2024 Arcan Multifamily Market Update

Dear Partners and Friends,

We hope everyone had a terrific holiday season and new year.  We are excited to report that the moment we have been waiting for has finally arrived: the new real estate cycle has begun. While we look at this new cycle with opportunity in mind, there is little question, however, that the industry is going to be dealing with the repercussions of the previous cycle for some time. Today’s landscape is quiet, and transactions remain scarce. It feels as if the entire multifamily market is joining together to mourn the loss of the last cycle, and that certainly seems appropriate. The period between 2010 and 2022 was a great time to invest in apartments. As the industry grieves the loss of the last cycle and anxiously copes with the reckoning required, we think that the 5 Stages of Grief is the most appropriate framework for analyzing the current market.

The first stage of the grieving process is DENIAL and that very much represents 2023. Interest rates climbed and operational challenges appeared broadly for the first time in a decade. Many investors, lenders, and operators buried their heads in the sand to hope for quick rate cuts or some other power to swoop in and save the day. Predictions abounded that the Fed would cut rates or the 10-year yield would somehow drop to near-pandemic era levels. Predictably, that did not happen and now time is running out (and for some, time already has run out). We are starting to see lenders and operators come to terms with troubled deals and recognize that dramatic rate cuts are not on the horizon. Denial also extends to the number of units still under construction. It is Arcan’s belief that many markets are overbuilt, and it will take time to lease up all the units under construction. This often results in increased vacancies and a decrease in rent. Indeed, that is the case today. Rents in Atlanta, for example, are down about 2.7% year-over-year and average vacancy is up to nearly 12%. In Q1 of 2023, more than 38,000 units were under construction in the Atlanta market. That number is closer to 30,000 units today. At current absorption levels (a little over 7,000 units in the last year) it will take about four years to lease the units that will be delivered in the next 24 months. Units under construction will need to drop precipitously to reach the equilibrium required for market rent growth to return in force. That will take time. It also hurts that most of this inventory is high-end class A. When construction costs are high developers are forced to build high-priced high-end units to achieve rents high enough to get an adequate return on your investment. This was very much the case in this cycle.

The challenge faced in 2023 obviously resulted in some ANGER as the Fed held firm in their inflation fight and consistently raised rates during the year. for real estate, working through these increases resulted in deals bleeding cash and shrinking capital accounts. Some lenders and operators are at odds with each other, and investors are squeamish as they are forced to determine (for the first time in a decade) which deals are successes and which are failures. We are also going to find more instances and accusations of fraud and mismanagement. While some bad behavior always exists, it is substantially less visible when everyone is making money.

Now that we are starting 2024, we have reached the BARGAINING stage. Market participants are pleading for the capital, interest rates and buyers required to get out of troubled deals. Most groups have recognized that maturing debt and expiring rate caps are coming due. There is a tremendous amount of capital prepared to buy (Blackstone is reporting $200B in dry powder for investment including a recent $30.4B real estate fund raise). Many buyers are optimistic and why shouldn’t they be? Multifamily fundamentals remain largely strong. The Atlanta market absorbed over 7,000 units in the last year and positive absorption is found in almost every Southeastern market Arcan tracks. The South is growing, and quickly. There are plenty of new residents moving to our markets in search of quality housing just not quite as many as developers had hoped. While some micro markets are in trouble due to an oversupply of new units, others are desperately in need of new affordable housing.

There remains a large bid-ask spread between what most buyers are willing to pay, and sellers are willing to accept. For the first time in almost 10 years, we expect the buyers to win this battle as the clock works against sellers. Refinancing seller’s maturing debt that was originated in the previous cycle’s low-interest rate environment will be expensive and proceeds likely to be lower than the original loan balance. This wave of maturities will force many sellers’ hands.

We expect the sum of these parts to result in a broad multifamily market DEPRESSION at some point in 2024. For some, it is already here. The rapid increase in rates has led to a plummeting number of transactions. Total multifamily investment volume in 2023 in the Atlanta market reached its lowest point since 2013. When you consider valuations have roughly doubled in that time frame, the real transaction volume is even lower. There is nothing yet on the horizon that would indicate the pace will increase in 2024. It is our expectation that we will see another slow year of transactions. Having said that, the pending workout of challenging deals and optimistic outlook towards rate reductions do present a light at the end of the tunnel. The big question remaining is: how long does this take? With fresh inflation data from December showing an increase back to the mid 3% range, rate cuts seem even further away.

