Michael Becker's Q3'24 "State of the Market"

Q3'24 State of the Market: "Generational Buying Opportunity"

Written by SPI Co-Founder & Principal, Michael Becker
Q3 2024 Newsletter

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Hi, Michael Becker Here...

At long last on September 18th, the Federal Reserve lowered the Fed Funds Rate by 50 basis points (0.50%) and signaled that the easing cycle has begun with many more cuts in their own forecasts in coming months. It has been 14 months since the last hike in July 2023 and 30 months after the first hike in March 2022. This is very welcome news for Multifamily investors like my firm, SPI Advisory. More on the impact of lower interest rates later in this article.

Generational Buying Opportunity

In my opinion, this is a generational opportunity to buy Texas multifamily... Arguably the best moment since 2011-2013 to purchase apartments. It is clear to me that:

• Multifamily valuations on average are down between 20-35% (depending on the quality of the asset) from the peak of Q1 2022. To be sure, the peak got silly with proforma cap rates in the 3’s in many cases, but nevertheless values are substantially lower than the Q1 2022 peak.
• In my view, specifically in Class A/A- properties in DFW, we have bounced off the bottom in valuations. I peg the bottom happened in October 2023 when the 10-Year Treasury hit 5%. That was the max pain point in the market.
• Interest rates are going directionally lower. The recent rate cut and the Fed’s dovish forecasts solidified that. That is historically supportive of lower cap rates.
• Institutions are back buying in a big way; other buyers will follow the leader. That will bid pricing upwards (cap rates downward) as a result.
• We are months away from a material drop in new apartment deliveries. It is virtually a mathematical certainty that new deliveries drop meaningfully in 2025. This should lead to upward pressure on rental rates due to less competition for tenants.
• Banks have been largely sidelined for 2 years and pressuring their clients to pay off loans. That has been mostly successful (excluding banks with significant office loan exposure), and their balance sheets are in a much better position than 2 years ago. Banks will start to turn back on their lending programs. That will be supportive of more liquidity in the multifamily space to compete with LifeCo’s and the Agencies and will provide borrowers with more diverse lending options from which to choose. Also, a more active lending landscape is historically supportive of higher valuations (see the craziness of 2021/2022 as an example).
• Given the recent supply headwinds, effective rental rates on new leases are flat to down YoY in many quality submarkets that have a concentration of new deliveries. So, not only are we able to buy at cap rates that are much higher than recent averages, but the underwritten NOI’s are artificially lower due to this (likely temporary) reduction in rental rates. These two trends have a compounding effect to lower property values. As interest rates fall, supply tapers off, and rental rates rise, that compounding effect will work in the opposite direction and values should rise dramatically.

The above factors have me convinced that we are at the onset of a Multifamily Bull Market. I cannot imagine this next cycle lasts 10 years like the last one did; however, IMHO, the next 4-5 years are setting up to be very favorable for multifamily investors. Those of us with the courage in our conviction and who have been buying quality apartments (and continue to buy) in strong, high-growth markets should be rewarded with outsized returns in the coming years.

My view on the impact of lower rates

The SOFR index is directly correlated to Fed Funds. As a result, the SOFR index—which had been sitting at ~5.35% for the past 14 months—is now at 4.85% after the Fed’s 50bps cut. This provides a bit of immediate relief to floating-rate loans, most of which are typically indexed to SOFR. However, most floating-rate loans have interest rate caps in place, so this won’t provide any monthly relief on net interest expense until SOFR falls below the strike on the interest rate cap. The rate cap payments cover the difference between the Strike Rate and SOFR. So, results will vary (and the extent of relief) froim situation to situation.

However, interest rate cap costs have fallen quite a bit in recent months as markets began anticipating interest rate cuts. Most lenders require borrowers to impound monthly escrows to fund the subsequent replacement interest rate cap, and the monthly impound amounts should be falling dramatically as they get reevaluated, typically two times a year. Floating-rate borrowers are on the back side of the rate cap escrow hell that has transpired the past 30 months. This should ultimately lead to monthly lender rate cap escrow requirements falling from A LOT to $0 per month in many cases, in addition to a ton of trapped liquidity being freed up. That is a huge pressure release for floating-rate borrowers. Below is a chart I got from JP Conklin at Pensford to illustrate this point.

