MBA NewsLink Multifamily Roundtable: High Rates, Stalled Rents and New Roofs
Introduction by Andrew Foster, CRE, Director of CMBS Surveillance with KBRA, Dresher, Pa.
Storm clouds are on the horizon for commercial real estate. This is common knowledge and conventional wisdom whether you’re listening to the likes of Warren Buffett, the Federal Reserve or even Elon Musk.
Talk of these troubles could be heard on Capitol Hill (as reported here in the Commercial Observer) in recent weeks when a bipartisan bill, H.R. 5508, which seeks to amend the tax code to make it easier for commercial real estate borrowers to defer taxes applied to their properties during loan modifications or debt workouts was introduced by Rep. Claudia Tenney, R-New York and Rep. Brian Higgins, D-New York. By now, everyone has heard the tales of office woe but what is happening in the world of multifamily?
Real Capital Analytics’ second quarter 2023 Capital Trends Report noted, “deal volume for apartment sector was almost hardwired to fall at double-digit rates from a year earlier in the second quarter. Sale activity for the second quarter a year ago was at a record high level, with cheap debt and a hunger for yield driving investors to chase deals at a record pace. Apartment prices are in retreat, with the RCA CPPI for the apartment sector down 11.7% from a year earlier in the quarter. This pace of decline was the sharpest across all property sectors. Still, one might view this decline as a normalization from an abnormally high level.”
In September, Yardi Matrix published a research bulletin that highlighted “expenses for multifamily properties nationally grew by 9.3% on average in the trailing 12-month period ending in June 2023, which is 63% higher than the 5.7% increase during the previous 12-month period. Expenses rose in most every category, but the biggest increase was in insurance, which was up 18.8%.”
It isn’t all bad news though. In August, Freddie Mac’s 2023 Midyear Multifamily Outlook noted that “after falling month over month for much of the second half of 2022, rent growth has returned in 2023, although at a more moderate pace than the past few years. Although the pace of rent growth is slowing as the market comes down from the record-breaking rent growth seen in early 2022, more than 80% of the top 49 markets have seen flat or positive rent growth for the year ending in May 2023.”
On the supply side, the outlook highlights that RealPage reports that roughly 1 million units are currently under construction across the country as of early 2023, a total not seen in nearly 50 years. For comparison purposes, however, the multifamily market is much larger today than it was in the 1970s and the new units coming online are concentrated in particular markets as well.
As uncertainty dominates discussions about getting deals done, MBA NewsLink convened three multifamily finance executives, Chad Musgrove, John Lloyd and Carl McLaughlin, to get their opinions on where the apartment industry sits and where it’s headed next.
MBA Newslink: Chad, describe the multifamily outlook heading into 2024
Chad Musgrove: We are at the end of an era – that is very cheap capital post the GFC. Now, we are getting a firsthand account of an intense deleveraging cycle. Cheap capital, limited supply and minimal risk in the bull run led to elevated values essentially even through COVID to their peak in 2021.
Since then, the cost of capital has increased dramatically, valuations have moderated, interest-only periods have ended, and debt service has ballooned. Banks’ balance sheets are full and capital ratios stressed, so we are under pressure to reduce exposure to commercial real estate and specifically non-multifamily assets. Short-term interest rates are up significantly, and the 10-year U.S. Treasury bond is several hundred basis points wider than its bottom; that has made credit is far less available, and the cost of financing has more than doubled creating a difficult transaction market. Agency lender volume has been down over 50-60%. For the markets to operate efficiently again, we still need corrections for values and pricing.
MBA Newslink: What are you most bullish about?
Chad Musgrove: The Agencies have an obligation to keep liquidity within the markets namely to support workforce and affordable housing so naturally I’m bullish on the housing sector. We may see some hurdles with Capital A – LIHTC, etc. affordable housing with bond cap volumes. With construction coming to a bit of a halt, there are some supply disruptions in certain markets that could create an opportune entry point for workforce housing as Class A rents have receded somewhat. We are highly focused on utilizing our balance sheet to support Agency sponsors and unlike a lot of our competition, we have capacity for new short-term bridge lending.
