Why Multifamily Is the Next Stress Point in Commercial Real Estate
When it comes to commercial real estate, a lot of attention is obviously paid to offices. But it's not the only sector facing strains. Apartment buildings — or multifamily residential — may also be in for trouble. For years, rates were falling and rents were rising, and owning and operating apartments was a moneymaker. Then things went into overdrive with the pandemic, thanks to plunging rates, surging rents and an explosion in new household formation. But all of that is reversing. Rates have surged. Insurance costs have surged. Operating costs have surged. The household formation boom didn't last. And in some areas of the country — particular in some Sun Belt markets — rents are actually falling. On this episode, we speak with Lee Everett, vice president of research and strategy at Waterton, on how a multi-family deal binge in 2021 will result in a huge hangover. This transcript has been lightly edited for clarity.
Key insights from the pod:
The multi-billion dollar boom in multifamily — 5:48
Work-from-home migration and multifamily - 7:3
CMBS, CLOs and the financing of multfamily — 9:10
How do cap rates work? — 10:48
The looming maturity wall for multifamily — 12:11
Why rents aren’t covering higher interest costs — 14:10
The math behind the multifamily boom — 17:09
Who are the bagholders in multifamily? — 20:24
How is multifamily marked to market? — 21:13
What triggers losses on multifamily investments? — 22:58
Growth in supply of multifamily housing — 25:17
Can multi-family be converted to single-family? — 27:38
Distressed opportunities in multifamily — 29:17
Joe Weisenthal (00:09):
Hello and welcome to another episode of the Odd Lots podcast. I'm Joe Weisenthal.
Tracy Alloway (00:14):
And I'm Tracy Alloway.
Tracy, when it comes to real estate troubles, one surprising thing is, I guess, how strong the housing market has remained this year, despite the rate increases. When people talk about troubles in the real estate industry though, mostly the conversation has been on commercial real estate.
Yes, and actually a specific segment of commercial real estate. So for obvious reasons, everyone has been very focused on what's happening to office properties, the whole work from home trend means there's less demand for offices, ostensibly, meanwhile, higher interest rates are increasing expenses. And so that has been the predominant area of attention.
But of course, there's also the forgotten — I call it the forgotten — commercial real estate, which is actually multifamily residential, which counts as commercial real estate technically.
Totally, and we talk about residential, and we often talk about it in terms of just single family homes and what's happening to home prices specifically. And of course, that's a huge part of the real estate industry and where people live.
We talked about this in September, I think it was with Julia Coronado. One other big thing that's happened over the last several years is just this incredible boom in apartment buildings, multifamily dwellings, particularly across the Sun Belt.
I remember this. Sort of 2020, 2021 there's just staggering amounts of construction of multifamily properties that were intended, I think, primarily to be rented out in super popular areas of the country like Texas or Arizona, places like that.
And of course, since then, my understanding is that we've obviously seen an increase in interest rates. We've also seen, or started to see, a decline in rents. And so your cost of financing is going up while your income from rentals is actually going down. That seems like a bad combination.
So a big question is who are, I guess, the bag holders or how heavy is that bag? Because presumably, no one anticipated this surge in financing costs. No one really anticipated the surge in inflation construction costs. And rent growth had been one of those things that just went up and up. It went wild during 2020, 2021, 2022, one of the most dominant drivers of inflation overall. But supply and demand seems to be a real thing and it seems as though, with this incredible boom in supply, that we actually have seen some softening in rents.
This is where we have to caveat that we never actually see the softening in rents. None of us will ever have rents cut, but in theory….
It's a mythical unicorn. Like, I have heard that rents go down. I have yet to experience it. Actually, I just got my new lease agreement offer.
I'll just say it's gone up, Joe.
Let's put it this way, charts exist on the internet that show the line going down the other direction. Whether those charts are actually reflective of anyone's reality, that's a separate question. But I have seen charts that, at least in some cities, again, probably more Sun Belt boom cities — Austin, Nashville, Atlanta — that rent prices have gone down. I've seen the charts.
I too have seen charts but let's keep going.
