Changes in Supply, Financing Make 2014 a Telling Time
Saying that Austin's multifamily market has been a strong performer for the past several years would be stating the obvious and hardly newsworthy, considering that all of the well-reported economic rankings list Austin at or near the top. Nevertheless, the numbers from the past five years are remarkable.
While 2013 will go into the record books as one of the best years for multifamily landlords, the real story for 2014 — and beyond — is how the market responds to the two forces that have clearly started to change: supply and financing.
There is no hiding the fact that a building boom is occurring in central Austin, as the cranes for multi-family construction easily outnumber the activity in hospitality and office properties combined. Completions for 2014 are expected to be approximately 12,000 units, with the highest concentration (more than 3,000 units) in the central sub-markets. This is a dramatic increase in new supply in a market that has been significantly under supplied due to the collapse of the capital markets in 2008.
After a couple of years focused on urban, in-fill projects, the recent third quarter reports indicate that developers are returning to the suburbs, with over 18,000 new units across 15 different submarkets in the development pipeline. This new wave of construction accounts for 8 to 10 percent of the total existing market, begging the question, “Is this too much of a good thing?”
The answer for owners of existing projects will depend on absorption. With the large number of completions on schedule for 2014, the market will clearly be tested to see if Austin’s strong population and job growth has created enough pent-up demand to fill the supply of new units. Absorption of rental units in Austin should be at an all-time high, given the frequency of new announcements from employers either expanding in or moving to the Central Texas area, as well as the national shift from home ownership to rental.
Meanwhile, the answer for the developers of the next round of projects will be largely determined by the capital providers. New projects in several submarkets are starting to have difficulty attracting capital, indicating the debt and equity markets want some time for the market to digest the current projects already under construction.
In addition, the current level of construction activity is driving construction costs higher, especially on the labor side in many trades. Higher costs and reluctant capital will certainly slow the pace of new starts beyond 2014.
Financing’s New Phase
The availability and pricing of debt financing is an integral part of the investment performance of an asset of any class, and commercial real estate is very capital-intensive and more susceptible to changes in the debt markets.
Within the commercial real estate world, multifamily finance — largely driven by the activities of the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac — has been in an enviable position for many years in both availability and pricing. But in the second quarter of 2013, a couple of important changes occurred that have rippled through the market.
First, the GSEs announced that they were being directed to reduce their origination volumes and ultimately the size of their outstanding mortgage portfolio. Second, the yield on U.S. Treasury bonds, the underlying index for mortgage rates, increased more than 100 basis points in a six-week period.
The market quickly had to recalibrate investment pro formas, with borrowing costs rising from around 3.75 percent or less for 10-year, fixed-rate loans to 5 percent or higher. Highly capitalized institutional investors that purchase all-cash or at low leverage levels felt little effect, but the leveraged buyers were quickly at a competitive disadvantage on core assets where cap rates and loan constants converged.
As a result, the leveraged buyers often turn to value-add and new development, where they can get higher projected returns and still utilize positive leverage. This creates the “barbell effect” that the brokerage community is now experiencing: high demand for the best core and value-add properties, but not much activity in the middle.
As far as debt financing is concerned, multifamily investors need to realize that this trend will continue. Any tapering by the Federal Reserve will likely lead to higher U.S. Treasury bond rates, and continued discussion in Washington clearly indicates that further restructuring of the GSEs is likely to decrease their appetite for new mortgage origination.
The Mortgage Bankers Association recently reported that multifamily mortgage origination at Fannie Mae and Freddie Mac was down 40 percent year-over-year in the third quarter of 2013. Indeed, for the first time in 15 years, the life insurance company originators are now offering significantly better terms than the GSEs, especially on loans with terms of longer than 10 years.
Multifamily investors who have been relying solely on the GSEs for debt should consider expanding their relationships with other capital providers as these changes in GSE debt pricing and availability continue.
— John Morran, principal, Texas Realty Capital