Newton’s second law of physics holds that what goes up must come down, but unlike objects in freefall, retractions in real estate cycles tend to unfold with varying degrees of pace and severity.
In the case of multifamily investment sales in Texas, it’s been clear for some time that the market is in a much different place than it was in late 2021 and early 2022, the latter period being when rate hikes began. In that golden era of multifamily investment sales, owners routinely achieved record highs of rent growth and brokers closed deals at legendarily high prices and low cap rates.
What isn’t so clear is whether the market has bottomed out yet with regard to those metrics. Attaining clarity on that subject will remain difficult until deal volume rebounds and gives owners and brokers enough data to accurately establish trendlines.
Like everything else in commercial real estate, the question of when deal volume will rebound is tied to movement in interest rates — unless maybe it isn’t. For as the world has seen over the past six months, what the Federal Reserve implies it will do and what it actually does aren’t always in sync. Some brokers see a connection between the misalignment of the Fed’s words and actions and the slowing volume of transactions.
“Six months ago, when the Fed indicated that we’d see several rate cuts over the coming year, there was some excitement and buzz around that thought process,” recalls Josh Hoffman, senior director in Cushman & Wakefield’s Houston office. “Initially, sellers had the idea that if rates came down, cap rate compression would follow, whereas buyers thought that if that happened, it would lead to more deal activity. When that scenario failed to come to fruition, the market as a whole almost came to a halt.”
Diminishing Data
The industry’s hopes of numerous rate cuts in 2024 get dimmer with each passing meeting of the nation’s central bank. And while there could be a token cut to juice the stock market in the runup to the presidential election, such an event is unlikely to open the floodgates of multifamily deals. In other words, the market could remain starved of relevant data through the end of the year.
“We’re realizing more and more that the current scenario is going to be the new normal for [interest] rates for a while,” says Jon Krebbs, managing partner at Dallas-based brokerage firm The Multifamily Group. “Sellers are coming to terms with that. Some equity is being lost, and others are realizing that they’re lucky just to get most or all of their equity back [when they sell]. But lot of this is tough to substantiate because so little product is trading.”
CoStar Group, of course, has some data to share even in times of minimal transaction activity. According to the industry’s de facto bookkeeper, all four of the major Texas markets experienced significant declines in the trailing 12-month period ending in June 2024 relative to the trailing 12-month period ending in June 2023.
During the 12 months leading up to June 2023, 360 properties traded in Dallas-Fort Worth (DFW). In the subsequent 12-month period, there were only 220 deals transacted. Houston saw a similar decline during those two trailing 12-month periods, going from 290 to 160 transactions. The dips in deal volume were slightly less severe in Austin (110 to 71) and San Antonio (100 to 64), according to CoStar.
“In a normal sales market, about 5 percent of the inventory turns over, as it did pre-COVID,” notes Mark Allen, executive managing director at Dallas-based brokerage firm GREA. “The peak of the market was 2021 through 2022, and in DFW, about 20 percent of the market turned over during that period. In 2023, the turnover rate dropped to just 2.4 percent. We aim to return to the historical average, but when transaction activity spikes as it did, there’s often a need to recalibrate expectations.”
Citing capital markets data aggregator MSCI, The Wall Street Journal recently reported that on a national basis, pricing for multifamily properties was down about 20 percent in May 2024 from the peak pricing levels that were recorded in July 2022. The newspaper also reported that MSCI’s data found that through May 2024, total multifamily sales volume across the country was down 44 percent on a year-over-year basis.
The future of interest rate cuts remains uncertain, but there is some sentiment among owners and brokers that rate hikes have at least reached their cyclical apex.
“We don’t know when or how much the Fed is going to cut, but based on moves by the European Central Bank and Bank of Canada on their overnight rates, it at least seems like they’re done raising and will make a cut or two in the coming months,” notes Michael Becker, principal of Texas-based investment firm SPI Advisory. “Relief on interest rates should be coming, and yields on Treasuries don’t seem like they’re going to run away to 6 or 7 percent like we may have feared a year ago. So there are some calming forces in the market.”
SPI Advisory has been active during this period of partial recalibration. In April, the company sold Parker Apartments, a 192-unit complex in the East Texas city of Tyler, and in June, SPI disposed of Oaks on Marketplace, a 254-unit community in the Austin area. Earlier this summer, the company also went into escrow to acquire two new assets in Denton.
