The star of the commercial real estate sector since the recession is the multifamily sector. A confluence of factors—including the collapse of single-family housing; microscopic interest rates; and capital sources that were quick to bounce back—helped push the sector forward. Its fundamentals also recovered more quickly those of the office, retail, hotel and industrial sectors.
In fact, multifamily values, cap rates and fundamentals in many markets have now exceeded their prerecession peaks. At the same time, other sectors have now recovered.
So what does this portend for the multifamily sector? NREI conducted its second annual research survey measuring industry pros’ sentiments on the sector. Our findings were that Goldilocks conditions remain in place. Fundamentals remain rock solid. Pricing, while aggressive, can still be justified based on occupancy rates, rent increases and interest rate expectations. Development, by and large, is not overly aggressive.
In other words, the sector is up and all signs point to its staying up for the foreseeable future.
From sea to shining sea
Respondents were asked to rate the relative strengths of the multifamily sector in each region on a scale of 1 to 10.
On a national basis, the West tops the regions with a ranking of 8.0, the East follows at 7.5, the South is third at 7.4 and the Midwest is ranked at 6.5. The rankings are all within 10 basis points of last year’s readings.
When the results are segmented to count only respondents active in the respective regions, the rankings for all four are even higher. In three of the four regions, the score by those active is 70 basis points greater than the scores from the collective results. Respondents active in the West score the region at 8.7, those in the South score their region at 8.1, trailed by the East (7.8) and Midwest (7.1).
“Our regional expectations are similar and reflect primarily the relative strength of employment growth across regions and the relative attractiveness of locations for young people,” says Martha Peyton, managing director, head of mark-to-market accounts and co-head of global research with TIAA-CREF Global Real Estate. “In the West, the tech sector is booming and creating opportunity for young people who are forming new households and renting apartments. In the South, Texas is the leader, especially Austin. The East and the Midwest are weaker because of the drag of localities with concentrations of relatively weaker industries that are not offering opportunity.”
The regions’ performances are tied to overall economic performance, shifting population patterns, increased employment opportunities and continued recovery from the recession, according to Steve Sorensen, associate director of analytics with Yardi Matrix.
“The Western region did show significant growth, and so did the southern corridor,” Sorensen says. “The top 37 markets for rental change over the last year—ranging from 11.3 percent to 5.1 percent—are all in the West or South regions.”
Of course, there are extremes in other markets as well. “I’d put New York in its own class,” says Joe Orefice, senior vice president and head of commercial real estate for New York City–based Investors Bank. The market “is at 98 percent occupancy. You can’t move too much from that.”
Overall, 55 percent of respondents say they expect occupancy rates to increase in the next 12 months. Additionally, 26 percent say they expect no change while 18 percent say they expect a decrease.
“In general, our members see near-historic highs in occupancy rates,” says David Borsos, vice president, capital markets, with the Washington, D.C. –based National Multifamily Housing Council (NMHC). “I find it difficult to think that occupancy rates are going to go much higher. There’s always going to be some amount in flux. There are always people moving in and out. … If there’s any room for movement up, it could be in some of the secondary and tertiary markets or in some of the lower-graded apartments.”
On balance, respondents expect the national occupancy rate to increase by between 10 and 20 basis points nationally. The national multifamily vacancy rate hovered between 4.1 percent and 4.2 percent throughout 2014 and came in at 4.1 percent at the end of the first quarter of 2015, according to preliminary numbers from Reis Inc.
“It’s very submarket specific,” says Cole Whitaker, a partner at capital solutions and investment sales advisory firm Berkadia in Orlando. “Overall, it’s going to be consistent. I don’t see major ups or downs, but I do think it will vary by submarket. That’s the same picture in all the major markets I deal with.”
Michael Bektel, a director at commercial real estate finance company Hunt Mortgage Group’s New York office, thinks occupancy rates have nowhere to go but down.
“While multifamily supply/demand fundamentals continue to look very strong, occupancy rates are likely to remain flat or dip slightly over the next 12 months,” Bektel says. “We have reached the peak, and as rents continue to rise and new units come on line … things could move slightly the other way.”
