Getting Back to Basics: The Multifamily Reckoning

As a multifamily investment sales broker, I’ve seen firsthand how hot the multifamily market has gotten over the past few years. Driven by an emerging asset class, relaxed investor thresholds and historically low interest rates, investors flocked to what’s been called the “darling” of commercial real estate.

Covid-19 added fuel to the fire, where we saw complete disregard for the fundamentals of investing. Many investors did anything and everything to compete against an ever-competitive buyer pool. Now, with the highest interest rates seen in years, many investors are struggling to stay afloat on assets they overpaid for, and buyers are being more conservative, getting back to basics. Here’s a look back on how we got here.

Post-2008

Following the 2008 great financial crisis (GFC), multifamily assets were often looked at as safe alternative investments, with demand driven even further from low interest rates and an expanding buyer pool.

In the GFC, the U.S. housing market experienced significant turmoil, with a wave of foreclosures and a drop in home values. As the economy recovered, multifamily housing emerged as a resilient and attractive investment option. In time, multifamily investments were seen as relatively recession-resistant, as people always need a place to live, regardless of economic conditions.

From 2008 to 2019, interest rates were already historically low. The 10-Year Treasury yield, often an interest rate indicator for Fannie Mae and Freddie Mac multifamily borrowing rates, came down coming out of the GFC. These lower rates made it more affordable for investors to finance multifamily properties, increasing the potential for attractive returns.

In 2012, the JOBS Act also opened the investor pool, allowing syndicators to advertise to the greater public and, for the first time, allowing for crowdfunding. This expanding buyer pool placed even more buy-side pressure on the asset class.

With more competition, “value-add” became the name of the game. I noticed investors increasingly looked for properties that offered an opportunity to increase cash flow through renovations, rebranding and better management. Properties were pitched with having tons of upside, whether proven or not (e.g., car port fees, pet fees, washer/dryer fees and, of course, unit renovation premiums). It was during this time that many new players in the industry made their first killing in the cycle.

Covid-19

Investors often seek safer investments during times of uncertainty. With everyone staying home, office and retail investments were at a standstill. At the same time, central banks, including the Federal Reserve, implemented accommodative monetary policies to stimulate recovery. The result was a perfect storm of higher rents from inflation, coupled with the extremely low interest rates. By the spring of 2020, the 10-Year Treasury yield fell below 1%, with some multifamily debt close to 2% at its low point.

The increased demand in multifamily and low interest rate environment caused multifamily cap rates to compress at astonishing rates. In our markets, I saw cap rates go from the 6% to 3% range within the course of two years.

All of this led to the most relaxed underwriting standards I’ve ever seen. Many buyers were keeping their terminal cap rates (the cap rate in which they expect to sell the property for upon their exit) flat, or even compressed futher. Buyers also assumed double-digit rent growth year over year, with the help of inflation and government handouts. All the while, government stimulus money helped to keep delinquencies low depending on asset class.

All of this led buyers to go into assets with negative leverage, meaning the income producing yield was less than the cost of financing. So many were simply counting on the fact that rates would stay relatively low while their income would go up until reaching positive leverage territory.

Fed’s Push To Tame Inflation

In March 2022, the Fed enacted the first of many interest rate increases. Stimulus money was beginning to cool down, and so was investor sentiment. Suddenly positive leverage on day one became more important. No longer are buyers willing to gamble as much with interest rates and pro-forma assumptions. Rents are no longer being underwritten with the extreme rent growth we’ve seen. And I’ve noticed there’s less appetite for “value-add.”

By October 2023, the 10-Year Treasury hit a 16-year high of 4.8%, with multifamily interest rates in the 6%-7% range. At the time of writing this, treasuries are on the decline, albeit still higher from what we were seeing just two years ago. With buyers taking on less risk, cap rates have increased and transaction volume has plummeted.

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