Long a darling of the commercial real estate industry, the rental housing market is showing warning signs, as slowing rent growth and demand, higher interest rates, and greater operational expenses test multifamily owners and developers.
The U.S. apartment market absorbed 90,827 units in the third quarter, according to RealPage Inc. While that’s an improvement from the negative absorption seen throughout 2022, the approximately 1 million apartments under construction nationally as of the third quarter is still outpacing demand and tempering rent growth in many markets.
As of the third quarter, rents nationally were up about 2% year-to-date, RealPage found, though the data-analytics firm predicts the year-end 2023 figure could come in below that amount.
That, on top of underwriting loan standards written during a different economy and multifamily market, will create financial headwinds for some owners in the coming quarters and years, especially for deals financed in the past two years with floating-rate debt. It’s likely to cause more lenders to pull back from the multifamily sector.
Stephen Buschbom, research director at Trepp Inc., during a webinar this week said the story around multifamily isn’t necessarily a straightforward one, but there’s increasing evidence of a disconnect between a property’s stabilization expectations at underwriting versus the reality now. That’s especially true of loans that originated after October 2021.
“If you entered the game later and you [had] a bias toward what rent growth will be [from] the past year or so, and that ends up in underwriting, you’re likely to underperform relative to what you thought you would get,” he said.
After the initial shutdowns and slowdown from the Covid-19 pandemic in early 2020, the multifamily market had a strong rebound in 2021 and into 2022. Low interest rates and high demand for apartments, not to mention what was frequently record rent growth, created a flurry of sales activity, with $335.3 billion in multifamily transactions completed nationally in 2021, according to CBRE Group Inc. By comparison, only about $29 billion in multifamily deals were completed in the third quarter of this year, CBRE found.
There is no evidence of widespread distress in multifamily yet, but the number of loans facing potential issues is rising. In October, the multifamily delinquency rate rose to 2.64%, up from 1.85% the month prior, according to Trepp.
Among the multifamily loans that have faced default recently, most are modifying terms, Buschbom said, a tactic he thinks more lenders will take as more multifamily loans face issues in the coming quarters and years.
“In many cases, they’re waiving or pretty dramatically altering the debt yield requirement,” he said.
By Trepp’s estimates, there’s been some $150 billion in commercial real estate collateralized loan obligation issuance, some 70% to 80% of which has gone to multifamily property types. While a short-term, floating-rate loan product, Buschbom said CLOs provide the ability to modify loans in ways that aren’t possible in, for example, commercial mortgage-backed securities pools, he said.
“There’s much more leeway to work with cash-strapped borrowers,” he said. “I’m hopeful we’ll see the modifications and flexibility ultimately pay off, and defaults and losses come in lower than what we would have thought … [but] it’s too early to tell.”
All eyes are on what the Federal Reserve will do with interest rates in 2024. It’s predicted by some economists and market watchers the Fed will move to lower interest rates next year, potentially at its May meeting. A recent Bankrate survey found 94% of economists believe the Fed could begin cutting interest rates next year.
One ripple effect if a rate cut were to happen could be that more households get off the sidelines — into owner-occupied housing and out of the rental market, Buschbom said.
“[That] could be detrimental to many of the assumptions of these [multifamily] loans,” he said, adding the nation’s housing-affordability issues have led many to believe rental demand will remain sticky in the short to medium term, therefore warranting higher rent increases baked into loan underwriting. “If that breaks because we have pent-up owner-occupied demand … that could really turn the business plan or underwriting assumptions on their head and prove very painful.”