It is our hope that ACCEPTANCE is closer than it appears, and we can start to get back to a normal market again in 2025. And by normal, we do not mean the post-pandemic boom of 2021-2022. The rent growth and transaction volume seen at a time of unprecedented easing of monetary policy appears to be a total anomaly. Looking back, with rents decreasing in many markets, it seems clear that a portion of the massive rent increases in 2021 and 2022 were not real. Ultimately, we expect rates to continue to be flat or down until such time as the rate increases of the pandemic are more normalized over the long term.

An overwhelming majority of Arcan’s competition is either completely out of the market or VERY selectively investing. What remains to be seen is how long the substantial amount capital raised to acquire assets will sit out waiting for either the right price or more distress. We at Arcan, however, think that there is ample opportunity to buy good deals today. While they may be fewer and farther between, they have started coming across our desk. Once the cycle of grief is completed, we believe that the multifamily market is poised for long-term outperformance.

Navigating the Current Interest Rate Environment in Southeastern U.S. Multifamily Real Estate

Dear Partners and Friends,

We trust this newsletter will find you well. It has been a little while since our last update and, as many of you certainly know, the multifamily market has changed significantly since the spring. Perhaps the single biggest factor affecting the market is the rapid rise in interest rates and this newsletter will delve into the complexities of the current interest rate environment and its ramifications for the multifamily real estate sector in the Southeastern United States. Given the recent trends—namely substantially decreased transaction volume, increasing cap rates, and rising operational stress—we wanted to make sure to update you on current market developments and how they affect our investment strategy as we move toward the end of the year and into 2024.

Interest Rates and The Southeastern U.S. Real Estate Landscape

Since the middle of 2022, The Federal Reserve has been walking a tightrope between curbing inflation and sustaining economic growth. Thus far, they have performed very well in what is a very tough task. While inflation is not yet tamed, The Fed’s aggressive rate raising has led to a substantial decrease in the inflation rate this year. As is the design, however, the Fed’s rate increases have led to much tighter credit conditions across the economy and significantly increased the cost of credit.

The interest rate environment has a profound impact on real estate acquisitions, dispositions, and operations. Rising interest rates mean higher borrowing costs, which deter investors. Just to illustrate how quickly rates have risen, in 2021 multifamily acquirers could borrow in the high 2% range and the 10-year yield was in the mid 1% range. Today, the 10-year is yielding 4.30% and fixed-rate debt will cost between 5.75-6.25% at a minimum. Floating-rate debt is even more expensive and very hard to obtain. Because almost all commercial real estate is acquired using some amount of debt (typically 50-70% of a deal’s capital is debt), the more expensive and harder to obtain it becomes leads to lower values and decreased pricing.

On the acquisition side, the rapid increase in rates has led to a plummeting number of transactions. Total multifamily investment volume in Q2 2023 dropped over 70% from Q2 2022. Moreover, Q2 2023 transaction volume was 27% less than the 2013-2019 quarterly average and was the lowest Q2 volume since 2014. For the next few quarters, we expect transaction volume to remain somewhat subdued, although perhaps not at the level seen in Q2.     

In terms of pricing, one would expect a decrease in real estate values and correspondingly higher cap rates in an environment with rising interest rates. Prices have come down, however, there remains a major gap between buyer and seller expectations leading to something of a standoff regarding pricing. Based on our many conversations with brokers and other market participants, as well as analyzing the few deals that have closed, it appears that cap rates have increased about 50bps this year. For well-located, Class B+/A- assets of the types that we are looking to acquire, cap rates are in the 4.75-5.25% range. We view these as attractive, as we think that ultimately interest rates will moderate, and cap rates may come down a bit over the next 36 months. However, with what we believe is significant market volatility on the near-term horizon, we expect to see some cap rate volatility as well, particularly in lower-end properties.

Higher Interest Rates and The Operating Environment

We have finally arrived at a time where owner/operators can distinguish themselves and drive value on property through efficient and well-managed operations. In the past few years, the market has not placed a particularly high value on operations as values climbed to incredible heights in a short amount of time. In an environment where prices are rising, nearly all deals work. In an environment such as today’s, however, those operators, such as Arcan, that truly run their assets well will demonstrate additional value and outperform.