When it comes to development, there is some concern about the amount of projects in construction, but the general sentiment is that overbuilding is not occurring. Overall, 35 percent of respondents say there is too much development occurring. An additional 44 percent say there is the right amount. Only 12 percent think there is too little development occurring.
Compared to a year ago, concerns about overdevelopment have risen slightly. In 2014’s survey, 28 percent of respondents said too much development was occurring. An additional 44 percent said there was the right amount and 18 percent said there was too little.
NMHC’s Borsos points out that based on population growth, demographic trends and the removal of older inventory from the market, there is need for between 350,000 and 400,000 new units nationally per year in the multifamily market just to maintain balance. Household formation was also constrained during the recession, but has now started to pick up. But during the recession, deliveries fell well short of that figure to stay flat. And now, during a growth period, deliveries are below where they need to be.
“Part of reason occupancy rates are so high is that we haven’t had enough supply in market,” Borsos says. “Last year, for the first time since the downturn, we were at a run rate that was comparable to the need for staying flat.”
But the demand for new product will persist and, in fact, could increase given the overall age of the nation’s multifamily stock. According to Borsos, of the roughly 19 million apartments in the country, 83 percent were built before the year 2000.
“As things get delivered, other product becomes dated,” he says. “Some of them are renovated. But in general as something ages, it gets obsolete.”
Investor Bank’s Orefice says that overall development is in check, but might be skewed in terms of too much luxury and too little affordable housing getting built. “Affordable is always the last thing to be built, and I don’t expect that to change without government assistance or tax credits,” he says.
Bektel adds that even if apartment construction starts begin to rise 25 percent above their long-term average, it will take seven years to make up for the lack of development in the period between 2009 to 2011.
On the rental side of the equation, 78 percent of respondents say they expect rents to increase in the next 12 months. An additional 13 percent expect no change. Only 8 percent expect rents to decline. On average, our survey indicated respondents expect rents to rise nationally by about 3 percent in the next 12 months.
The sentiment matches what respondents said one year ago. In the 2014 survey, 81.5 percent of respondents said rents would increase in the next 12 months. Respondents expected rents to grow nationally by 2.7 percent.
In fact, actual rental growth outpaced those expectations. According to statistics from Reis Inc., asking rents increased 3.3 percent and effective rents rose 3.5 percent in the four quarters ending March 31, 2015.
Sorensen says his firm’s projections show even greater gains. The forecast for 2015 estimates a 4.5 percent increase for rents. “Stagnant wage growth and high housing prices should limit any large shift back to single-family housing, keeping demand for multifamily strong,” he says.
Beating down the doors
In terms of investment, there is some sentiment that cap rates can’t possibly decrease and have nowhere to go but up. Overall, 54 percent of respondents expect cap rates to increase in the next 12 months. Additionally, 28 percent see no change and only 18 percent expect further declines in cap rates. On average, respondents expect cap rates to rise about 15 basis points in the next 12 months.
“This actually shocks me,” NMHC’s Borsos says. “Let’s be realistic. … Transaction volume in the first quarter was up significantly. It shows a huge amount of demand.”
The other determining factor is interest rates. On that front, “everybody has forecast interest rates increases for years now and been wrong across the board,” Borsos says. “So I don’t see what forces are going to push cap rates up.”
But Blake Okland, vice chairman and head of U.S. multifamily with ARA, a Newmark company, has another explanation for the response. “I would say that the 18 percent that expects decreases, wants cap rates to decrease,” Okland says. “They are buyers that want more yield or may have exposure to some pockets where steep rental increases are likely to soften.”
However, the sentiment was similar a year ago. Then, even more respondents—59 percent—expected cap rates to increase. An additional 22 percent said they would be flat and only 19 percent expected further decreases in cap rates.
Instead, in the second half of 2014, cap rates nationally fell to 4.4 percent, according to Real Capital Analytics (RCA). That matched the historic low the firm measured in the second half of 2006. In terms of volume, RCA measured $112.4 billion in multifamily deals—a 9 percent gain over 2013’s volume of $102.8 billion. (RCA’s data captures sales of properties or portfolios worth $2.5 million or more.)
