Q4 2022: State of the Market: "Opportunity Ahead," with Co-Founder and Principal, Michael BeckerSean M

State of the Market: "Opportunity Ahead"

Written by Michael Becker
Q4 2022 Newsletter

Michael Becker Here...

For my article in our Q3 newsletter, "Multifamily Demand Drivers," I spoke about the fundamental undersupply of the US multifamily housing market and how, specifically, the 4 major Texas markets are projected to need to build over 650,000 units between now and 2035 in order to keep up with the demand. Additionally, in previous newsletters I spoke about rising interest rates, and in this newsletter, we sat down with JP Conklin at Pensford to gather his thoughts on the interest rate market and its short-term and long-term impact on the debt markets. In this article, I will mingle these two thoughts together.

As we close out 2022, I feel that we’re beginning to see the onset of some dislocation or pressure in the general commercial real estate market evidenced by the rising interest rates driving an increase in debt service costs and lowering loan proceeds on the new debt available in the marketplace… Additionally, there has been a substantial increase in Interest Rate Cap costs YTD resulting in a huge use of cash for floating-rate borrowers, as JP spoke about in his article. Specifically, in the multifamily space, we’re seeing a lot of lenders sitting out of the market right now, which is a significant contrast to the robust number of options of debt funds, Life Co’s, CMBS, banks, and, of course, the agencies (Fannie/Freddie) available when we started the year. Right now, our options have dwindled down to the agencies and some of the banks providing liquidity to the market at much more conservative terms. The Life Co’s are still lending, however, their terms are typically sub-50% LTV on "Trophy Assets," a negligible subset of the market. But, with the cost of debt today, it doesn’t make sense for those types of deals to use leverage. So, today, if a Core "Trophy Asset" sells, it’s typically to an all-cash institutional buyer who will put leverage on it later when the capital markets improve.

So, across the board, we’ve seen multifamily asset values contract from their Q1 2022 peak, but largely, there’s been very limited transaction volume as a bid-ask spread in the marketplace between what sellers are willing to take and what buyers feel they need to move forward remains. In Texas, from my viewpoint, this phenomenon appears to be most pronounced in the workforce housing space, which consists primarily of 1970s and 1980s vintage properties. This specific segment of the market is where I anticipate the most value to be found in 2023, specifically in the latter part of the year.

Let me elaborate on my working investment thesis a bit . . .

Anyone who’s followed me or heard me talk over the past many years has probably heard me discuss how our company, SPI Advisory, started out primarily investing in workforce housing deals. Over the last decade (since we first started buying deals in 2013 and up until recently), cap rates have generally compressed in the multifamily space. As we started 2022, this anomaly had resulted in narrowing what had historically been a larger spread between the top of the property grade (Class A deals) and the bottom of the grade (Class C deals) to a point where there was virtually no significant difference in cap rates between the two grades. To illustrate this point, back in 2013 when I purchased my first multifamily deal, Texas multifamily cap rates were around 5% for Class A (Newer Construction), 6.5% for Class B (1980's Construction), and 8-8.5% for Class C (1960's & 1970's Construction). Whereas, by the beginning of 2022, all the property grades were right around a 4% +/- CAP across the spectrum.

As the spread narrowed, starting in 2017, we took the opportunity to sell our older assets and trade into newer assets at a similar cap rate. In retrospect, I will admit that we were slightly premature in that move as we bought deals at an 8%+ cap, moved revenue up substantially, and then sold them for a 6% cap while generating large profits along the way. Had I known that cap rates would reach 4%, we would have held out a bit longer. With that being said, I feel confident about how our portfolio quality is positioned today, as we own substantially newer and nicer deals compared to 4-5 years ago.

I attribute the dramatic compression in workforce cap rates over the past many years to have been driven largely by 3 main factors: We had an abundance of lending options available. As lenders got more competitive, debt funds started to push leverage up further by allowing buyers to pay more for those deals and model better projected returns to attract capital. There was a substantial increase in the percentage of loans done by debt funds in 2021 compared to 2020 when agencies were the dominant lender. 
There’s been an influx of new interest in the multifamily space fueled by a surplus of emerging podcasts spreading awareness of our industry. (I'm partially at fault for this one). Additionally, there’s been an excess of new multifamily "Gurus" surfacing to teach the masses their techniques on how to source deals and raise capital. Consequently, since 2020, there’s been an oversupply of new sponsors who’ve flooded the space and started buying what they could afford (typically older, vintage deals much like we did at SPI Advisory when we started out).
Finally, a large amount of equity in the last 3 years came from the recycling of capital. Due to cap rate compression, regardless of the expertise of the sponsor or the cost basis in the deal, multifamily sponsors have been able to buy a workforce housing deal, paint the exterior, renovate 10-20% of the units, and sell it for a substantial profit just 2 years later, making their investors rich along the way. Those investors would turn 1 dollar into 2 and then reinvest those funds into two news deals thereby fueling more and more demand for multifamily syndications.