We are seeing a few operational issues that will be surmountable challenges for seasoned operators and major problems for inexperienced and poor ones. Most notably, rents have either stagnated or slightly decreased in most Southeastern U.S. markets. Many new entrants in the multifamily market, particularly syndicators, built their financial models around the assumption that rents would continue to increase at the pace that we saw in 2020-2022. This was never realistic and now many of those who believed this are stuck with ineffective value-add programs and property revenues that are well below what they had budgeted.

In addition to revenue stagnation, we have seen certain expenses explode in the past year. The most egregious example of this is insurance costs. While national insurers have made the news by pulling out of the single-family markets in California and Florida, we are seeing massive premium increases on properties that are not in major risk areas and have no previous claims. Insurance is a major cost center and most operators have not accounted for today’s high insurance costs.

The Coming Bridge Loan Cliff

The rise in interest rates compounds the operational challenges that owner/operators are currently facing—most notably in the form of climbing interest costs on floating rate bridge debt. Many of our competitors – again, particularly syndicators – acquired their assets by using high-leverage, floating rate debt. While that debt was attractive in 2020-2021, it has now become a major liability for them as their interest payments have more than doubled in many cases. This has led to situations in which the free cash flow from their properties is unable to service their interest payments. Moreover, many of these buyers paid top dollar for their assets and they are no longer worth the same amount. This puts them in a precarious position, as they cannot easily sell these assets since they would almost certainly have to take a loss, if not lose their entire investment. We have recently seen a number of these owners issue capital calls or seek preferred equity to hold onto their assets.

In the next 24 months, billions of dollars’ worth of these bridge loans are due to maturity which represents hundreds of properties. These loans were secured at a time when underlying assets were purchased at relatively high prices between 2020 and 2022. Given the reduction in values since their origination, a significant number of these properties will not sell for high enough amounts to cover the loan balance. Thus, the refinance or sale of these properties poses a significant challenge. Lenders will have to choose between foreclosure or some kind of work out with their borrower. If these properties are subject to foreclosure, most lenders will decide to sell them. This situation is likely to exert additional downward pressure on pricing in the coming months.

While bridge debt can be useful in certain circumstances, Arcan does not have a single bridge loan or floating rate debt instrument in our entire portfolio. Starting in 2021, we made the decision to finance all our properties using conservative, fixed-rate debt and we are now reaping the benefits of that decision as our interest payments have remained constant and manageable, as they have always been.

Opportunities in the Midst of Challenges

The silver lining of this turbulent environment is the emergence of acquisition opportunities for patient buyers, such as ourselves. With many operators under stress, a number of properties are likely to come onto the market at prices that reflect the new economic realities. Many of the bridge loan-funded properties are 1970’s and 1980’s vintage and we expect that the quality of these assets and the volume of available deals will likely drive cap rates a little higher than they are today. While we are not necessarily buyers of most of these assets due to vintage and quality, we do expect that our target assets (those built in the 1990’s and newer) will also see a corresponding cap rate increase.

Arcan is very well positioned to take advantage of the current market dynamics. As mentioned, our portfolio consists only of fixed rate debt and all of our properties are performing very well. While expenses are largely higher than we would like, they are still at very manageable levels. In addition to rising cap rates, we are also seeing a number of great deals that have assumable, fixed-rate debt that provides immediate positive leverage. While these types of deals are relatively scarce, we are seeing a good number of them off-market. Given our deep experience with these types of transactions, we are a buyer of choice for many sellers.  

Going forward, we are poised to take advantage of rising cap rates and declining real values. We do not believe, however, that interest rates will come down in the foreseeable future and thus how we finance our acquisitions will remain extremely important. As always, we believe that utilizing moderate, fixed-rate leverage is the most prudent method of acquiring a property and maximizing long-term value for ourselves and our partners. While you may sacrifice some upside by not maximizing leverage amounts, you also take dramatically less risk. In today’s volatile interest rate and valuation environment, we believe that this is the best way to achieve outstanding, risk-adjusted returns.

Overall, we believe that we are entering another excellent period for acquiring great multifamily assets at attractive prices. While prices and cap rates will certainly not return to 2008-2012 levels, we believe that they are more attractive than they have been in years and are likely to stay that way throughout 2023 and 2024. Moreover, multifamily fundamentals remain very strong – the current distress felt by operators is purely due to financial structure, not underlying property performance or market dynamics. This creates a situation in which good operators, such as ourselves, will have the opportunity to acquire fundamentally sound properties at good prices. We look forward to sharing these opportunities with you.   

