By Taylor Williams
Multifamily investment sales activity has been muted across major Texas markets during the first half of 2023, underscoring the unfortunate reality that even the most coveted asset classes are not immune to severe macroeconomic headwinds.
Much like a year ago, the combined effects of stubborn inflation and corresponding interest rate hikes have wrought visibly negative changes to the world of multifamily investment sales. But in summer 2022, deals were still getting done at a decent clip; price disparities and depreciation were the most significant and obvious impediments to deal velocity. Today, buyers and sellers are more closely aligned on market realities as relates to price points, but many are simply not motivated to transact — at least in the short term.
According to data from RealPage, in the first quarter of 2023, there were 337 multifamily transactions within the Dallas-Plano-Irving triangle, down from 510 in the first quarter of 2022. The greater Houston area saw 266 deals executed in the first quarter this year, a decline from 410 during that period in 2022, while the Austin market’s total number of transaction fell from 191 to 123 quarter-over-quarter.
Multifamily sales prices responded differently to reduced deal volume from market to market. Per RealPage, in the Dallas-Plano-Irving market, the average per-unit price during the first quarter was about $182,000, down from $195,500 per unit in the first quarter of 2022. But both the greater Houston and Austin areas saw their per-unit prices rise. The former increased marginally from roughly $157,000 to $160,000 per unit on a quarter-over-quarter basis. Per-unit prices rose more sharply in Austin, ascending from $215,500 per door in the first quarter of 2022 to $227,000 per door during the opening period of this year.
Colliers’ research department also found that depressed deal volume is unique to neither Texas nor the multifamily sector. The full-service real estate firm’s latest report on U.S. capital markets activity found that commercial deal volume totaled about $77.5 billion in the first quarter, a 58 percent decrease year over year.
The report’s authors noted that deal volume and velocity in the first quarter were the lowest they’d been since 2013 and attributed the profound decrease to investors pulling back, wide bid-ask spreads and tightened borrowing standards in the wake of the regional banking failures in mid-March.
“The most common sentiment among sellers is, ‘If I don’t need to sell this year, I’m not going to,’” says Al Silva, senior managing director investments and executive director of the multi-housing division at Marcus & Millichap. “However, we should see more deals come to market as the bid-ask spread closes and pain points begin to manifest a little more acutely, which should translate to greater deal volume in the second half of the year.”
“We’ve had to start underwriting differently; in today’s market, you can’t just plug an interest rate into a model and expect the deal to pencil the same way in two months at closing,” adds Andrew Mueller, director at the Dallas office of Greysteel. “You have to have some flexibility in terms of expectations of where rates are going and price that into your assumptions.”
By way of illustration, Mueller references a sale of a multifamily property in Fort Worth that his team closed in February 2022 at a 2.95 percent interest rate. A year later, he says, that same deal would have likely closed at an interest rate in the high 5s.
What Could Change?
Of course, every investor’s situation is different in terms of liquidity.
Owners that are facing loan maturities and need to refinance may wind up listing their properties, beginning later this year, if rates don’t come down — which seems unlikely in the near term. Most multifamily owners that have bridge loans are currently exploring options with their lenders and investors rather than fire-selling at depressed prices, which Silva notes is another reason that there have been so few deals on the market in 2023.
Bridge loans, which typically feature short terms and floating interest rates, have been in high demand among commercial investors in recent months as the magnitude of rate hikes has eased and borrowers have looked to position themselves for long-term financing within the next 24 to 36 months.
Sources say that these would-be sellers with impending loan maturities and balloon payments have likely owned their properties for several years, allowing them to take advantage of the gargantuan rent growth that occurred between late 2020 and early 2022. Those landlords and their equity partners could view their situations through that more charitable perspective and decide that it’s simply time to move on.
Earlier this year, California-based Magma Equities, in partnership with Australian institutional investment firm Macquarie Asset Management, acquired Bardin Greene, a 285-unit property in Arlington. In announcing the deal, the partnership characterized the asset as ‘recession resilient,’ a testament to the strength of multifamily fundamentals in Texas that are helping to offset some of the pain from massive interest rate hikes.
“The majority of sellers right now that are in position to meet today’s market have owned their properties for four to five years, and usually longer than that,” says Matt Pohl, managing director at the Central Texas office of Walker & Dunlop. “That allows these sellers to be profitable and take full advantage of the rent growth they experienced during the course of their ownership. They recognize that they’re not transacting at peak pricing, but their deals are still very profitable.”
“We are seeing deals get put under contract right now because the seller has held the property for a while and seen good rent growth, and the equity sources want to execute the same business plan on another property,” adds Mueller. “Or in some cases, the sellers want the dry powder because they think opportunity is going to come and things could get worse, so they’re selling for that reason.”
Mueller also draws attention to an unusual circumstance that could bring some sellers out of the woods: attractive in-place debt structures.
