At the close of the first quarter, a few descriptors come to mind for the multifamily industry: steady and resurgent. The last three years have been far from smooth, as volatility, rapid gains, and steep declines have dominated the apartment market. On an overall basis, the apartment market made tremendous gains, but volatility and uncertainty permeated the market. After a challenging year in 2022, the industry has returned to solid ground and is exhibiting many of the steady operating characteristics that have made it one of the strongest investment classes across cycles.
The macro-economy continues to experience a number of headwinds, including persistently high inflation and bank failures which have led to mounting concerns of a financial crisis. However, the apartment industry has soldiered on and posted a good first quarter, especially given that this period is usually marked with flat or declining fundamentals.
Operating Fundamentals Remain Balanced
According to Radix data, net effective rents are up 60-basis points year to date nationwide, and while that does not amount to tremendous growth, it certainly beats the 20-basis point decline in rents we saw during Q1 2022. Traffic and leasing have jumped substantially since the beginning of the year, indicating the strength of underlying demand across the nation’s housing market. The only metrics posting declines in Q1 were occupancy and units available to rent.
One of the major components of multifamily performance that was overlooked in the historic growth of 2021 was the impact of new supply. With the exception of a few month hiatus, in the immediate aftermath of the COVID-19 outbreak, multifamily construction has continued at a breakneck pace. However, demand was so strong for multifamily that new supply was hardly an issue, even in markets adding tens of thousands of new units per year. Now that demand has leveled off and returned to pre-COVID levels, new supply is once again weighing on occupancy, and the number of units apartments have available.
Based on data from BuildCentral, there are roughly one million units in properties of 50 units and above currently under construction in the markets tracked by Radix. On top of that, there are more than two million in the planning and pre-construction stages. While the recent run-up in interest rates will make it significantly harder for new construction to pencil, and as a result, I expect many of the deals in planning to fall out, a total pipeline of more than three million units represents tremendous supply growth in the coming years.
Supply is heavily concentrated in markets that have seen the most population and economic growth, so operating performance should stay balanced. However, even with continued strong demand, owners and operators will be competing for residents for years to come.
Transaction Market Mired In Slog Due To Interest Rates And Credit Conditions
While operating fundamentals remain well balanced with moderate growth emerging, the transaction market continues to face the challenges that began when the Fed started raising interest rates last year. Rising interest expenses for properties tied to floating-rate loans have led to significant uneasiness for owners and investors. Limited distributions, capital calls, and in some cases, loan defaults have begun to emerge across the country. Sellers and buyers remain far apart on valuations, and because of this, transaction activity has plummeted.
In the recovery from the Great Financial Crisis, it was lenders who “extended and pretended,” preferring to extend existing loans to owners rather than foreclosing in hopes that fundamentals would improve. Now, the opposite is emerging, with owners choosing to extend their loans where possible in an effort to ride out the current interest rate volatility and hope that buyers come back to the table.
The recent failure of Silicon Valley Bank and Signature Bank led to the immediate concern that a financial crisis was brewing and that our banking system had major issues. SVB and Signature did not have huge multifamily exposure, but nonetheless, fear of bank failure led to speculation of an even tighter lending market than currently exists. Some lenders are getting more conservative, but for the most part, capital remains available for multifamily investment and development. The challenge is that borrowers are struggling to find deals at prices that work, given the current interest rate environment.
While it may sound counterintuitive, the failure of these banks may be a positive for the multifamily transaction market. The Fed raised rates in the March meeting but intimated that the tightening cycle is likely ending. Chair Jerome Powell mentioned that tightening credit conditions in the wake of the bank failures have had similar effects to a rate hike. If we are at or near the top of the interest rate market, this should bode well for multifamily transactions, as stability will bring buyers off the sidelines as sellers face loan maturities and need to sell assets.
Overall, the volatility of the global economy seems to have leveled out. Yes, there are still major issues, including the ongoing war in Ukraine and increasing tension between China and the United States. However, there seems to be a level of calm settling over the economy. We still may see a recession as a knock-on effect of the Fed’s hawkish policy, but if and when we have a recession, it will likely be mild and short-lived. This relative stability has allowed multifamily to return to its own normalcy, with seasonal patterns emerging, steady and resurgent growth occurring in many markets, and operating fundamentals performing well. Supply and demand will once again determine which markets and submarkets outperform in the coming months.