Well, so then the question is what is really happening in reality? And we’ve sort of got to get a temperature check on, okay, if rents are going down unexpectedly, supposedly, if all these things have caught the industry by surprise, how big is that bag? Who's holding it and how much trouble could it be in? And I think we have to have this conversation because again, so much of the discourse has been about office.
It's all offices, all the time. So now we turn to the forgotten corner of commercial real estate.
Well, I'm very excited we have the perfect guest to discuss it. Someone with a lot of experience in the multifamily world. We are going to be speaking to Lee Everett, head of research and strategy at Waterton. It's a multifamily investment manager. It's been around since 1996. So Lee, thank you so much for coming into the studio and coming on Odd Lots.
Lee Everett (04:45):
Thank you very much. It's a pleasure to be here.
Who are you and what is Waterton? And I just asked that at the beginning because I figured listeners might want to know why we're talking to you.
My name's Lee Everett, as you stated. I've been in the industry now for roughly 20 years, the entire time focused on the residential sector and I've touched everything from senior living to multi- to single-family. Primarily I've spent that time advising internally or externally as a consultant, c-level executives on the multifamily sector.
Today I head up research at Waterton, that's a multifamily investment advisor with about 15 billion AUM (*Editor’s note: Our guest misspoke. Waterton has $10.4 billion in real estate assets under management). Today we operate in the top 30 markets in the US. We're primarily a value add shop, so we're buying, improving, selling homes. Our funds are primarily closed end funds, so it's a controlled hold period and a controlled time
You mentioned research and you also mentioned that you were a consultant. What are the kind of things that you're hearing in the market right now?
I think it's dark days in general for a lot of the market right now and it's primarily been driven by a capital markets event that we've never experienced in this industry. I tend to think that we are going to end up seeing the ‘21 and ‘22 vintage, which was the largest transaction volume years on record for multifamily by huge amounts, end up one of the worst vintages in the history of our industry. In 2021, in the fourth quarter alone, over $150 billion in apartments transacted.
Wait, sorry, which quarter in 2021?
It’s Q4 and over the course of the year, over $300, almost $400 billion transacted. To put that in perspective, the previous high in 2019 was under $190 billion for an entire year. So capital came into the space like we've never seen before.
Now this capital entrance, it was primarily driven by two things. The rent growth that you both have alluded to earlier. What we saw that year was over 700,000 renter households form in the US, that is over two and a half times the prior record. And as such, we ended up with rent growth that pushed over 15%. Some markets — Phoenix, other Sun Belt markets — you saw rent growth on new lease turns coming over 20 and 30% pretty consistently. And what was really crazy about this was there was a massive spike in renter incomes. So these rents were relatively affordable as incomes were actually rising quicker than rents at this period.
Was that driven by people moving into the area and maybe doing more work from home and bringing higher salaries with them?
In many instances, yes. That's what would primarily drive the large renter income increases in, say, Las Vegas where you're getting some LA people that may not have been as wealthy there, coming into a market where your median income is like $60,000, $80,000s — a lot wealthier relative to the median in Las Vegas.
It also was driven by frankly a lot of household fractionalization that was pent up demand. You had people losing roommates, you had people moving out of their mom's house that had been there for a long period of time. I mean, being frank in 2021, we had working age population losses as a country while we were generating all of these households.
So the explosion in the labor force allowed people to form households both as Millennials that hadn't, and this filled a lot of the suburban product, the single family rental product and such. Gen Z back filled the city at an incredible rate. This wasn't like the Millennials coming out of the GFC where everybody had three and four roommates. Gen Z was living with one, maybe two roommates at the most and a ton of them were able to live alone in our major cities. That just drove demand that we'd never seen.
Real quickly, say the numbers again for 2021, what was the total for that year?
The total transaction volume? It was between $350 and $400 billion.
And the previous high in 2019 was $190?
It was around $190.
And when you say vintage, that's very specific, or I think of it as a specific term related to CMBS. So commercial mortgage-backed securities. So is the suggestion that the financing for these multi-family properties was bundled and sold off as bonds?
It was bundled, but primarily as CLOs, which I think we're going to need to get into, because that's sort of the other side of the coin here. At the same time we had this vintage first off, what I mean by that is deals that traded in that year or were purchased in that year, and you had basically a half a trillion dollars trade between the beginning of ‘21 and the middle of ‘22.
