Economic Uncertainty Leads Multifamily Sector Into ‘Discovery Mode’

While the multifamily sector has remained strong throughout the pandemic and the housing shortage shows no signs of abating, rising mortgage rates and a potential recession have led to uncertainty. Partner Insights spoke with Ben Pagliaro, managing director of real estate finance for CIT, a division of First Citizens Bank, about how changing national circumstances are affecting the multifamily sector. 

Commercial Observer: I talked with CIT last fall about the state of multifamily housing. What have been some of the more significant changes in multifamily from that time to now?

Ben Pagliaro: The big one is the Fed is fighting inflation, so interest rate expectations and the returns on risk-free Treasury assets have all increased. That pushes out the return expectations for risk assets, including multifamily investments. 

The market is still in discovery mode on where asset valuations will adjust to. Some of the transactions that were signed before the adjustment in interest rate expectations a couple months ago have had purchase price reductions requested. There’s not a lot of trade volume right now. So overall, the market is still evaluating these trends.  

The other big, interrelated trend in discovery mode is that we’ve been through a decade of cap rate compression supported by low interest rates, and now you’re looking at a reset. Different assets will feel that in different ways. Another key factor is that last year there was strong rental growth everywhere, and the expectation was for that strong rental growth to continue. While some markets have increased 20 to 30 percent over that period, now it’s starting to slow down, and it’s yet to be seen where that ends up.

How have the prospects changed from last fall to now for multifamily investors?

There’s a lot of caution in the market among investors right now. There will be opportunities, but cap rates are moving in the opposite direction from where they’ve been for the last 10 years, so cap rate expectations are adjusting up. Some investors are hitting the pause button due to this to see how it all shakes out.

Is capital as easy to obtain now as it had been? And what effect have higher interest rates had on that?

Capital – and debt capital in particular – is not as available as it was. It’s not that liquid right now. In the multifamily space you have agencies, banks, life companies and debt funds as major categories of providers. The debt funds have been really affected by all of this. A lot of them are effectively out of the market. For banks, it’s a mix. You’ve got many that are providing some of the only liquidity in the market outside of the agencies and life companies on bridge deals. But there are also a number of banks that have hit the pause button. Agencies haven’t been as competitive over the last couple years because of what was happening with interest rates on the long end of the curve. But now, especially with the prospect of a recession, when they’re offering a longer-term deal, that’s probably going to become a little more attractive – one of a lesser set of debt quotes on a deal.

Where do you see the greatest investment opportunities within multifamily these days?

From a debt perspective, there are a lot of good investment opportunities out there. You’re placing debt at historically low leverage points with a lot of at-risk cash equity behind you. You might be placing that debt on higher-quality assets – newer vintage in stronger locations – than you might have otherwise. Going forward from a debt perspective, it’s about trying to find the locations and markets that are balanced on pre- and post-pandemic demand drivers. Markets in the South and the West have been some of the stronger ones we’ve been looking to place debt into. But again, we’re following the equity and where the transactions are. 

From an equity perspective, the opportunities will be for assets with strong cash returns in locations that would be poised for growth in the medium or longer term. That’s where you’ll see most of the near-term investment opportunities. Then, looking forward, I don’t think we’re there yet, but there will probably come a time where some higher-yield opportunities will be here on assets that otherwise traded at very low cap rates in the past. I’m sure folks will be looking for that as well.

Are there any deals in the past year or so you can tell us about?

Not specifically, but we facilitated a number of multifamily acquisition financings that looked pretty similar to each other, with relatively low leverage points – 55 percent to 60 percent leverage in markets with strong fundamentals: good rent growth, low vacancy and balanced supply. Many of these assets at the time were achieving strong, recent-leasing rent growth. 

The COVID-19 pandemic spurred on some population shifts throughout the country, as people relocated out of certain areas and toward others. At this point, where has that had the greatest effect on the local multifamily sector?

The major in-migration markets have been the relatively affordable housing-cost ones in warm or mild weather locations in the South and the West. This is highlighted by the Southeast – pretty much every state there has been strong, led by Florida, and the Southwest has also been strong, led by Arizona. But also, you’re seeing strong markets even within California – the Inland Empire has performed really well as an affordable alternative where you’re able to get more space at lower cost.

Last year, CIT was being cautious about lending on multifamily in downtown areas. Is this still the case?

With work-from-home trends still in flux, we remain more selective for assets in downtown areas. That said, an asset with strong historical cash flows during this period would remain attractive. Some greater central business district regions have some of the newest, redeveloped areas, maybe cooler neighborhoods that were repurposed with new restaurants or other strong amenities. A lot of those areas have new multifamily properties and maintain solid demand, so I think some of those areas are doing OK.

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