“There are some owners that are locked in with low, long-term interest rates, and all of a sudden those loans are assets,” he says. “A few years ago, when we marketed deals with loan assumptions for sale, they didn’t get as much attention as those that didn’t have [debt assumptions]. But now, if you have a good loan — 60 to 65 percent leverage and a sub-4 percent interest rate — that’s an asset, and those properties are getting a lot of looks.”
Further, some owners whose loans have long-term, fixed-rate debt may also become motivated to sell if they believe that supply gaps are forming in core Texas markets. These individuals could theoretically point to robust development pipelines and new deliveries that could keep rent growth firmly in check over the next 18 to 24 months. According to data from CoStar Group, developers are expected to deliver about 531,000 new units nationwide in 2023 — a 40-year high.
Such thinking is reflected in underwriting on new projects in which rent growth is projected to be flat for the first year or two before picking back up in subsequent years. But if sellers move quickly now, they can still exploit cap rates that some experts believe are “artificially low.”
“In some cases, especially for the rare Class A transaction today, the dearth of product in the market is actually creating a competitive environment that’s keeping cap rates artificially low,” says Scott LaMontagne, managing director and market lead for Central Texas at Northmarq. “That should eventually level out as merchant developers hit the transactional market. But right now, cap rates on Class A deals in Austin are in the low 4s because these buyers don’t have other options right now.”
Whatever the case, sellers in today’s market need a pressing impetus or strong faith in the formation of future supply gaps to transact. The days of selling just for the sake of selling during a strong market are gone.
Buyer Sentiment
On the buyer side, liquidity still exists for multifamily deals within both the private equity and institutional investment sectors. The temporary sidelining of these capital sources represents the “dry powder” that sources say is building up across major Texas markets.
Many investors are simply waiting for more clarity on rate hikes from the Federal Reserve and stabilized yields on Treasury notes. Yields on the latter securities fluctuated violently in the immediate aftermath of the regional banking failures in mid-March but now appear to have stabilized. During the one-month period that ended on May 19, the difference between the high and low points of the 10-Year Treasury yield was less than 35 basis points.
When the market feels comfortable with the behavior of these metrics and institutions, sources say deal volume should pick back up. Institutional capital, in particular, should be more aggressive when greater economic stability prevails, as these groups are overwhelmingly in the market for choice asset classes, namely multifamily and industrial.
“From an institutional and fund perspective, retail is flat, hospitality still has a black eye from COVID and there’s not enough industrial on the planet to meet the demand of these massive funds,” says LaMontagne. “So multifamily is really the only place they can deploy and scale. We’re also hearing about re-balancing in the pension funds and life companies nearing completion, which will allow those groups to get back into the market.”
“The Fed has signaled an intent to pause rate hikes, and Treasury markets seem to have mostly settled into a range-bound level in which you can sort of predict what your index rates will be 60 days into a deal when you’re going to the closing table,” says Silva. “So if you take that uncertainty off the table, it makes the buyer pool more comfortable.”
Until those events come to pass with permanence, however, buyers are likely to proceed with caution, and not just on trophy deals. Silva, who specializes in Class B and workforce housing properties in the DFW area — a niche that has been backed by exceptionally strong fundamentals in recent years — has already seen preliminary signs.
“Tour activity has dropped some. We were averaging 30-plus tours per property in late 2021 and early 2022, and it’s now more like 15,” he says. “Also, 12 to 15 months ago, we were probably fielding an offer for every two tours; now you can do 15 tours and maybe get an offer submitted from four of those groups. So there’s been some pullback in the size and scope of the buyer pool, which is related to leverage. There were also newer players, syndication groups in the market, that have taken a big step back.”
While sellers often have more individualized agendas, the buyer side of the market tends to exhibit more
group-think behavior. Yet there are some opportunistic buyers in the market today, says Pohl.
“Institutional capital sources are more active now than they were 90 days ago, although private capital is far outpacing institutional capital in terms of taking advantage of what they perceive to be great buying opportunities,” he explains. “They believe we’ve reached the pinnacle of the rate cycle, and that they can buy at a cap rate in the low 5s or high 4s and find themselves in a lower cap rate environment within the next three years. In that sense, they see a window of opportunity.”
Sources say that private buyers hold an advantage in this market due to their willingness and ability to underwrite deals more aggressively.
“They’re more willing to tweak growth assumptions, and slightly nimbler because they don’t have to navigate investment committees,” continues Pohl. “In most Sun Belt markets, there have been concerns about supply growth that mitigated assumptions on rent growth for institutional buyers, whereas private capital sources have projected slightly higher growth rates, edging out the institutional competition, though that’s starting to even out.”