2023: One Cycle Ends, a New One Begins

Spring is the season of rebirth. How appropriate, then, that we are writing this article on the first day of spring 2023 as the old multifamily cycle ends and a new one begins. 2022 was the end of an extraordinary multifamily cycle that emerged from the wreckage of the 2008 financial crisis. In this cycle we saw multifamily become a true institutional asset class and capital poured in from across the world. Cap rates compressed, value-add programs took off, and property values soared. The monetary and fiscal response to the COVID-19 pandemic extended the cycle and prices continued their upward trajectory from 2020 to early 2022.

In 2022, with COVID-19 in the rear view, a new villain, inflation, emerged in the economy and we believe heralded the beginning of a new cycle. Over the course of the past year the Federal Reserve has aggressively raised interest rates in an effort to combat the menace of increasing prices. Their efforts are finally beginning to be felt, but inflation has a long way to go before it returns to the benchmark 2% level. The Fed’s job is as-yet complete, but its aggressive tightening has had major effects throughout the multifamily market and the economy overall. Perhaps the most acute of these has been the failure of Silicon Valley Bank a few weeks ago. This bank failure was the largest since 2008 and the second largest ever. In addition to SVB, Signature Bank was closed by the FDIC as well, UBS took over Credit Suisse, and First Republic teeters on the brink. What is most remarkable to those of us who experienced the financial crisis of 2008 is that it was not risky assets that led to these failures, rather it was losses on the supposedly safest of assets, Treasurys, that led depositors to flee these institutions. We believe that the failure of these banks definitively answers the question of whether the cycle has ended. The question now is: what effects will this turmoil have on the apartment and real estate markets?

Fear

While failing banks are a cause for concern, but the Fed and Treasury seem to have soothed fears of an immediate financial crisis. The equity and fixed income markets have not reacted in a way that indicates panic or significant fear for the future. Moreover, the biggest banks are awash in liquidity as depositors have moved their money from small and mid-size institutions to the SIB’s. In many ways, this mitigates the risk of a true financial crisis, although there could still be some issues amongst the smaller banks which are the backbone of small business lending. It is also highly likely, as noted by Fed Chairman Powell on Wednesday, that the banking issues over the past few weeks will lead to a general tightening of credit conditions.  

While Arcan Capital believes we are likely in the beginning stages of a recession, this will not be a replay of 2008. Where there was once a dearth of capital, we now have an abundance. The financial system overall is in good shape and asset quality remains high. Even with the recent mismanagement of duration risk in bank asset portfolios, most banks are highly liquid and will likely not take major losses. An inflation issue is, in many ways, the opposite of the problems we faced in 2008 as it represents too much money chasing too few goods. As rates rise to battle increasing costs, we can expect more turmoil, but we don’t see a disaster on the horizon. In 2008, every deal was a problem for every investor. In 2023, some deals will be a problem for some investors, particularly those who have floating rate debt instruments and others who overleveraged in order to acquire middling quality assets at incredibly low cap rates. This will create both opportunity and perhaps a consistent belief that more opportunity is right around the corner. At Arcan Capital, we believe the result could be a longer than anticipated period of average returns as investors and the Fed wait each other out hoping for a crash that never comes or a financial boon that is perennially around the corner.

Performance

Across the industry, property performance has been good over the past year or so, but not great. Rising costs have slowed leasing traffic and collections in certain areas of the multifamily industry. This was particularly true over the generally slower winter season. As layoffs and slow economic growth continue, we expect rent growth to be subdued for at least the next year. Market rent growth in many major markets is flat, down or at its lowest point in nearly a decade (excluding the brief initial COVID reaction in 2020). Many other markets continue to see annual rent growth in the 2-4% range. This was previously considered a solid growth rate, but now seems a laggard after years of 5% plus rent growth. Investors and operators need the time to adjust to this new normal and realize that it was the old normal too. The tremendous rent growth we saw over the past few years was the anomaly, and we may not see those numbers again in this generation.

We do believe, however, that rents have further room to grow in markets that were not overbuilt this past cycle. While the dust still has to settle, it seems clear some markets will suffer from too much new product. The Atlanta MSA still has over 35,000 apartment units under construction and even more planned. By the time all planned units are completed in Nashville, about half of every apartment tracked by Costar will have been built this last cycle. These are dynamic high growth markets Arcan loves, but that is a lot of new product. Given the cost of construction, new apartments come with high rental rates, and affordability continues to be at the crux of the housing market.

