Multifamily: A shelter from the commercial real estate storm

Commercial real estate (CRE) is navigating a figurative storm, triggered by higher interest rates, falling property valuations, and severe issues in the office sector. Despite this difficult backdrop, there are areas we believe investors may find opportunity. We view multifamily debt as a very promising sector of CRE, offering the best credit quality and potential for steady risk-adjusted returns. 

Historically, Class A and B multifamily buildings have been recession-resilient, and the sector has provided a good hedge against inflation as rents tend to reset annually¹. Regardless of economic conditions, multifamily maintains relatively stable demand. People always need somewhere to live. We believe multifamily will be the CRE sector that will likely recover the fastest from whatever damage it has suffered in recent years.

Turning to renting and away from owning

Macro headwinds often increase the demand for multifamily. For example, today’s sharply climbing mortgage rates have doubled or tripled the cost of homeownership over the last two years. This, in conjunction with an undersupply of single-family homes (Exhibit 1), is pushing the market towards rental properties.

Liquidity

Another compelling reason to invest in multifamily properties is their liquidity. In an otherwise illiquid asset class, multifamily stands out because it can almost always be sold within 90 days or less, even though pricing may vary. This liquidity is largely driven by Fannie Mae and Freddie Mac, the federally backed mortgage companies that provide debt to the industry. Indeed, even in times of significant credit dislocation (the GFC for example), the government has yet to stop lending in the sector.

Temporary headwinds

Given the industry dislocation, multifamily is not without its near-term challenges. Nonetheless, we believe it is still the best positioned CRE sector today. We view any issues with multi-family as balance sheet issues, versus fundamental asset issues we see with office.

Multifamily valuations are down in the current environment, but these dislocations should provide an excellent entry point. We see properties are largely leased, and tenants are paying rent. The issue is that these properties were bought at higher valuations, back when money was cheap and before the Fed responded to inflation. Those valuations don’t exist today.

Multifamily as an asset class is still sound, and the lending thesis still strong. For example, assume today’s valuations are down 25% from peak, and we are making a 65% LTV multifamily loan on that reset value. Incurring a loss on that position, assuming initial valuations, would require a 50% decline in asset value. The probability of that happening is very low.

Excess supply in select markets represents another headwind for multifamily. This is resulting in some slowing of rent growth as well. We also view this as a short-term issue. When rates were cheap in 2021 a lot of shovels went into the ground. By 2022, when rates popped, construction activity ground to a halt; it has not returned. From our perspective, it is a matter of skating to where the puck is going, not where it’s been. Yes, an excess of supply comes on the market over the next 12 months (Exhibit 2), After that there is a cliff.

No one will secure a loan, and construction will likely halt—maybe for two or three years. This pause will help unwind any excess capacity in the market. By the time we reach 2028 or 2029 and review the weighted average supply of the past 5-years, it will appear as a normal period.

We also anticipate increased demand in the Sunbelt region. Migration patterns in the United States—folks moving away from high-tax, high-cost-of-living areas, such as California, New York and Illinois, to more affordable, low- or no-income tax states—will likely continue. In 2022, six of the 10 fastest-growing counties in the U.S. were in Texas, while the others were in the Phoenix area and Florida. The story was much the same in big cities, as populations in New York, Los Angeles and Chicago declined; while Dallas, Houston, Orlando and Atlanta continued to expand.

A storm may be roiling the CRE market, but we believe multifamily is well-positioned to weather the storm—and eventually prosper. For those managers with dry powder, low leverage and limited office exposure the opportunity set is vast—the best we have seen in a decade or more. Market dislocations, after all, create opportunities to invest low and separate yourself from the pack.