Q2 2024 Michael Becker's "State of the Market"
Q2'24 State of the Market: "Workforce Housing Capitulation"
Written by SPI Co-Founder & Principal, Michael Becker
Q2 2024 Newsletter
Hi, Michael Becker Here...
I’m keeping this quarterly newsletter article brief, as we’ve been very busy at SPI Advisory as of late… So far, in 2024, we’ve sold two properties, have one in escrow scheduled to sell in July, and recapitalized one of our properties with a loan maturity. So far we haven’t been successful in acquiring anything new; however, we are working on a two-property portfolio (one 1970s and one 1980s vintage deal) we have in escrow with a Family Office partner and are tracking to have a couple more in escrow in the near future. Given the choppy environment we’re currently in, I count ourselves fortunate to be as active as we have been. Many of our peers have done little to nothing over the past 24 months.
As I've mentioned in prior newsletters, we have continued to focus on acquiring Class A/A- assets, as we feel they have provided the best value in the market to this point; however, we expected more opportunities in the workforce housing space going into 2024.
As we enter Q3 of 2024, I can confidently say that capitulation in the workforce housing space is upon us. There are too many over-leveraged, lesser-experienced firms that purchased value-add workforce housing deals in 2021 with unsustainable debt structures for there not to be some "blood in the streets." Once those comps are recorded, it will drive pricing expectations down for B and C workforce products, even for stabilized deals from quality owners.
The apartment market is very segmented right now, and, depending on the submarket and vintage, it’s very disparate between the segments. We at SPI are primarily focusing on DFW and Austin right now, so I’ll break down my observations of what I am seeing in real time:
DALLAS-FORT WORTH
I'll start with DFW:
- Well-located Class A & A- deals in DFW are holding up very well. That is largely what SPI holds in our portfolio today, so we feel fortunate to be relatively in good shape.
- We are seeing several trades with trailing income at 100% tax-adjusted cap rates in the 5%+ range. I would say fully stabilized deals with no story or value-add upside are probably in the 5.00-5.25% range (I've seen lower caps trade too), and, if you have a deal that has more of a story, you can see those trade with a 4-handle starting on the cap rate. Investors really favor the 9ft ceiling product from the early 2000s, as it’s a newer vintage property but still provides value-added opportunities.
- We have seen a steady increase in the number of listings and sales relative to 2023, so we have collected a fair number of data points, although we are still way off from 2021 and 2022 sales volumes.
- It’s clear to me that values are off the bottom, and I mark the bottom as October 2023, when the 10-year Treasury rates touched 5%.
- Well-located Class B deals (1980s vintage) in DFW are also holding up.
- To me, it seems like we are in the 5.5-6% range for cap rates (100% tax-adjusted on trailing income) for the quality, well-located Class B product. There is still a good amount of appetite for this product, especially compared to the relatively limited inventory that is for sale. The overall deal sizes are smaller compared to newer vintage deals, which makes it a bit easier to capitalize for some groups.
- Lesser-located Class B products and well-located Class C (call it 1970s vintage for this purpose) are trading in the 6-6.5% cap range (on trailing income, 100% tax-adjusted). Some deals get as high as 7%, but those are generally outliers.
- Investors can get positive leverage as, generally, borrowing interest rates with the Agencies are in the mid-5%s today, as these properties generally have high affordability based on the way the Agencies calculate it. So, most of this product is very "mission rich." As a result, the loan spreads tend to be very low. SPI can get nearly a 100bps loan spread quoted after a 1.25% rate buydown on 5-year loans in the 65% LTV bucket, which means you are generally 100bps of positive leverage on this segment from day one.
- Lesser-located Class C deals or 1960s vintage properties with unfavorable characteristics like aluminum wiring or chillers are still pretty much a "no bid." I would suspect that it would take around a 7.5-8% cap rate to clear the market, and virtually no seller is willing to accept that value. So, this segment is at a standstill.
We only focus on Class A to A- in Austin, so I will speak about that. Austin doesn’t have nearly the amount of 1980s or older vintage properties relative to say DFW or Houston, so its importance is much less to the overall market as compared to DFW or Houston.
- Well-located Class A & A- deals in Austin are on sale relative to DFW.
- There are a ton of new deliveries that existing product is competing with, which has largely kept the larger institutions on the sidelines from buying in Austin.
- For one of the few times in the past several decades, Austin is cheaper than DFW to buy multifamily properties.
- I would say stabilized Class A & A- cap rates are generally in the high 5s (trailing number, 100% tax-adjusted).
- You are also seeing developers offering deals pre-stabilized at a bigger discount to move units. These are more often the lesser-capitalized groups; this isn’t the larger developers offering pre-stabilized deals for sale. We’re seeing these offered at a 10-20% discount to what the property would be once stabilized.
What does that mean for SPI Advisory's Strategy Today?
In my opinion, I see the relative value today in generally buying a bit older in DFW and newer in Austin. To me, it also means that it’s "go time" right now. I don’t think the window for the best deals will be open for very long.
At the higher end of the property grade, we are seeing cap rates very firm for newer construction deals in DFW, as the new supply is much more in check in DFW compared to Austin. As I have spoken about previously, I see new deliveries falling off a cliff around Q2 2025, as it’s been very difficult to capitalize and finance a new construction deal since the failure of SVB and First Republic in March of 2023. So, being oversupplied is a bit of a burning match that is closer to burning out with every day that passes, especially in DFW.
In my observation, values are back on the rise in DFW for new construction and will only accelerate from here as the new delivery pipeline keeps shrinking. In Austin, we have to be at or near the bottom for valuations. With the larger percentage of new deliveries in Austin relative to existing apartment stock, it might take a bit longer for Austin to recover, so the window is likely to be open longer there.
The DFW Class B and well-located Class C markets are starting to see deals trade in more meaningful numbers. Deals that are selling are usually deals that have been owned for a long time, and the seller has a profit in them still. The other type of sellers are the relatively better-off buyers in 2021 or early 2022 who didn’t have as much leverage or didn’t overpay as badly. However, they have upcoming loan maturities or rate cap expirations, so they are starting to sell at a large loss – albeit still above the debt basis. So, we are seeing that in the marketplace much more today than in 2023, as their time is running out.
What we aren’t seeing on a large scale is the sale of properties that are worth less than debt. Those lenders are either working with the existing borrowers or just swapping out operators (kicking out the existing group) and working to improve operations while waiting for a better market to sell the assets into. This is very different from what we saw post-2008 GFC. Still, it’s suppressing inventory for sale.
Our focus in the older space is largely on the first group that can sell above debt basis as the others are still in purgatory. We want deals that are in well-located submarkets with stabilized assets that can sell above debt basis, however (although likely a material loss for the current group). Those are going to qualify for nearly 80% LTV on a no-BS underwriting from Fannie/Freddie. I’m not saying we would actually take 80% leverage, but that is a good shortcut or rule of thumb. IMHO, if it’s a well-located asset and can qualify for ~80% LTV with the Agencies, it’s probably a really good time to buy it.
Hopefully, we can end our new acquisition drought soon and present some investment opportunities to take advantage of today's deals that are on sale. Indicate your interest in near-term offerings with SPI Advisory.
Cheers,
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