Pricing and Transactions

Transaction volume in the multifamily space reached break-neck speed in 2021. Transactions were still happening at a strong pace to end 2022 but the Fed’s rapid tightening and the corresponding 10 Year Treasury yield increase slowed transactions significantly. Q1 of 2023 will mark the lowest transaction volume of the last decade other than possibly the COVID shutdown of Q2 2020. Many buyers are pausing or are out of the market completely. This is true of a number of debt sources as well, with debt funds offering bridge loans particularly silent at the moment.

There is also the matter of rising cap rates. With the quick reduction in transaction volume, cap rates across the southeast have risen to 5% and above for nearly all product types.  This is remarkable, as we are still not seeing a meaningful gap between the lower end assets and higher end assets on cap rates. This doesn’t make much sense and Arcan believes this to be a tremendous opportunity at the moment. We are jumping at the chance to acquire higher quality assets at similar metrics as lower quality assets.

We also believe that pricing is likely to stabilize near current levels absent a major economic shock. We suspect that as soon as asset pricing begins to drop to a level we would consider extremely attractive, some of the massive amount of capital waiting on the sidelines will swoop in. This displays the strange, yet stable detente of our current market. While prices have fallen 15-20%, a tremendous amount of money has been made in the last decade and it needs a place to go. Right now, apartments are still a great investment and are outperforming other real estate asset classes as well as fixed income portfolios. Therefore, Arcan believes any potential major drop in prices will be buoyed by the capital waiting to put the gains of the last several years back to work. We continue to believe that anyone waiting for bloodbath like what we saw in 2008 and 2009 will be disappointed as there is simply too much dry powder on the sidelines. Once a few groups start acquiring, others will jump in not wanting to miss the opportunity themselves.

 Although we believe that pricing is likely to have stabilized, we do very much believe that there were a lot of assets purchased in the last 12-24 months that are in a lot of trouble. The high LTV, floating rate debt used to acquire these properties is tremendously more expensive as rates have risen across the board. Many assets are no longer covering their debt service and cannot benefit from a new fixed rate loan because the deal was overleveraged at purchase. In this instance an operator will have few options; it can continue to put money into the deal and wait it out. This may include a massive fee to purchase a new rate cap. The other option is to sell, potentially at a loss. In the year ahead, many owners will have some difficult decisions to make. Again, while we do not believe that these assets will be available at fire-sale prices, we do think that many are good assets that were simply acquired improperly and will potentially be for sale at attractive prices.  

The most interesting thing about the pending 2023 turmoil was that much of it was easily avoided. Firms like Arcan that sold all floating rate deals heading into this environment and fixed their debt on all new acquisitions to avoid floating interest rates will find their situation far more palatable even as prices start to decrease as interest and cap rates rise. There were many firms that not only used aggressive floating rate debt but also paid record prices at the wrong time. They will face a challenging environment moving forward that we look forward to capitalizing upon.

Conclusion

The near-term macroeconomic outlook is troubling. While we may avoid a deep recession, we think that, at minimum, a short recession is already here or likely to occur in short order. Inflation is still a major concern, and the financial system has shown some recent weakness. While some industries will have significant problems, we believe that the multifamily sector is healthy overall. While trouble is clearly on the horizon for some operators in our space, most operators will find a way to make money. In terms of real estate, anyone following the trends knows that consumer behavior coming out of the pandemic wreaked havoc on traditional office and retail. We believe a real reckoning is approaching for those asset classes. Multifamily, hotel and industrial assets might only have to make their way through a downturn, which they have a multitude of times. The short- and long-term demographic changes of our country and the continued unaffordability of single-family home ownership continue to make apartment investing extremely attractive. This is especially true as the southeastern United States continues to grow rapidly.  We just need to get though whatever hurdles await in the coming years.

Ultimately, prices for apartments, particularly higher quality and well-located assets have not been this attractive in years. Arcan Capital is far more bullish on investment today than at any time in the last 5 years. We ultimately believe you make and lose money based on the price you pay. Currently, you are paying up to 20% less than in the last 12-36 months based on our underwriting metrics. While interest rates have made these prices similarly appealing from a return standpoint, you are still tangibly getting a better deal. Arcan will maintain our focus on solid real estate fundamentals. Accessible assets that are well built and in desirable neighborhoods will continue to outperform. Hold periods of 2 years were never truly realistic in apartments, even if it worked well for several years. If you are open to buying quality assets and holding them for several years to let them and the market mature, then apartment investing is still very much the place to be.