That vintage is everything that traded over that period and while you had these soaring fundamentals I spoke about, at the same time SOFR was zero, the 10-year was zero to one. So financing was so easily available. You had people enter the space that had never been in the space before. They were projecting massive revenue growth and they were project able to buy at very low yields because of the low financing costs.
Now what were those low yields? Cap rates in the space got down to say in Phoenix for 1970s and ‘80s vintage product that wasn't ideally located, you were looking at a three and a half percent cap rate.
Can you just remind me of cap rates, from what I remember...
It’s like the inverse of PE, right?
So maybe this has changed, but from what I remember, like less than 5% was considered pretty good, not that risky. And like more than 7% is kind of bad. Is that right?
You're backwards, so the higher the cap rate, the higher your income to price ratio is. So it's NOI over price and the less NOI you have over price, essentially the more risk you're taking on in the deal because you're relying far more on value to be driven by price growth rather than NOI growth.
When you're buying at say a three and a half cap a not ideally located property, you're very much relying on that income to price ratio staying the same or declining, especially if you're doing so with interest rates that are around 2%, which is what you were looking at at that period in time for short-term floating rate debt, which is what really flooded the space and this is what's become, what fed these CLOs that have grown.
[I have] a million questions already, but why don't we actually, just since you said we talked about the financing structure, short-term floating rate debt. So Tracy and I have done a number of episodes on credit and the looming maturity wall for corporations — Tracy insists I say ‘looming,’ but in the case of this, this has to be refinanced very quickly. Like talk about the sort of, someone does a deal. What are the terms, how far, when do they have to pay it back? How does that work?
So these deals were primarily financed by debt funds and what ended up happening was they were issuing what's called bridge loans. These bridge loans were meant for people who entered the space to be able to buy a property with floating rate high leverage. By high leverage, I'm talking 75% to 80%, sometimes even higher.
Now when you're buying floating rate at a 225 interest rate handle with 80% leverage, your returns look really good until that floating rate debt starts to move upward. And what we've seen today is a 500 basis point increase in SOFR since that debt were done. So you're looking at 5% higher interest rates, the fundamentals that were there in ‘21 are no longer there so you have declining NOI and as such, what you've seen is these bridge loans that need to be refinanced in ‘23, ‘24 and somewhat in ‘25, they don't pencil anymore.
You were essentially, to get this debt writing to a debt service coverage ratio in ‘21 of about 1.25 and that's how much your income can cover your debt. Today, because of increase in debt costs, decreases in net operating income and increases in other expenditures such as insurance — some of these buildings are looking at a debt service coverage ratio below seven and that's very common and means these buildings can't pay their debt.
This is a mounting wall, I think in’ 24 we're looking at about $34 billion in CLOs that are going to need to be refinanced. Another $12 i[billion] n ‘25 and we've got another seven to nine to get through this year.
Wasn't the original pitch? Okay so sure these are financed with floating rate loans. So if interest rates go up, the cost of that financing is going to go up and put stress on the property itself. But wasn't it supposed to be able to raise rents to offset that?
Yes and some properties did, many did. But ultimately, people started to project rent growth to continue for longer than was rational. As I sort of described earlier, we had this household formation explosion in 2021, but ultimately what that was was it pulled some demand forward from 2022 and the massive apartment supply wave began to come to market in ‘21.
And then on top of that, even if you raise rents today, insurance costs have gone up in such a way that it's deeply, deeply impacting the market. You're looking at renewals right now costing 30% to 50% additional every year. I've heard quotes of 3,000 a unit to insure in Florida right now, over a thousand in Texas.
So you have massive increases on the cost side, massive debt increases that were never underwritten for and rent growth that you achieved some of, but you're not going to achieve in the longer term. Particularly with the nature of this product, a lot of it in markets like Phoenix was bought by syndicators, new people to the space, social media sensations, fundraising on LinkedIn, and people such as that.
This is like real estate TikTok.
Tracy, I was going to say, it's been one of our recurring jokes over the years on the podcast, like, what if we get into trucking? What if we get into this? It sounds like a bunch of people took that joke literally and said ‘What if we get into X?’