The sentiments on cap rates seem largely tied to respondents’ expectations on interest rates. Overall, 79 percent of respondents expect interest rates to increase in the next 12 months. Only 2 percent think they will decrease. Meanwhile, 18 percent expect them to remain flat.
Such overwhelming expectations don’t mean interest rate rises will come to pass. In 2014’s survey even more respondents—86 percent—said interest rates would rise in the next 12 months. Instead, benchmark 10-year Treasury rates as of mid-April stood at 1.9 percent compared to 2.7 percent 12 months ago.
Implicit in those answers is the notion that spreads between cap rates and interest rates would remain constant. Therefore, any rise in interest rates would trigger a similar rise in cap rates. But a one-to-one correlation in those metrics is not necessarily what would transpire, according to some observers.
“Even though the Federal Reserve will almost certainly tighten before the end of the year, there is so much global liquidity and so much demand for U.S. investment opportunities that pricing of high-quality U.S. property is likely, in my judgment, to have further upside,” says TIAA-CREF’s Peyton.
In fact, something that may prevent the sentiment on cap rates from coming to pass is the persistent high demand—from a variety of investor types—that remains in the market for multifamily properties. “I was talking to a longtime owner in Texas about a property he was selling in the Carolinas. They got over 30 offers. Out of the 30, he knew 10 percent of the names,” Berkadia’s Whitaker says. “He’s been in the business for 30 years. That’s a lot of new blood in the water.”
Overall, 43 percent of respondents said they plan to buy and another 43 percent say the plan to hold. Only 14 percent are looking to sell. If this is an accurate reflection of market dynamics, it means buyers vastly outnumber sellers, which means aggressive bidding, high prices and low cap rates.
“That’s fundamentally a problem,” Borsos says. Buyers are faced with an unbalanced market. “And as a seller, if I can sell out of a cap rate that was way lower than my analysis when I bought this, I have to think about that,” he says.
Sentiment on this front, however, did move some from a year ago. In the 2014 survey, 55 percent of respondents said they were looking to buy and 32 percent said they planned to hold. Only 13 percent said they were looking to sell. The shift in results came in the form of about 10 percent of respondents shifting from saying they were planning to buy 12 months ago to saying they are planning to hold today.
“As long as owners understand that they’re only going to have these kinds of cap rates while interest rates are down, then they can make a smart business decision,” Whitaker says. “There are a lot of owners saying they will hold simply because they have a long-term debt mechanism on their property. And what we have seen and transacted is that even when paying defeasance costs and with cap rates being so aggressive, it may make sense for more of those people to sell.”
Flush with cash
What will drive continued health for multifamily investment are high levels of capital availability—on both the debt and equity sides—for the sector.
Overall, 54 percent of respondents observe that capital is more widely available today than it was 12 months ago. An additional 34 percent say capital availability is the same. Only 7 percent say there is less capital in the market.
“The availability of debt capital is higher than ever and should continue,” Yardi’s Sorenson says. “The availability of equity capital—especially on the (limited partner) stack—will tighten this year, reducing availability for many transactions. Current interest rates have been fueling many transactions that in other cycles would not have been possible. That is what makes this cycle so volatile.”
Investors of all stripes—traded and non-traded REITs, pension funds, private equity funds, private investors, high-net worth individuals and foreign capital—are all chasing property on the equity side.
Some of the new movers in the market include domestic funds that have shifted more attention to the multifamily sector and an uptick in interest from foreign buyers. In the Southeast, for example Latin American investors are coming in, according to Whitaker.
“Deal sizes—especially in major markets, with rents high and climbing and cap rates low—have gotten big enough to source bigger capital sources that need to be efficient how they spend time,” ARA’s Okland says. “That’s a reason we’re seeing an increasing flow of foreign capital into multifamily.”
“Foreign money likes the perceived relative safety associated with U.S. real estate and a dollar-denominated asset, and more foreign investors have educated themselves on the additional inherent inflation hedge associated with multi relative to other property types,” adds Hunt’s Bektel.