Arcan Capital Multifamily Update: Strategic Value

As we approach the first anniversary of the COVID-19 pandemic, the apartment market has very much recovered from the lows of last spring. What began with a dramatic fall in rental rates in March of 2020 resulted in what most would consider a very successful year in nearly all of the markets Arcan tracks. Overall, rents are up, and transactions bounced back in spectacular fashion in the second half of 2020. While collections and employment are still a concern, the apartment market appears to be moving on from the pandemic and the data indicates more good news is on the horizon. On the surface, the story is nothing short of excellent, all things considered. If you dig deeper, however, some concerns about the market arise. While Arcan is very bullish on the sector long-term, we think much of today’s market is overvalued and believe a very targeted approach to value investing is the best way to move forward.

Transactions

Transaction volume across the country collapsed in the second quarter of 2020 but rebounded in spectacular fashion at the end of the year. As a point of comparison, the Atlanta market had $2.6 billion in transaction volume in the fourth quarter of 2019. In the fourth quarter of 2020, this number ballooned to almost $4.0 billion (1). This incredible volume growth was a bit anomalous, as there were very few transactions in the prior two quarters. For example, in the second quarter of 2020 Atlanta recorded its lowest transaction volume since the first quarter of 2012. On an annual basis, transactions were down in 2020 but not nearly as much as expected after a massive fourth quarter in which Atlanta set a record for transaction volume. Notably, cap rates in Atlanta fell to below the national average, as attention on the market continues to drive additional investment and more aggressive pricing. While still very reasonably priced for a market of its size and caliber, Atlanta is no longer an inexpensive multifamily market.

Performance

The rebound in transaction volume is likely tied to two forces in the market that have both been positive. The first is rent growth and the second is interest rates. Rent growth was down substantially from the beginning of the pandemic through May of 2020 but bounced back. In Atlanta, for instance, annual rent growth was 4.6%. Annual rent growth is positive in every major market we track in the Southeast except for Nashville (-1.0%) and Orlando (-0.5%). The common theme of those markets is their reliance on tourism, which we expect will begin to rebound soon (2). This rent growth is a welcome surprise given the turmoil of 2020.

Another major factor is interest rates. In 2020, as the Federal Reserve eased the Fed funds rate and embarked on additional quantitative easing measures, interest rates plunged accordingly, which is a favorable move for apartments. Moreover, financing remains abundant and is primarily driven by Fannie Mae and Freddie Mac. Interest rates are priced based on spreads over treasuries. Therefore, when the 10-year T fell to as low as 0.50% in 2020, interest rates for apartment loans were in the high 2% range. That is astoundingly low and provides great leverage for assets even if buying at cap rates below 5%. As the 10-year T rallies (now 1.48%) and interest rates rise, more pressure will be on apartment prices to lower in order to maintain returns for investors. We believe we may have seen the bottom as far as interest rates go and if interest rates rise too much, value must come down.

Collections

There is no denying that COVID-19 changed the way businesses operated in 2020 and apartments were no exception. Beyond common area closures and procedural changes, the largest shift was in rent collections. The federal and various local eviction moratoria combined with inefficiencies in local municipalities have made evictions rare, even if technically permitted. Many properties have multiple residents in occupancy for over 6 months without paying rent and with no sign of being able to remove them. The inability to remove tenants is just as harmful to collections as the pandemic, maybe even more.

Rent collections across the country fell but were closer to keeping pace with 2019 than expected. That started to change as we approached year end. January 2021 collections were over 2.6% behind 2020 at (93.2% versus 95.8%) and the delta is increasing (3). This may not sound like a massive increase but make no mistake, a 2.6% lower collection figure is a 62% increase in delinquent rent across the country. Moreover, Arcan’s data reveals that this reduction in collections is not evenly distributed. Class C assets and below are far more likely to suffer from collections issues than Class A and B properties, so even while rents increase, they are collecting disproportionately less than they were prior to the pandemic.