“Cash deals are rare in the multifamily workforce housing, so really what you’re looking for is experienced,
mid-sized private equity groups, both local and out-of-state — that’s who’s filling the void and getting awarded deals,” concurs Silva. “They’re doing that by leaning on longstanding relationships with debt providers and equity sources to get the deal across the finish line.”
Today, buying a property in the low 5s or high 4s would likely constitute moderately negative leverage, meaning the buyer’s going-in cap rate would be below the all-in interest rate — although not egregiously. That analysis takes into account the Fed’s current targeting of a range of 5 to 5.25 percent on the federal funds rate and assumes a 200-basis-point spread by a lender on top of that. That scenario is hardly ideal from a buyer’s perspective, but it’s workable.
“Buyers are still accepting some negative leverage, but the more well-heeled, institutional capital wants and expects to be at neutral or positive leverage within 18 to 24 months max,” says LaMontagne. “They need to believe in the trajectory [of the rent growth] to accept negative leverage. And while brokers or sellers might currently be underwriting 5 to 5.25 percent cap rates, the reality is that because there are so few deals and so little transactional velocity right now, especially in the Class A space, those numbers are somewhat propped up.”
As for leverage ratios on their loans, LaMontagne says that regardless of where trailing cap rates are, 65 percent loan-to-value is about the minimum threshold for private capital sources to do a deal.
Of course, investment strategies can and do vary tremendously from group to group, and some investors are taking a more cautious approach when it comes to negative leverage. Brennen Degner, CEO of DB Capital, a Denver-based multifamily investment firm that is active in Texas, elaborates.
“If the expectation is for future market rent growth alone to pull us out of negative leverage, then we won’t do the deal,” he says. “If there is a value-add business plan where we see a clear opportunity to generate positive leverage through revenue generation that is more than just expectations of rent growth, then we can get comfortable with negative leverage.
The net result of these market factors and conditions is, generally speaking, something of a stalemate in which some sort of magic domino needs to fall in order to get the deal done. John Tallis, an associate on Mueller’s team at Greysteel, characterized the dynamic between buyers and sellers accordingly.
“If the sellers want or have to sell, they have to meet the market, and if they’re not motivated, they’re going to stick to their price,” he summarizes. “And if folks are staring down a deal that’s being underwritten at negative leverage, especially mom-and-pop buyers, they’re probably going to pivot and ask for some special or seller financing.”
Construction Concerns
Inflation and subsequent rate hikes have proven to be sufficient in mitigating deal volume for even the most resilient asset classes in the most attractive markets. But that’s hardly the only uncontrollable force that multifamily owners, investors and brokers are contending with today.
The panic that drove regional lending giants Silicon Valley Bank and Signature Bank into the ground and forced fire sales of Credit Suisse and First Republic Bank did not stop with those institutions. In the aftermath of those failures, customers fearing insolvency in the regional banking sector, which holds the lion’s share of commercial mortgages coming due in 2023, moved funds out of those institutions and into Wall Street giants.
Regional banks also tend to be go-to sources of financing for new construction. Sources say that the demise of the aforementioned regional banks doesn’t mean that these lenders have stopped doing new construction loans, just that they’re significantly more limited on how much leverage they can provide and how many of those deals they can do in a given period.
“There has been a lot of talk about difficulties in getting construction debt, and there is a fallacy in the market right now that banks are not lending on new construction,” says LaMontagne. “Banks have finite buckets of capital, which is usually a percentage of the total available dollars to loan out. But right now, developers are extending loans or going into mini-permanent finance structures, so capital isn’t available for redeployment.”
“On top of that, overall deposits are down at a lot of banks, and since banks lend at a multiple of their deposits, there’s fewer total dollars available to be lent out across all service lines,” he continues. “That’s where the pressure on construction lending is coming from, not them being entirely out of the market. Regional bank failures aren’t great for overall market sentiment, but they aren’t punitive to multifamily beyond the construction lending space.”
Of course, in commercial real estate, one player’s nightmare scenario can be another’s dream. Should construction lending take a serious hit, the supply gaps that are building across Texas will become more pronounced and visible, paving the way for a return to strong rent growth in the coming years.
“If you’re a buyer today, you probably feel good about rent growth three years from now,” says Pohl. “Assumptions on rent growth are light from now until the end of 2024. But they are expected to ratchet up in 2025 and 2026, when broader multifamily supply levels should be well inside the five- to seven-year running average due to potential liquidity concerns arising for many construction lenders.”
“Between the elevated costs of construction, expected flat-to-negative rent growth and challenges accessing construction financing, there should be a slowdown in supply growth,” says Degner. “With that said, there’s still a ton of product in the pipeline that hasn’t been delivered. We don’t anticipate seeing the benefit of the construction slowdown for a few more years, and by that point, we will likely be in an entirely different point of the next cycle.”
— This article originally appeared in the June 2023 issue of Texas Real Estate Business magazine.