was all of a sudden unleashed in the past 10 to 12 months, and now some of that is starting to subside. We knew this level of lease trade-outs wouldn’t last forever; it just provided a big jilt in the beginning.”
While rent growth throughout Texas and major U.S. cities as a whole has been prolific of late, Metta points out that household income has kept pace with asking rents on new leases. In some instances, he says, household income growth has actually outpaced what renters typically pay as a percentage of their income — a key point that’s often overlooked in the discussion of whether strong rent growth is sustainable in an inflationary environment.
Last December, Newmark brokered the sale of Nexus East, a 352-unit community in East Austin. While pricing for multifamily assets has cooled a bit from that time, the sector still offers strong returns in markets that are experiencing healthy in-migration, like Austin.
For some tenants, when their disposable incomes become stretched to a certain point, they will inevitably be forced to at least consider other rental options. But with high occupancy rates in major Texas markets and supply growth hindered by supply chain disruption, sources generally agree that this scenario has yet to come to fruition.
Instead, a more realistic pitfall into which investors could step involves the concept of negative leverage. This scenario occurs when the total cost of debt, which is rapidly rising from a period of historic lows, exceeds the cap rate at which the asset trades. Investors that buy under those circumstances are banking on the continuation of massive rent growth.
“In some situations with certain assets, you could justify buying at a lower cap rate because of where rents were and were going,” explains Booth. “As historically low as cap rates were, rent growth was historically high. So there was some offset, but now we see that rent growth is going to slow down, so you can no longer justify negative leverage.”
“For deals we’ve bid on, brokers are coming back to us and asking us to revise our bids, as sellers realize they can’t get the prices they could a few months ago,” Booth continues. “So we’re not hearing of that many deals getting done at negative leverage. Deals that fit that profile are likely newer vintage product in select submarkets with minimal capital expenditures attached to them and a reasonable expectation of strong rent growth.”
Debt Decisions
During the months leading up to the pandemic, as well as during its opening stages, the government-sponsored enterprises that are Fannie Mae and Freddie Mac provided the most liquidity to multifamily markets, in keeping with their mandates. Agency lending volumes continued to rise in 2020, as interest rates remained at historical lows to encourage spending and borrowing amid the larger shutdown of the U.S. economy.
More recently, however, as prices shot up at rapid clips, bridge lenders sensed opportunity in the market. Buyers needed more leverage to cover rising prices, and those that couldn’t circumvent that problem via their own or a partner’s equity looked to high-leverage bridge loans for their financing.
While these loans are typically structured with floating interest, rates had still been at historic lows. And with competition for assets as fierce as ever, taking a slightly higher rate in order to close quickly and win a deal seemed like a fair trade-off.
“Almost none of the deals that sold in DFW in the last 18 months were [financed] with agency debt,” says Krebbs of TMG. “Most deals were bridge loans because agency debt couldn’t get buyers enough leverage because of the agency’s requirements on debt service coverage.”
Krebbs adds that this trend is slowing now that interest rate hikes have begun and escalated. “Properties being financed with bridge loans have become much more expensive in this interest rate environment,” he says.
In Austin, Jones says that bridge debt was a popular route for value-add deals because they offer flexibility in terms of extensions and exit options. Since value-add investors typically have shorter holding periods, usually intending to make their capital improvements, boost rents and sell within a few years, this method of financing made sense for that segment of the market. Not so much for core deals, however.
“In the last 18 months and for all of 2021, bridge loans were very popular because they were inexpensive and flexible,” he says. “Almost all buyers in 2021 used bridge debt at sub-3 percent rates, and the agencies were falling behind in terms of loan production. In 2022, as the cost of floating-rate bridge debt skyrocketed, buyers realized that it’s tough to buy a 3-cap when the cost of debt is well above that. Therefore, investors are shifting to fixed-rate debt options.”
Part of that shift is attributable to movement in the Secured Overnight Financing Rate (SOFR), which recently supplanted the London Interbank Offered Rate (LIBOR) as the benchmark rate by which commercial lenders price their inter-lending activity. The rate is on the rise, putting further pressure on capital costs and prompting more buyers to seek fixed-rate financing. Between March and mid-June, the SOFR rate rose by 145 basis points from zero to 1.45 percent.
— This article originally appeared in the July 2022 issue of Texas Real Estate Business magazine.