Investors in multifamily real estate are grappling with a phenomenon known as “negative leverage”—when mortgage interest rates exceed initial property yields—and have been since the spring. Largely for this reason, sales volume during the third quarter declined from the year before, the first year-over-year decrease since winter 2021. Still, many investors remained engaged and continued to bid aggressively for assets, and acquisition cap rates overall were essentially unchanged from spring levels.
Investors have good reasons to pursue apartment acquisitions even when debt costs exceed the initial cash flow yield of acquired properties. Fundamentally, apartment market performance remains healthy, characterized by high occupancy, positive absorption, and above historical average annual rent growth. Moreover, housing in America, particularly in markets experiencing unusually high levels of population in-migration, is in short supply, and homeownership is increasingly beyond the reach of American renters, keeping apartment demand high.
Although optimism about market and specific property performance is warranted, investment risk is clearly greater now than in 2021, when multifamily property sales rocketed to record levels. What are the best practices for investors in the current market? Lument has a few recommendations.
Recommendation One: Markets Are in Flux, So Don’t Be Overly Aggressive
Take your cue from investor activity. Investors have been active in recent months—despite a decline in sales volume during the third quarter, sales during the quarter totaled about $53 billion—but the number of participants in property auctions has declined. A property that may have attracted twenty bids in March might now receive no more than a handful.
The property market is undergoing “price discovery,” a process by which buyers and sellers reach a new pricing equilibrium after a change in valuation fundamentals. Until a new equilibrium is reached, it is better to bid cautiously and risk missing out than to be too aggressive and be exposed if prices stabilize or decline.
Recommendation Two: Be Prepared to Sharpen Your Pencil
When markets are undergoing price discovery, sellers often find that they can’t command the price they expected based on recent sales comps or they find that the winning bidder in the first round falls out over a financing contingency. Don’t be surprised when a seller requests a revised offer. In other words, it no longer may be necessary to submit a “best and final” offer in the first bidding round. Rather, it may be better to be cautious in the first round and prepared to make a more competitive bid in the second.
Recommendation Three: Underwrite Operating Expenses Carefully
Know what you are getting into. Underwriting the pro forma income statement becomes more challenging in an inflationary environment. Under negative leverage, accurately forecasting operating expenses assumes even greater significance when determining the viability of a deal.
Drill down below the surface of compensation expenses. It may not be sufficient to simply apply a broad inflation adjustment to your compensation costs. Understand who is on the payroll and the prevailing market wage for each employee skill set. Gather information on the labor supply and demand conditions in the target market and take care not to extrapolate conditions from your home market to the target’s.
Be mindful that the insurance costs borne by your current properties may not be applicable to an acquired asset. Conditions in the property insurance market have been difficult for owners for years but recently have deteriorated, raising costs significantly. If possible, discuss coverage options with more than one carrier.
Recommendation Four: Apply Greater Scrutiny to Your Pro Forma Rent Assumptions
Just as sellers are being compelled to adjust their price expectations, buyers must reassess their pro forma rent projections. The trajectory of rents in markets across the country changed dramatically in August and September. Rent growth in many formerly soaring markets returned abruptly to earth. It is advisable to consider flat or even declining rent scenarios in your deal underwriting.
Recommendation Five: Recognize That Market Absorption Behavior is Moderating
The pace of household formation and, consequently, apartment absorption accelerated during the pandemic and for good reasons. But many of the relevant motivations are diminishing and the government subsidies that helped finance the phenomenon have ended. Prospective buyers should bear this in mind when forecasting market space demand.
Recommendation Six: Volatile Markets May Provide Pricing Opportunities
Having an offer accepted by a seller is a critical step but closing requires assembly of a complementary capital package. In volatile markets, this can be a challenge. Bear in mind that pricing in volatile markets can entail surprises, particularly when employing alternative sources of debt, like bridge or mezzanine loans, for which pricing spreads can shift dramatically in a short period of time. Rate lock as early as possible when conditions permit, and when they do not, recognize that volatility can work in your favor and be prepared to lock at a moment’s notice.
Investing when markets are in transition adds a layer of risk to a market that may be “priced to perfection.” But with risk comes opportunity. Lument stands ready to help your firm navigate these choppy waters and has at its disposal the financing tools required to close prudent transactions even in these unsettled conditions. Please reach out if we can be of assistance.