As the market recalibrates to higher interest rates, I’m observing general cap rate expansion across the board. However, the market is again starting to price in the risk of asset quality where it largely did not over the past several years. As a result, the cap rates of Class A deals are much “stickier” and we’re seeing the workforce housing (Class B & C) caps expand at a much faster pace. In particular, I’m seeing the least desirable Class C deals -- ones with boilers, flat roofs, chillers, or inferior locations -- have their cap rates expand the most. Speaking from personal experience, owning a flat roof chiller deal sucks.

This divergence in cap rates makes sense to me when you consider the creditable replacement cost argument you can make in regard to Class A buildings, but it isn’t equally as applicable to functionally obsolete, 40-60 year-old workforce housing… If developers cannot successfully model a profitable exit, they cannot attract debt and equity to build the project, and, as a result, new supply will pull back, thereby putting upward pressure on rents until deals new construction “pencils” again. So, unless development costs fall substantially, there is a floor on how low Class A deals can go in consideration of “per pound play” and the equity buy off on the discount-to-replacement cost play in a low supply, rising population environment.  On the other hand, workforce housing deals are driven much more by fundamentals and debt terms, so the floor is much lower compared to newer construction.  

Coupled with cap rate expansion, here are a few additional pressures workforce housing operators face today:The workforce housing tenant base, who generally maintain lower-paying jobs, are more stretched today than ever before due to rising inflation eroding their purchasing power. As a result, organic rent growth slows faster in the workforce housing deals compared to Class A deals. Additionally, delinquency and bad debt is much more frequent and pronounced as a percentage of revenue here, too. I believe when we hit a recession, this will substantially erode the revenue in workforce housing deals.
The workforce housing space is where Debt funds lenders focused the majority of their lending over the past few years. At the beginning of the year, the typical debt fund structure was 80% leverage with a 3-year maturity and two 1-year extension options. These were typically floating rates with +/- 4% spreads over LIBOR or SOFR. Both LIBOR and SOFR will have gone from practically zero when the year started to north of 4% by year's end, thereby making the debt service on these deals more than double to around 8% all-in rates. These debt fund borrowers are getting squeezed a few ways with rising interest rates which are likely mitigated somewhat by having an interest rate cap in place. However, these borrowers will likely have to buy a replacement cap which are exorbitantly expensive today (we have those pressures on our Freddie Floaters, so I am very familiar with it). This is a huge use of cash along the way.
Current Debt Yields sizing rates will prevent workforce housing borrowers from the ability to refinance. A debt yield is similar to how you calculate a cap rate, except the formula is NOI / Loan Amount = Debt Yield. In 2020 and 2021, the debt funds’ deals typically sized to a Year 3 stabilized Debt Yield of around 7% (I heard of some debt funds at the beginning of this year quoting 6% stabilized Debt Yields…crazy), which means going-in, Debt Yields were in many cases around 4%. Fast forward to today, and most banks, the debt funds that are still active and agencies are all backing into Debt Yields of between 9-10%. This absolutely crushes loan proceeds for these deals, and there’s no way these borrowers will be able to size for a refinance at their current loan balances.
To compound this, most of these loans have interim Debt Yield test covenants. Meaning that 18 or 24 months into the term, the lender will check in on the current Debt Yield to see if the 7% Year 3 Debt Yield is at least at 6% 18-24 months into it. If not, they have re-margin requirements built into the loan documents which obligate the borrower to pay the mortgage down to a level at which the NOI supports a 6% Debt Yield. If they can’t do that, it will trigger a hard cashflow sweep where the lender will suck all of the cash through a lock box to ensure the borrower doesn’t distribute any money out. This is a difficult condition to operate under.
Throw in the mix that a huge percentage of workforce housing owners today just entered the business within the past few years. That means they’re less experienced and will be the ones making decisions for better or worse. Also, many are likely not well capitalized since they haven’t had the luxury of going full cycle by selling numerous deals over the past decade to generate liquidity. As I mentioned earlier, these operators bought what they could afford, with as much leverage as they could, as they didn’t have the capital or track record to obtain better quality or lower leverage deals.  