In the case of both sales, the company felt comfortable pulling the trigger at the closing price points (which were not disclosed) due to having bought at a low basis in the pre-pandemic era and implementing capital improvements.
“The deals that aren’t moving are those that are maybe 80 percent levered, in which the owner didn’t do capital expenditures and paid debt service instead of doing renovations with that money — those deals are now below their debt basis,” Becker explains.
“Some buyers are taking on dumpster-fire deals and turning them around, but the juice may not be worth the squeeze in terms of how much they’re offering and how much time and effort it will take to turn some of these deals around,” Becker continues. “Austin in particular is oversupplied, and you can acquire those assets well below replacement cost. This is a moment in time in which today’s oversupply in Austin is setting up tomorrow’s undersupply. And rent growth should be very strong in 2026-2027.”
With broader market uncertainty comes a reluctance to transact, which can be a contagious feeling.
The alternative is for owners to accept that the days of obscenely cheap debt are over, recognize that market parameters have shifted and get back to business. Acknowledge that value destruction has occurred and that some deals are dead where they stand. Resign to the reality that some return thresholds are not going to be met, and that some sales may result in losses. Embrace the downturn, rip off the Band-Aid and begin looking to the future rather than the past.
This is much easier said than done, of course, especially when it’s not your money at stake. But it’s an approach that some brokers can endorse; whether or not their clients can do the same is another story. But to some degree, this is what needs to happen to get deal volume back on track, thus allowing the market to obtain the comparable sales data it needs to facilitate an accurate reset in values.
Flight to Quality
Sources say that as prices have fallen across multiple subcategories of multifamily assets, many investors have seized opportunities to trade up. Buyers that traditionally targeted Class C properties are now seeing opportunities to purchase Class B assets, while players that traditionally lived in the Class B space are now targeting Class A deals.
“There’s a lot of pent-up demand out there, but there’s more demand for higher-quality assets,” says Allen. “Brokers marketing assets that were built in the past 15 years are seeing high demand when the properties are priced correctly for the market. Both sellers and brokers have been unexpectedly pleased with the cap rates and prices achieved on some of these assets recently, prompting them to encourage owners who have been on the sidelines waiting for market stability to consider selling.”
“Two to two-and-a-half years ago, when the market was peaking, you could maybe buy a Class C deal at a 5.5 percent cap rate, but now you can buy a Class A deal at that rate,” explains Krebbs. “Because you can now buy a Class A asset at a more attractive cap rate, buyers for C product are looking to move up to [Class] B or even A.”
Krebbs is quick to point out that the depth of this trend is difficult to substantiate because so little product is trading. Nonetheless, he believes that the market is now far enough along into its adjustment phase such that owners have accepted new pricing parameters and are more willing to meet the market.
“Generally speaking, it’s not a great time to sell, so clients that don’t have to sell are being advised not to do so,” he says. “At the same time, sellers have gotten a lot more realistic because rate cuts haven’t really come like people thought they would. The debt markets have established a new normal, and we’re not likely to see rates come down drastically.”
“Sellers seem to be more understanding of the fact that current prices and cap rates are the new normal, agrees Hoffman. “They are recognizing that interest rates won’t retreat to previous levels, nor will cap rate compression. So they’re more OK with moving forward at these numbers without those expectations of really high prices and low cap rates.”
That mentality, if widely adopted, could be instrumental in helping deal volume rebound and facilitating the larger recalibration in values.
“Sellers’ expectations at the beginning [of the year] were for interest rate compression and cap rates to come down and to have higher per-door prices and transaction volume as a whole,” says Hoffman. “Now they’ve come to terms with the new realities of the market, so we’ve seen that bid-ask gap close, which should allow transaction activity to pick back up.”
Allen believes the writing could already be on the wall with regard to deal volume picking back up in the second half of the year.
“As of today, 2024 seems to be a slower transactional year versus 2023,” he says. “During the first five months of 2022, for DFW assets with 50-plus units, there were 249 properties that traded. In 2023, there were 66, and to date through May 2024, there have been 41. Listing activity is a leading indicator of sales, and in May there were 25 new listings in DFW, almost as much as the 32 listings throughout the first four months of the year. That being said, transaction velocity should increase through the second half of the year.”
— This article originally appeared in the July 2024 issue of Texas Real Estate Business magazine.