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.