What if we became landlords?
What if we became multifamily landlords in Phoenix.
Can I just say right now, I have no desire to do that ever.
I don't either.
I don't think these people really had that desire either. Their ultimate goal was to flip these apartment buildings. They wanted to buy them, renovate them, use the bridge loan to get through that period and then sell it to someone that would then use agency Fannie or Freddie financing to hold the building long term.
And whoever they sold to, they planned on being the true operator. Now a lot of these people that have no operating experience and entered the space are stuck being landlords and they really aren't necessarily sure how to do that. So that's also hurting the revenue side. You have to have economies of scale, experience, vertical integration and such in order to be a landlord. And those structures don't exist in a lot of this new capital that entered our space.
We're talking about all the various calculations that go into underwriting one of these things. So insurance cost, the cost of the actual money to build or buy the property, expected rental income, things like that. How do people normally make those estimates? Or, like what kind of data do they use to make presumably, again, in normal times like a rational forecast for what all those moving parts might look like. And then I guess to your point about the oddity of 2021, 2022, what were they looking at then?
So first off, I think there was a lot of faith in the sector in lower for longer, too much faith, frankly, I'd believe. And now if you believe in a soft landing and higher for longer, that's a very painful transition. And the reason that's such a painful transition is cap rates or your yields historically have had a 200 basis point spread to the 10-year.
So normally the risk-free rate should be at a discount to a real estate rate. And that held when SOFR was zero and you were buying at a three and a half cap rate. Today, in order to buy with a 10-year even at four three as it is today, historically that would tell you your going in cap rate should be a six three and your exit cap rate should be even higher than that in order to be conservative.
Those metrics really don't work for what was bought in that vintage. But today you want to go into A, not have negative leverage, so you need to be able to afford your debt, that's where that 200 basis point spread comes into play. You want to be conservative based upon long-term history, supply-demand balance, population growth and all that and you want to look at that as you get into rent growth.
Expense growth has become much harder to peg so you want to be as conservative as possible there. And a lot of the longtime players understood this and were frankly priced out of a lot of deals over ‘21 and ‘22 because of this. Now what also happened back then was when you have 20% rent growth, people just plan on raising rents for 5% a year every year after they mark to market to that 20%.
I think it was a lot of looking at recent history instead of long-term history. There was a lot of denial about interest rates that today we take into account in every underwriting model and frankly again, the more experienced players were, but the newer capital didn't really understand that at the time.
So the relationships of spread, population growth, and supply-demand were all just distorted and they've come a lot clearer now. But even today, as you model that, people don't want to feel the pain on the sales side. So you have a massive bid-ask spread still in the market today. That's why transaction volume, I gave those huge numbers before, last quarter transaction volume was only $30 billion, which is almost as low as it was at the bottom of the pandemic.
What happens when inexperienced operators are stuck holding the bag and have to be landlords?
Well, if they can't afford the property, they give the keys back and that's where a lot of, I think, pain is going to be felt in this sector. There's a lot of debt fund CLO issuances out there and if the debt service coverage ratios don't pencil today, they aren't going to pencil any better tomorrow barring a major recession resetting rates, which ironically would be probably the bailout for the sector at this point in time.
In your view, I mean, because the downside of recession is job loss and people not being able to pay the rent, but in your view, the greater stress is actually on the financing side rather than the rental income side?
Absolutely and I think these debt funds are going to end up holding the bag. One of the largest ones out there, I think I saw issued $14 billion in debt over that period I'm discussing. Today, the book value on that's already in the low nines and that's not using the most true current market data and some of the more sort of down projections you're seeing because rent losses are occurring in some places such as Austin and places such as that. And those sort of losses are just going to continue to grow over the next couple years as the supply works its way through the system.
This is what I wanted to ask, actually. You mentioned mark-to-market earlier. How often are these loans marked to market and again, like what are the sort of numbers that are going to feed into that?
So initially when I was talking mark-to-market that was on the rent side, and that's something that doesn't happen that often, but everybody was buying buildings in ‘21 and essentially assuming they could immediately raise the rents by 20% marking them to market.