What I just described above is brewing below the surface in many of the workforce housing deals right now. This makes me think of the Warren Buffet quote “When you combine ignorance and leverage, you get some pretty interesting results.” So, I believe a lot of deals are dead right now, they just have some liquidity in their entities to keep up for the time being, but as soon as that liquidity dries up is when the bodies will start to drop. Many of these sponsors don’t have the cash to solve their own problems, and I am unsure how well capital calls will be received by investors if the deal is underwater to its debt basis.

Likely Opportunity in 2023

On the good news front, we are seeing early indicators of inflation roll over in real-time, and the Federal Reserve just signaled that they will slow the pace of rate hikes to monitor the lagging effects rate hikes have to the economy. Reading between the lines, I speculate that this means a pause is nearing, which will be followed ultimately a few to several months later by rate cuts as we battle a likely rise in unemployment and a weaker economy. It truly feels like there is light at the end of the tunnel in the Fed’s fight against inflation.

If what I think is going to happen actually happens, it’s a mixed bag for apartment investors. The good part is that borrowers will get a ton of relief with interest rates going down, which will result in causing rate cap costs to fall dramatically and making new loans size much better, in particular for the agencies. The bad part is that you would expect delinquency to rise and rents to stagnate or fall for a period of time. If history holds, that will be most pronounced in the workforce housing space.  

Couple my expected decline in workforce housing fundamentals with a powder keg filled with the inexperienced, undercapitalized sponsors that are over-leveraged, there must be problems in this space. I think the spark that will make the powder keg explode will be the 18-24 month Debt Yield test all the debt fund lenders will test for. So, look to debt fund deals done in 2020 and 2021 as the clock runs out on those deals. When those sponsors can’t re-margin the loans or refinance out, they’ll be forced to sell in a distressed scenario. That’s what I believe is going to be the opportunity we have in 2023, likely in Q3 or later, as everyone works through the property-level liquidity as the rate hikes have been an incremental process since March 2022.  

The wild card that is harder for me to handicap is the fact that a lot of the debt fund lenders were large multifamily owners such as Related or Starwood. They might be savvy & depending on the scope of problems capitalized enough where they will be able to take the properties back and work them out themselves vs. selling into the market at whatever price it takes to clear it off the books like a bank would. If that happens in large scale, it mutes the level of opportunity I see coming at this space. 

This is what I expect to happen in 2023, and I hope to channel my inner Marty McFly and go back in time to the 80’s to take advantage of this dislocation. I am sure happy that we will be basically a 3-to-1 net seller this year and have raised a bunch of cash through sales for us and our investors in 2022. 

To be clear, I do not think this is the Great Recession of 2008 all over again. The scope of the problem isn’t nearly as widespread as it was then. The banks, Life Co’s, and agencies all had solid underwriting fundamentals for their loans. I believe for multifamily, this is largely concentrated in the workforce housing deals with debt fund loans put on in 2020 and 2021 of which there were a lot of them. The owners of workforce housing deals with 7-10 year agency loans should largely be fine and, if they choose to, can ride this out. So, overall this is a subset of the multifamily space I think will be most impacted. 

I also don’t think that this opportunity will be around for too long -- probably somewhere between 6 to 12 months of opportunity before the market clears these deals out and we are more or less back to normal. Why is that? Well, there’s a ton of capital on the sidelines in general waiting to be deployed. To me, interest rates appear close to topping out with inflation likely rolling over and history tells us that the Federal Reserve on average cuts rates 9 months after the last hike, which means the first rate cut appears to be likely in Q4 2023 or Q1 2024.  Moreover, we have the agencies to provide liquidity to the multifamily industry that will put a floor on how bad this can get which you don’t have in office, industrial, or retail property types.  Finally, the 4 major markets in Texas need 650,000 more units to keep up with the projected demand between now and 2035, so the fundamentals will still play a big role in investor appetite once the capital market issues resolve themselves.  

In the meantime, I am getting prepared as much as we can to be ready to capitalize on this upcoming opportunity.