On the debt side, government sponsored-enterprises (GSEs), life insurance companies, commercial banks and conduits all have targets to meet or exceed 2014 production volumes. “We’re in the banking sector and we see lots of other banks coming in all the time,” Orefice says. “You’ve also got the agencies being much more aggressive.” Investors Bank is strictly a first-mortgage lender typically originating loans in the $1 million to $50 million range. Last year the bank did about $2.9 billion in multifamily volume and expects to grow that figure to $3.5 billion in 2015.
Multifamily mortgage originations were up 7 percent in 2014 from 2013, according to the Mortgage Bankers Association (MBA). For the year, loan volume for GSEs increased 33 percent. Origination volume grew in each quarter of 2014. According to MBA’s index, where 100 is equivalent to an average quarter in 2001, multifamily originations in 2014 came in at 152 in the first quarter, 201 in the second, 264 in the third and 375 in the fourth quarter. The volume in the fourth quarter represented a 42 percent year-over-gain.
As of the end of 2014, the MBA reported $964.0 billion in outstanding multifamily debt—a 6.6 increase over 2013. Banks ($34.5 billion) and agencies ($21.6 billion) accounted for the lion’s share of the $60.0 billion rise in volume.
In our research, we found 60 percent of respondents believe that lending activity in the sector will increase. An additional 29 percent expect no change. And 11 percent expect lending activity to decrease.
When it comes to terms, most respondents don’t think lenders are changing their terms. Just more than half of respondents—55 percent—believe loan terms will remain unchanged in the next year. About one-third, 32 percent, believe loan terms will loosen and 13 percent think they will tighten.
There’s some anticipation that loan-to-value (LTV) ratios might move. Overall, 49 percent of respondents expect LTV ratios to remain flat. But about one-third, 34 percent, expect an increase of 1 to 5 percent. And 10 percent of respondents expect an increase of 6 to 10 percent.
But an element that seems more important in today’s environment than either of those factors has been the re-emergence of lengthy interest-only periods. Some lenders are now offering up to five years of interest-only periods on new debt. In fact, the desire for interest-only from borrowers means borrowers often putting more equity into a deal and lower LTV ratios.
“Fannie and Freddie are quoting interest-only periods from anywhere from one to five years on 10-year money, depending on location, sponsor and asset class,” Berkadia’s Whitaker says. “Interest-only surely improves your internal rate of return. That’s been a primary factor in why cap rates are so low. The debt cost is below 4 percent during the interest-only period. If you have a cap rate that’s in the 5s, you’re still getting a decent cash-on-cash return.”
Keeping LTV ratios in check is also a sign that lenders are seeking to avoid repeating some of the mistakes that occurred in the run-up to the last recession.
“Everyone has muscle memory of the downturn,” ARA’s Okland says: “That was generally a lender-driven problem. We weren’t tying the credit quality of the borrower and the asset as much as we should have. … Today, generally speaking, we’re not seeing structures of 95 percent loan to purchase price or loan to cost. And it will remain that way.”
Still the one?
Respondents rank multifamily as the most attractive property type. On a scale of 1 to 10, multifamily comes in at 7.8. Industrial follows at 6.8. Hotels rank third at 6.4. Office (6.1) and retail (6.0) come next. The rankings were similar to last year’s results. Then, multifamily came in at 8.0 followed by industrial (6.7), hotels (6.5), retail (6.0) and offices (5.8).
“Over the past few years, it has been the most robust in terms of returns and appreciation, and this should continue,” Yardi’s Sorenson says. “Multifamily is typically poised to weather an economic downturn better than the other sectors.” n
The research on the multifamily real estate sector was completed via online surveys distributed to readers of National Real Estate Investor in March and April. The survey yielded 313 respondents, of which 255 operate in the multifamily sector. Recipients were asked what regions they operated in (and were allowed to select multiple regions). Overall, 42 percent said they operated in the South, followed by the East (42 percent), West (37 percent) and Midwest (36 percent). Approximately half of respondents are investors and developers and about 20 percent are brokers.