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.