CONTRIBUTORS
Richard Byrne
President,
Benefit Street Partners
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.
Home Ownership is Getting More Elusive
Exhibit 1: Monthly House Price Trends by Index
Sources: Standard & Poor’s, Federal Housing Finance Agency, CoreLogic, and HUD.
Note: Monthly house price trends, shown as changes in respective house price indices applied to a common bas price set equal to the median price of an existing home sold in January 2003, as reported by the National Association of REALTORS®. Indices shown: S&P/CoreLogic Case-Shiller 20-metro composite index (NSA), January 2000 = 100, FHFA monthly (purchase-only) index for U.S. (SA), January 1991 = 100, and CoreLogic-Distressed Sales Excluded (Monthly) for U.S. (NSA), January 2000 = 100.
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.
Spike in Multifamily Supply, Then a Cliff
Exhibit 2: Number of Multifamily Deliveries
Source: Costar US Multifamily Report, April 2024. Mortgage Rate source from National Association of Realtors.
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.
WHAT ARE THE RISKS?
Past performance does not guarantee future results. All investments involve risks, including possible loss of principal.
Risks of investing in real estate investments include but are not limited to fluctuations in lease occupancy rates and operating expenses, variations in rental schedules, which in turn may be adversely affected by local, state, national or international economic conditions. Such conditions may be impacted by the supply and demand for real estate properties, zoning laws, rent control laws, real property taxes, the availability and costs of financing, and environmental laws. Furthermore, investments in real estate are also impacted by market disruptions caused by regional concerns, political upheaval, sovereign debt crises, and uninsured losses (generally from catastrophic events such as earthquakes, floods and wars). Investments in real estate related securities, such as asset-backed or mortgage-backed securities are subject to prepayment and extension risks.
Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls. Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the bond’s value. Low-rated, high-yield bonds are subject to greater price volatility, illiquidity and possibility of default.
Equity securities are subject to price fluctuation and possible loss of principal.
An investment in private securities (such as private equity or private credit) or vehicles which invest in them, should be viewed as illiquid and may require a long-term commitment with no certainty of return. The value of and return on such investments will vary due to, among other things, changes in market rates of interest, general economic conditions, economic conditions in particular industries, the condition of financial markets and the financial condition of the issuers of the investments. There also can be no assurance that companies will list their securities on a securities exchange, as such, the lack of an established, liquid secondary market for some investments may have an adverse effect on the market value of those investments and on an investor’s ability to dispose of them at a favorable time or price.
Diversification does not guarantee a profit or protect against a loss.