Now on the debt side, they aren't marked-to-market nearly as quickly as you'd like. Even on the valuation side, I think your cap rates are moving upward way more slowly than you'd expect. On the bank side there's a lot of mark-to-market left to happen and I guess the roundabout way of answering your question is it's happening, but not nearly quickly enough.
On the debt fund side it's going to mostly happen as these workouts happen, as these refinancings happen and as this debt comes due in this wall of maturities and the wall of maturities is real on this short term debt, they're going to be able to extend somewhat. But these people that couldn't afford interest rate caps that didn't have the reserves for it, that that debt's going to mature and it's going to hurt.
What's the catalyst for a lot of these to take losses? Is it like, eventually they have to mark-to-market, although I'm still unclear what the trigger is for having to do that. Or eventually they have to refinance and maybe they can't get the financing? Is that the thing that starts sparking losses because otherwise, as we've seen for the past year or so, it feels like they could just sort of string it out for a very long time.
So the issue with stringing it out becomes how bad the debt service coverage ratios are today, so you have to have a really motivated lender. These lenders have so much debt out in the space today [that] it's going to be difficult to do this for everyone. One of the larger syndicators that got themselves in trouble in the Phoenix area has done around $650 million in workouts over the last year and a half.
Wow. In workouts, so like [just] taking care of troubled loans.
Yes, and that's where you're going to mark-to-market these things as the loans get worked out, as they get refinanced, as they get brought back. And the trigger is either people not being able to pay their debt service, which is happening.
I've been in New York for the week and seeing friends in the industry and these are friends that work on the lender side and they're getting keys given back to them all over the country already. So this is something that's starting to happen. Another friend just mentioned a deal he just bought in New York for less than the construction loan. So there's pain and we're starting to see it.
People are calling us that haven't been able to finish developments because the equity partner pulled out and they're offering chances to get in low and every bid that we place today is frankly low. And that's because we believe the market has more pain as this mark-to-market happens.
But the events haven't fully cascaded because not all of the loans have been dealt with. And the other thing people like to do is extend and pretend in our sector, but I don't think that's going to be as viable going forward because it's really hard to extend and pretend if your debt service coverage ratio is up 0.6.
Talk to us a little bit more about supply specifically. So one thing that's happening is I, maybe perversely, I imagine as supply chains have eased over the last year or so, probably [you’ve] had a lot of projects that were moving slowly that finally finished and opened the doors.
And so you have on the one hand this looming maturity wall over the next few years. And then as you mentioned, more supply hitting the market into a weak market and multifamily construction had a very good decade even going into Covid, is my understanding. And then it just took off in 2021 so talk to us about those dynamics?
There’s been for over the last year more than a million units under construction and if you think about that in terms of the total housing market, you had what? 1.8 million total housing units under construction? So the majority of the housing instruction in our country at this point in time is the multifamily product and between construction backlogs over the pandemic and then the low interest rate environment allowing tons of shovels to get into the ground for development, we just blew out records and we're at levels last seen in the early seventies and we're close to surpassing, if not having surpassed those levels.
So supply is hitting en masse and the way it's hitting is typically in limited sub-markets and limited markets. Downtown Nashville has the majority of all of Nashville's supply and right now you can't throw a baseball there without hitting three cranes, similar to a downtown Austin.
These nodes within these markets are going to be fine in the long term, but this glut of supply is just overwhelming demand in the short term. And this is something we haven't seen for a long period.
Now the flip side is low interest rates where the catalyst for that explosion, the higher interest rate environment, has actually been driving [housing] starts down over the course of the last year. And we've seen a massive slowdown in starts, so as it looks currently through mid ‘25, you're going to continue to have really accelerated deliveries. You're going to continue to have some fundamental challenges, but late ‘25 into ‘26, you should start seeing a lack of supply in the market again. Again, that is without a reset of interest rates.
And then rents can go up, yay. Well, on this note, if owners are handing back the keys to multifamily properties and presumably maybe someone else is buying them, another institutional investor or something like that, could you ever get a situation where a multifamily property is divided up and sold off as single-family units? Like could it become owned by people?