In Summary

The multifamily market in early 2021 is complicated to say the least. Rents are increasing at a solid pace, leading investors to believe that they can continue value add programs and revenue growth which will increase value. Conversely, delinquency increased by 62% and is getting worse with evictions still very difficult to process. Financing is abundant and interest rates are compelling, creating positive leverage even as prices increase. Having said that, prices are extremely high and cap rates are falling. In Atlanta, for instance, cap rates have now fallen by an average of 240 basis points since 2010. We are in the midst of, or at the end of a very long and powerful performance by multifamily. How long it will last in anyone’s guess. Arcan feels the market has been overpriced for nearly two years and expected the COVID-19 situation to be the reckoning. Instead, multifamily is the darling of investors because it outperformed office, retail and hotels in 2020. Given the pricing and duration of the current cycle, Arcan is focused on value. Major renovation projects are getting harder to execute as returns shrink. There is very little margin for error in apartment investments and for that reason, Arcan remains strategic about where we can identify value. We are attracted to secure, performing assets with an opportunity to improve. Arcan is now even more selective when it comes to the location, demographics and asset condition. While our return expectations have come down, there is still a good opportunity to make money if you are careful and diligent. Larger returns will be back, but 2021 is a good time to be patient, focus on quality, and avoid bad investments.

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1 Multi-Family Capital Markets Report, Atlanta - GA - CoStar

2 CoStar Analytics, Multi-Family Markets

3 National Multifamily Housing Council, NMHC Rent Payment Tracker

The State of the Economy, The Consumer, and The Effects on Multifamily Investments

2021 is now well underway and as we head into the first anniversary of the COVID-19 pandemic, we at Arcan think that this is a good time to reflect on the state of the economy and what we think the near-term future holds. Hard as it is to believe today, most people had not heard of COVID-19 at this time last year. When the pandemic did strike the U.S., most of us thought that it would be short-term economic blip and we would all go back to normal within a few weeks at most. Clearly, this would not be the case. Only now, however, can we start to see some of the economic trends that have emerged. Many are not what we imagined them to be when the virus first hit.

In addition to looking at economic data in the aggregate, we believe that informed investors will also pay close attention to the performance of distinct sectors, regions, and consumers. Perhaps the most interesting dynamic is that of the consumer. While we have written on the burgeoning stratification of workers previously (see discussion on that topic in our prior post), the American consumer remains, generally, in good shape. This is somewhat surprising given the historic job losses over the past year, but it does reflect a potential for strong growth once the virus is under control.

For multifamily assets specifically, the continuing stratification of workers will play a meaningful role in determining which properties perform well and which do not. We continue to see Class C assets struggling with collections and rent growth. These properties tend to cater to tenants who work in retail, hospitality, and other public-facing jobs. However, many consumers who live in Class A and Class B properties are actually sitting on substantially more cash reserves than pre-pandemic. This bodes very well not only for overall near-term economic performance, but it indicates that most will continue to pay their rent and it could lead to increasing rents as well.

2020 GDP and Where We Are Today

In the spring of 2020, most observers predicted a sharp economic contraction followed by either a “V”, “U”, or “L”-shaped recovery. The road back has been more complicated (i). The economy contracted sharply in Q2, followed by a significant “snap-back” in Q3 and strong growth in Q4. Q4 growth could arguably have been stronger, but many states and localities reimposed lockdowns of their economies in November and December (ii). End of 2020 Nominal GDP was $21.48 trillion compared to $21.74 trillion at the end of 2019 (iii). Thus, the economy has regained much of its losses, but it has not yet reached its 2019 high. The pace of growth has also slowed considerably, though this was to be expected. Moreover, while GDP growth did bounce back to a large degree, major stratifications opened between sectors and different types of workers. Restaurants, for example, continue to struggle mightily while many tech firms are reporting record profits (iv).

As we head further into 2021 and beyond, we expect the pace of economic growth to subside and return to recent historic averages in the 2-3% range. This is barring any unforeseen negative externalities related to the virus, such as a vaccine-resistant variant emerging. Unfortunately, the virus does remain a major risk factor and will continue to do so until far more of the population is inoculated. Given the recent ramp-up in vaccinations, however, we are hopeful that the economy will continue to emerge from lockdowns and resemble its pre-pandemic form by the end of 2021, if not sooner. The reduction in COVID-19 cases and hospitalizations should lead to increased consumer confidence and continued economic growth in 2021 and 2022.

