Publications

- November 1, 2022: Vol. 9, Number 10

5 Questions: Multifamily landscape is changing as capital markets slow

by Mike Consol with Matt Frazier

For years running, multifamily has been unofficially deemed the Property Type of the Year (with apologies to the industrial sector). It has seemed nothing could break the stride of multifamily projects — until recently. Suddenly, there is a drag on the property type for reasons that Matt Frazier, founder and CEO of Jones Street Investment Partners, is well acquainted with.

What are the forces causing multifamily housing sales to slow?

In short, the Federal Reserve. Multifamily fundamentals have been strong, but the rapidity of the Federal Reserve’s rate increases has created broad uncertainty, including within multifamily capital markets. The cost of debt capital has nearly doubled since the beginning of the year, and asset values have become more difficult to identify. Thus, transactions have slowed, and they will likely remain suppressed until there is clarity regarding the Federal Reserve’s endpoint. Additionally, investors considering opportunities beyond multifamily are identifying distressed opportunities elsewhere, including in the public markets, and are awaiting the right time to re-engage.

Put in perspective the ramifications of higher interest rates while developers are aiming to build more stock to alleviate the U.S. housing shortage?

Higher interest rates are going to be a negative force on housing production in the short term, paradoxical and counterproductive when considering that a currently undersupplied housing market is a primary driver of inflation. Inflationary pressures already pushed input costs on new construction higher; however, much of that increase was offset by higher rental rates and operating income, meaning new development still provided an attractive economic return. Rising rates will lead to a greater cost of both debt and equity capital, raising investment return hurdles and limiting the amount of new supply that can deliver. That may be further worsened by a recession, which may cause rental rates to slip and vacancy to rise, creating a double whammy of higher costs of construction and flat (or lower) income.

Are banks and other lenders still underwriting multifamily projects? If not, what’s the issue?

To date, local and regional banks have remained more active than larger institutions, at least with development financing. Smaller banks have been more attuned to local market fundamentals, and since those fundamentals have been strong, those banks have remained present in their markets. Larger banking institutions have been less active, presumably due to macroeconomic concerns and greater regulatory pressures.

That said, stabilized multifamily enjoys more debt capital liquidity than other real estate sectors because of the presence of Fannie Mae and Freddie Mac. Their backstop creates more liquidity in the multifamily sector than exists in other property types. Multifamily debt markets are challenging right now, given interest rate uncertainty, but they are still more liquid on a relative basis.

Does this situation vary by geography?

I can only speak to the geographies in which we are active, which is the Northeast and mid-Atlantic regions, where local and regional banking institutions have remained active. Fannie Mae and Freddie Mac remain engaged in all geographies. More broadly, we do think there may be some separation in transaction volume across different regions. More volatile markets in the Southeast and Southwest may see activity slow, as those markets have not only been priced more aggressively, but they are also more prone to changes in operating fundamentals. Much of the investment interest in those areas has been predicated on high growth, and if that growth slows in a recessionary environment, capital flow may slow as well.

What strategies are available to multifamily investors and developers to manage the current situation?

Now is when investment sponsors are able to distinguish themselves. The importance of stable capital structures on existing investment portfolios will be self-evident, as those who previously took capital risk through short-term debt or equity arrangements run the risk of capital calls or forced exits. That may create opportunities for more stable investment sponsors and operators.

Additionally, a current — or coming — recession will highlight the importance of operating expertise, perhaps even more so than did pandemic lockdowns, as those were in many ways offset by government stimulus. The best way through the present uncertainty is to focus on fundamentals.

Finally, capital allocators will be able to distinguish strong sponsors and operators in this environment. A lot of institutional investors will be out of the market for some period because of their structural restraints. More creative capital allocators can use this time to back strong sponsors to find opportunity in dislocated investment environments.

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