Real estate pundits like to use the baseball inning analogy to describe the real estate cycle. And people have been saying it’s the seventh inning for three years now. Are we in a rain delay?
Whenever new construction starts booming and capital becomes plentiful, caution flags go up and a potential bubble must be considered. With regard to multifamily, there are two types of deals that have recently crossed my desk with greater frequency. First, there are the groups that buy Class B apartments in good markets, invest some capital to spruce them up, push rents toward Class A and then sell them as Class A product. Thanks partially to Freddie Mac and Fannie Mae, low coupon financing at sometimes 80 percent loan-to-value has made this a popular strategy that has helped compress cap rates.
The other groups are simply building new construction in a strong market. This requires a bit more risk, and construction lenders have become more skittish lately about leverage levels. However, developers insist that having the newest product will have a “build it and they will come” effect, and joint venture equity partners are often willing to feed this strategy.
So is this bubble likely to burst? Possibly, but only for certain pockets. Yes, interest rates are a significant risk if you are buying existing product at 5-6 percent cap rates or building into a 6-7 percent cap rate. However, the demand for rental housing in strong markets seems to be insatiable. Let’s look at the fundamentals:
• Homeownership rates have fallen from 69.2 percent in 2004 to 63.4 percent in 2015, the lowest level since 1967 (Source: Harvard University and Enterprise Community Partners)
• Seventy-four percent of renter households earn incomes of less than $50,000 (Source: National Multi Housing Council) implying they will likely remain renters.
• Delinquency rates on multifamily loans are only 0.73 percent for banks, between 0.02 and 0.07 percent for life companies, Freddie Mac and Fannie Mae, and 4.73 percent for CMBS (Source: MBA)
• Over the last 10 years, existing lower and middle class multifamily units were converted to higher end (luxury) or owned units (condos) while other lower end units became obsolete.
• Simple population growth has fed the need for more units. With developers concentrating on high growth areas, this has led to high absorption.
• Foreign capital is getting more comfortable investing in assets other than the gateway cities, keeping multifamily on an upward trajectory. EB-5 money is anxious to invest in new multifamily, too, and has helped fuel additional development in growth areas.
Notwithstanding all of the aforementioned positives, there are signs that the easy money has been made and challenges have subsequently arisen. Construction lenders have suddenly found religion. Much of that caution is due to the reserve requirements placed on them by Basel III and FRTB [Fundamental Review of the Trading Book]—which raises the cost of their capital by 50 to 75 basis points—but another is that these lenders are concerned that certain areas are getting overheated. Everyone’s seeing all of the cranes in Miami and don’t want to be the last ones in. While lenders had not reached the leverage levels from 10 to 12 years ago, they are getting more discerning regarding sponsor and market quality.
So, will the formula of buying Class B and upgrading the units work going forward? That depends on the market. And cap rates and interest rates will have to cooperate. There’s a correlation between the two, and certain markets will be left behind. The oil bust will have an overflow effect in Texas. Last year, Houston and Dallas increased their inventory stock by 19.7 percent and 8.8 percent, respectively, with vacancy rates increasing by over 3 percent in each market (Source: MPF Research). And areas that you wouldn’t assume would be prone to overbuilding are showing sharp increases in vacancy rates. Downtown Boston’s vacancy rate has increased by 14 percent over the past two years, and Philadelphia’s University City has risen by 13.5 percent over the same period (Source: CoStar Group).
So now when a developer calls a prospective lender or equity partner with an easy turnaround deal or new development, you may have to drill down a little deeper. The eighth and ninth innings are approaching, and Mariano is warming up in the bullpen.
Dan E. Gorczycki is a senior director for Avison Young in New York, specializing in Debt Financing, Equity Raises and Structured Financing, often in multifamily.