JP noted that the market is pricing the Fed Funds Rate ultimate landing spot around 2.9%, while the Federal Reserve’s Summary of Economic Projections survey has the landing spot closer to 3.5%. The second Pensford chart below shows historical accuracy of the forward yield curves in rate-cutting cycles. If the economy achieves the soft landing we hear so much about in the financial media, or if it’s a harder landing with a recession, this will likely determine if rate cuts exceed both the Fed’s and the market’s expected cuts. There is a real chance that Fed Funds could go below 2% in a recessionary environment.

My main takeaway from the September 18th Federal Reserve meeting and 50bp rate cut is that it is clear there are going to be many more rate cuts between now and year-end 2025. Short-term interest rates are unequivocally falling; however, it is less clear how much the longer end of the Treasury rate curve will fall, since that part of the curve has fallen quite a bit already ahead of the recent rate cut. The 10-year Treasury seems like it might be more range-bound near its current levels (call it 3.25-4.00% range), unless there is more significant economic weakness than is priced in currently.

The bottom line is the rate cut is a strong signal for real estate investors that the interest rate headwinds we have faced for 30 months have shifted and are now becoming tailwinds as rates get lower. This should lead to greater confidence market-wide that it’s safer to start buying apartments again, which will lead to more investors and capital allocators getting off the sidelines, which in turn should support higher valuations.

My view of the General Multifamily Market

Beyond interest rate cuts, we are starting to see the light at the end of the tunnel regarding the large wave of new supply that we have lived through since 2022. I have previously stated many times that, ever since March of 2023 when Silicon Valley Bank and First Republic Bank failed, it’s been very difficult to capitalize with equity or get debt to build a multifamily project. A typical garden-style property takes about 24 months to build, and a wrap property takes about 30 months. So, I have been forecasting that, come +/- Q2 2025, we should see a material slowdown in new deliveries. For the markets we participate in at SPI, that delivery slowdown is likely to happen sooner in DFW and should take a bit longer to materialize in Austin, as Austin has a much higher percentage of their total apartment stock under construction relative to DFW.

To illustrate this point for DFW, we pulled historic construction starts and forecasted deliveries from CoStar. You can see in the charts below that we are now past the peak of deliveries, and, as we head into 2025, there will be a meaningfully lower number of units delivered.

• Dallas multifamily construction starts (left) have collapsed from 41,200 in 2022 to 11,500 YTD to their slowest pace since 2014.
• DFW market-wide deliveries (right) will fall to near 10-year lows in the next 24 months. In conjunction with the continued population growth in DFW – the #1 fastest Major MSA growth in the U.S. for 2023 (U.S. Census Bureau) – this should provide a massive tailwind for rental growth in coming years.

Today's Oversupply is setting up Tomorrow's Undersupply. This appears to be a near mathematical certainty. Barring a major economic contraction, starting in the 2nd half of 2025, I believe we should see rental rate growth reappear in a bigger way. Rent growth should accelerate as we enter 2026 and through 2027. To reiterate: on average it takes 24 months to build a garden apartment building and 30 months for a wrap structured parked building. Developers cannot snap their fingers and deliver apartment units; it takes years to do so. With the coming void of new multifamily inventory relative to demand, rental rate pricing should be pressured up in the coming years.

In addition, throw in the fact that:

• Labor availability has improved, which is helpful in combatting wage inflation for onsite employees & contract labor. The Covid stimulus money has been spent, and more and more people are back looking for work.
• Multifamily property taxes in Texas should have reached a near term peak in 2023. We expect a couple of years of lower property taxes market-wide, which is a major expense line item for our buildings.
• Also, we saw a double-digit percentage decrease on average on our insurance renewals in May 2024 at SPI. Insurance costs are down year-over-year, which is very welcome news.