Longer term, there are increasing worries about the federal debt-GDP ratio as well as individual firms overleveraging on cheap debt. However, with interest rates likely to stay at or near their current levels until at least 2023, these concerns may remain muted. Arcan believes, however, that these longer-term risk factors must be considered when looking at multifamily investment opportunities, particularly as this monetary stimulus substantially raises the risk of inflation.

The State of Today’s Consumer

One of the most interesting developments over the past year has been the incredible degree to which Americans are saving their money. The personal savings rate surged to unprecedented highs in 2020, with over $1.4 trillion saved in the first nine months of the year alone (v). This amount was double the total savings over the same period in 2019. While the savings rate has come down substantially off its highs from the spring, it remains elevated relative to its historical average. Americans are sitting on vast sums of saved money, much of which is expected to be spent later this year as the COVID-19 situation is brought under control.

The savings rate has remained elevated for a variety of reasons, including the effect of consumer perceptions of safety as well as government lockdowns. Consumers have shunned certain types of businesses and most states and municipalities have either closed bars, restaurants and music venues wholesale or severely limited their capacity. Spending at these businesses has declined precipitously during the pandemic. While much of this spending has shifted to goods, consumers have saved more than in prior periods.

An additional factor in the increase in the savings rate is fiscal stimulus from the U.S. government. As of February 22, 2021, Congress has passed two distinct rounds of fiscal stimulus directed at the consumer. While the policy merits of such stimulus can be debated, there is no question that many Americans have used this additional cash to either save or pay down debt, presumably leaving them in better fiscal health. As the pandemic is brought under control and the service sectors of the economy begin to re-open, the consumer is surprisingly very healthy.

Effect on Multifamily

Overall, consumer spending represents roughly 2/3 of U.S. economic output, thus the increasingly sunny consumer outlook bodes very well for the economy and is one of the primary reasons the fourth quarter of 2020 was so strong. Indeed, Q1 GDP projections have increased sharply as economists factor in the surprising strength of the American consumer. The Atlanta Fed, for example, revised its Q1 GDP forecast from 4.5% growth to 9.5% growth within the span of a week (vi). As the pandemic subsides, we are likely to see a surge in demand for certain goods and services, specifically those tied to hospitality. In turn, this should prompt additional hiring in these sectors and continue the cycle of growth.

Multifamily stands to benefit greatly from the strength of the consumer. The increase in the savings rate and the renewed economic growth could potentially translate to higher rents in the near to medium term. Many cities, particularly those in dense, heavily-taxed states have seen outflow of population and corresponding rent decreases during the pandemic. Conversely, cities both large and small in the Sunbelt have generally experienced population growth and rising rents as well. This trend is likely to continue post-pandemic, though rents are likely to bounce back in gateway cities such as New York and San Francisco.

Arcan focuses exclusively on the Southeast, thus we are increasingly confident that well-located properties in our region will not only continue to outperform those in other regions, but the pent-up demand and increase in consumer savings could lead some renters to look for more premium product in the next few years. As such, we think that there may be some additional market rent increases in select markets. However, as monetary stimulus continues to inflate asset values, the need to be a strategic investor is ever more important as the turnaround in pricing can always come sooner than expected. And while most consumers are in excellent shape today, inflation can quickly erode any savings power they may have attained over the past year.

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(i) “This is how the global economy will recover from COVID-19, according to CEOs”. September 22, 2020. World Economic Forum. “https://www.weforum.org/agenda/2020/09/covid19-recovery-shape-economy-ceo/

(ii) Grace Hauck and Chris Woodyward “New Coronavirus Restrictions: Here’s What Your State Is Doing To Combat Rising Cases and Deaths. November 13, 2020. USA Today https://www.usatoday.com/story/news/nation/2020/11/13/covid-restrictions-state-list-orders-lockdowns/3761230001/

(iii) Economic Indicators. Moody’s Analytics. https://www.economy.com/united-states/nominal-gross-domestic-product

(iv) Annie Palmer. “Amazon reports first $100 billion quarter following holiday and pandemic shopping surge”. February 2, 2021. CNBC. https://www.cnbc.com/2021/02/02/amazon-amzn-earnings-q4-2020.html

(v) Josh Mitchell. U.S. Household Income, Savings Rose at End of Last Year. January 29, 2021. The Wall Street Journal. https://www.wsj.com/articles/consumer-spending-personal-income-coronavirus-december-2020-11611873351

(vi) Federal Reserve Bank of Atlanta. GDPNow. https://www.frbatlanta.org/cqer/research/gdpnow