December 2023 – Multifamily Trends and Expert Insights Revealed

The Multifamily Investment Environment as 2023 Comes to a Close

As we wind down 2023 the 10-year is yielding about 4.25%.  This is down roughly 75bps from its recent peak when it toyed with a 5% handle at the end of the 3rd quarter.  Not surprising, the multifamily market has been largely frozen this year with transaction volume down roughly 72%.

Will the wait-and-see attitude of most owners in 2023 transition into an I-must-do-something panic in 2024 as this year’s short-term loan modifications and extensions mature?

$75b in multifamily loans matured in 2023 and many were able to kick the can for another 6-to-12 months to join another $129b in 2024 maturities that will need to be refinanced or sold next year.

The fastest tightening cycle on record over the last 18 months initiated a pricing reset that is still ongoing.  To date, Green Street estimates that multifamily values are down 30% from their recent peak.

It’s important to note that the vast majority of the estimated loss has yet to be realized as owners would prefer to sell in a more accommodating rate environment.  Unfortunately, barring a systemic event, it is difficult to envision another zero-rate environment that would be needed to salvage much of the equity deployed during the pandemic period of 2020 to 2022.  Many of the deals with leverage of 70% or better during this period will experience a total equity loss.

The backdrop of current market conditions provides a great segue into a new section we will periodically add to our monthly update – Expert Insights.  In Expert Insights, we will define and share some important principles and terms we adhere to as disciplined multifamily investors.

Let’s get started!

Expert Insights:  Using Historical Baselines to Price Real Estate

We often hear of “risk-adjusted return” in real estate.  Due to the lack of historical returns information, private real estate, with some narrow exceptions (NCREIT indices), does not easily lend itself to the traditional risk-adjusted measures (standard deviations, sharpe ratios, etc.).

Therefore, industry veterans gauge asset and market risk using historical “cap rate spreads” as an indicator of a particular investment’s attractiveness.  A cap rate is simply a property’s net income return, expressed as a percentage, when bought for all cash.  For example, if you buy a property for $1M and your net income is $80K you have an 8% cap rate.

A cap rate spread is simply the premium above a certain baseline yield meant to compensate for the additional risk inherit in real estate investment (market, operating, liquidity, etc.).  The most used baseline yield in real estate is the 10-year Treasury.  

Since the Great Recession of 2008, cap rates, on average, have yielded 300bps (3%) more than the 10-year yields.  With the current 10-year yield (~ 4.25%) this would indicate cap rates need to be in the 7.25% range to reach its average spread.   Currently cap rates are roughly in the 5.75%-6% range.  This indicates real estate is still around 17% overvalued using this particular baseline.  This is well illustrated in the following chart.

It should be noted that the 10-year cap rate spread is constantly in flux and not a perfect indicator of value, but it does provide important historical guidance on where the market is in terms of overall value.

In our opinion, effective use of the cap rate/10-year spread is to use the medium 10-year yield over a 15-year period.  This mitigates short-term anomalies, such as the virtually zero rate period we experienced during the pandemic.

This would have prevented many sponsors from overpaying for deals during the pandemic if they had underwritten their exit cap rates using the 10-year 2.90% 15-year medium as a baseline - instead of assuming the 10-year yield would remain at pandemic period yields.

We will wrap up this issue’s Expert Insights by saying there are other historical baseline indicators experienced firms use such as the BAA bond and mortgage constant spreads to evaluate the market.  We will cover some of these and much more in future issues.

Holiday Wishes!

All of us at Essential want to take this opportunity to send our warmest thoughts and best wishes for a wonderful holiday season and a very happy New Year!

P.S.  As a board member of the Family Office Real Estate (FORE) Institute we are excited to announce that FORE will be hosting its annual Investment Forum in Keystone, CO in February.  This is a great opportunity to network, learn, and be inspired by the best minds in real estate investment. With immersive sessions and expert-led panels, it's the must-attend event of the year for industry professionals. Join us to shape the future of family office real estate investment and ensure your legacy thrives.

Please drop us an email if you would like to learn more about attending this must-attend event as we work to shape the future of family office real estate investing.