You could convert to condo, it happened I think back in ‘05, ‘06 during that rush, a lot of the challenge is going to be, and I don't want to sort of state this too aggressively, but multi-family construction is typically not going to be at high, as high, of a level as a condo construction. That has to do with supply chains, economies of scale, the design of the units and I don't know that it's as natural a transition as you would think.
Now in the same point, these condos are still going to be really expensive too. So the switch off isn't going to be ideal. But what we are seeing, and we get phone calls for this all the time now, is on the new developments, the senior debt or the construction loan doesn't quite go far enough because they can't get as much leverage as they had expected.
So they're calling other players in the institutional world such as ourselves and looking for mezz financing or preferred equity to fill a piece of the debt stack to get them over that hump. And that debt is highly accretive in terms of how it's pricing right now because of the demand, but also because of some of the risk for the new supply. So that's been a big change in the space is this sort of aggressive appetite to plug the financing gap with preferred equity.
Is there a brewing sort of industry of opportunistic distressed investors who are getting capital together to take advantage of some of this pain that you're seeing?
We have been fundraising. We are sitting on the sidelines and I think it's fair to say there's blood in the water and the sharks are waiting to swim at this point. There's going to be opportunities through this pain that I don't think the sector's seen since the great recession in terms of opportunities for true discounted and distressed purchases.
You're seeing lenders already calling other players where people can't make the debt service coverage and being like, can you come in, will you come in at a discount? We'll give you X off par if you come in and can buy us and just bail us out of this bad situation. So there's 100% going to be a lot of the more established institutions trying as hard as they can to take advantage of this market disruption.
Lee Everett, that was great. It's very jarring and when you discuss the raw math of it — of rates going up, rent's not penciling, household formation, nothing like it was in 2021 inward migration, nothing like it was in 2021, all this sort of TikTok or podcast realtors, insurance costs.
That's something that we talked about with the Howard Hughes CEO as well, which is just sort of this wild dynamic. I could see why more pain is on the way. So thank you so much for coming on Odd Lots.
Tracy, I'm really glad we had that conversation. We don't really say ‘perfect storm’ as much as we used to when we used to talk about supply chain.
No, but we just did on the wind energy episode.
We're bringing it back.
This one really does seem like a perfect storm of just all kinds of different things going on.
Absolutely. And I do think — funny isn't the right word — but it is intriguing the degree to which people saw the post-pandemic period, which I think any reasonable person would've thought there are weird things happening right now. Like, you have this huge migration, interest rates are super low because we've just had an emergency, basically the economy just shut down. And yet it seems like some [people] extrapolated that very short and traumatic period of developments to, like, it's going to keep going for the next five years.
This is actually something that's striking to me is how we see this from industry to industry to industry. Everyone sort of fell into this to some extent. I mean, you certainly saw it in tech for example, with all of the ‘Oh, it's all e-commerce now and everything is going to be shopping online.’
Eventually those trends basically reverted to trend. Or Netflix shooting up and then people realizing actually it's going to go back to roughly the old trend, which is an upline and it might be an upline in multifamily too, but it got so far deviated. But it is weird. I mean, like, you figure there is not going to be multiple migration waves from San Francisco to Las Vegas. You sort of knew that had to be a one-off almost by definition and yet you get the impression that people saw the lines going up and they wanted to play.
I'm still amazed, I mean Lee mentioned this, but like the amount of construction in Austin that's still going on. And if you think that like in 2021 it would've been even more, I can't imagine, they really were booming. Those Sun Belt towns
People with a Bloomberg, or I guess Fred too, just pull up that US Multifamily Unit Started For Rent [chart] and you see it trending up very clearly from December, 2009 to 2020. And then it just shot up, it exploded in 2021 and ‘22 to levels that we really haven't seen in about 35 years or something. It's pretty striking. It all came together well and I thought Lee did a great job of putting it all together.
Absolutely, and it is going to be interesting to see how much of these deals get worked out now. I couldn't believe that one number from just one institutional entity, like $650 million in workouts. That's crazy.
And the fact that keys are already being sent back is really interesting. I mean, we talk about this but the ‘loom’ is here and the bigger wall may still be coming, but obviously for some players it's already hit.
The nature of the maturity wall is that it's always looming. Even when it's here, it's still looming. Alright. Shall we leave it there?
Let’s leave it there.
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