Increased Market Participation

Institutions have realized that this supply story is about to play out as I described above, and they are back in a big way. Every major institution has either bought or is actively trying to buy in DFW right now. In the past few months, KKR, Blackstone, EQR, and Goldman all have purchased apartment buildings in DFW. They are front running the future multifamily undersupply story in real time.

I believe now that we have the first rate cut on the board, and as soon as the Presidential Election is behind us (no matter who wins), that will then lead to smaller firms and private capital re-entering the market and trying to buy apartments in greater numbers (already is happening today). I predict that once the calendar flips to 2025, there is a further material increase in buyers across the spectrum chasing deals, which will be supportive of higher values.

Take Advantage of Market Opportunity

For over a year now, those who have heard me speak have heard my simplistic business plan below (the G-rated version):

• You must buy discounted apartment deals in 2023 and 2024.
• Survive ‘til 2025 on owned deals (I would now add keep buying in 2025 as values rise).
• We will thrive in 2026 & 2027 (rental rates are setting up to see outsized growth compared to historical metrics).
• Valuations should rise substantially by 2028 and present the opportunity to sell a large portion of our portfolio for substantial profits to our investors.

New Investment Offering: Class A, Value Add in an Irreplaceable Location

Those of you who want to join in with me taking advantage of this Generational Opportunity to buy discounted multifamily buildings should consider SPI Advisory’s next investment opportunity that will be available in mid-October. It is located im the very affluent Lakewood neighborhood of Dallas, Texas and is called Winsted at White Rock. A few key highlights the investment are:

1. Irreplaceable location in prestigious Lakewood neighborhood
• Steps from White Rock Lake and trails; close proximity to Central Business District
• Zoned to Lakewood Elementary School, one of the highest rated schools in all of Dallas; Only 1 of 3 Apartments zoned to Lakewood Elementary
2. Insulated from Supply; Extremely high barriers to entry
   • Only 1 project under construction within 2 miles
   • 0 units delivered in 2023 and 2024; 136 units delivered annually since 2016
   • Lakewood is only 1 of 3 supply constrained submarkets in DFW
3. High-quality Class A Asset with Significant Value-Add Upside
   • Majority of units are ‘Classic’ or 'Partial Upgrade'; $300+ Renovation Premiums
   • Well-positioned to capture rental upside through interior and exterior renovations
4. Attractive Loan; Positive Leverage Day 1
   • Freddie Mac, 5-Year Fixed, Full-Term Interest-Only loan at a 4.99% interest rate at 65% Leverage
5. Significant Discount to replacement cost and comps
• $75-$100k/unit below today’s all-in replacement costs for this neighborhood and infill location, if you could find land to build on
• Material discount to both direct submarket & greater DFW sales comps
6. Outstanding Demographics
   • Average household income of $194,000 within a 1-mile radius and $88,000 average income for current rent roll
   • Average Home List Price in Lakewood of approximately $1.9M
7. Favorable Projected Return Metrics
   • Average Cash-on-Cash: 8.4%
   • IRR of 17%
   • Equity Multiple: 2.05x

The final item of note…with this offering for the first time in SPI Advisory’s history, we will be offering a preferred return structure like most of our peers in the industry. The main benefit for the passive investor with this change in structure is it improves the priority position of passive investors’ ongoing cash flow. Before the sponsor (SPI) gets a portion of any ongoing distribution upon the sale of the asset, the investor has to have received a cumulative 8% annualized return on their invested dollar; if not, SPI will not receive any of its promote. We feel this structure enhancement will be well-received by our long-term investors and are excited to share more details about the Winsted at White Rock opportunity in the near term.

Sound Interesting? Here are two actions you should take now...

1. If you do not currently receive marketing emails from us, join our database by filling out our Passive Investing Interest Form today. That way we can be sure you receive our emails about this new opportunity.
2. Whether you are currently in our database or not, please take steps now to prepare to invest. Our offerings finish quickly and are first-come, first-served. Jennifer's article will help point you in the right direction on how to prepare for this 506(c) offering.

We look forward to your participation in the Winsted 506(c) offering!

Cheers,

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