MBA Newslink: John, what servicing hot topics would you highlight for DUS lender community in the second half of 2023?
John Lloyd: A few key themes have manifested in servicing as a reflection of the evolving landscape of the real estate industry. The first is rising property expenses, primarily driven by insurance costs. Insurance costs have increased particularly for coastal properties, but record-high insurance losses, prolonged wildfire seasons, increases in severe weather and higher construction/materials costs mean that no market is spared. We’ve even seen a few specific examples of insurance costs increasing by more than 400%. As a result, there have been more insurance waiver requests for higher deductibles, payment plan flexibility and even waivers for when coverage is unattainable. We’ve also seen that payroll has increased significantly for most properties over the past year. As rent increases cool off, many properties are unable to offset these rising expenses. The result, in many cases, is lower net cash flow, which means more loans on the watchlist.
Another area to keep an eye on is property condition. The COVID-19 pandemic and subsequent supply shortages of 2020 and 2021, coupled with inflation in 2022 and 2023, have heightened concerns about deferred maintenance and general quality of the underlying collateral. The Agencies and primary market lenders have become much more focused on upfront inspections as a result. There is also increased attention on ongoing monitoring of property conditions. For example, if conditions are an issue at one property, then the Agencies may proactively review additional properties from that same sponsor. Servicers should consider a similar approach even if inspections are not due immediately. In addition, the GSE’s are bringing on more servicing staff to review and monitor the property inspections.
MBA Newslink: Chad, what are you hearing from borrowers as to capital needs and current challenges?
Chad Musgrove: Borrowers continue to struggle with finding a capital structure that is accretive to acquiring multifamily assets in today’s market. Many borrowers need capital requiring lower returns to make transactions work, as the cost of capital has dramatically increased. Many still must contend with the notion of negative leverage for multiple years during the investment hold period; previously that was only for the first year. Aside from pure financing costs, the best deals still have a decent bit of competition. The most concerning issue facing borrowers today is increased operational costs – namely insurance costs. In many instances, we are seeing the inability of sponsors to obtain the proper insurance coverage ultimately leading to deal fallout.
MBA Newslink: Carl, how are market participants navigating the increased pressures of rising costs and interest rates?
Carl McLaughlin: Let me address the pressures of rising costs first. Those of us who have been around for a few years understand the cyclical nature of our industry, and we aim to navigate similar cycles better than we did in the past. In this instance, I feel that market participants are really looking at their teams and processes to reevaluate, identify and prioritize what is critical from a business and profitability perspective. Any in-flight existing technology efforts may have capabilities and requirements adjusted to improve delivery timelines — with a focus on efficiency — and to aid in reducing general and administrative costs where possible. Of course, pricing, spreads and the other usual levers are in play, but I expect there is more collaboration and communication from the front of the business to operations and servicing teams to holistically assess the costs to do a deal.
Cycles with higher interest rates frequently cause speculation as to duration and adoption of what the ‘new norm’ might be. I think overall issuers and other market participants are responding better to these types of cycles and have been forced to be more creative and efficient at bringing new products to market at what participants believe is the right price, even if that rate reflects where the market is. While some may be hesitant to bring a lot of floating-rate product on their books because of the associated higher costs, shorter duration paper with options to prepay seem to be the “happy medium.”
MBA Newslink: John, as the multifamily industry anticipates some challenges in 2024, can you share some lessons learned responding to various COVID asset management challenges?
John Lloyd: We learned several valuable lessons that will continue to guide our approach. Personally, the pandemic taught me that while we cannot always predict the next business challenge, teamwork and communication are critical components to working through any crisis. While it might not have been the optimal setup, our employees demonstrated that a lending business can be run effectively in a remote environment. In fact, NewPoint launched in June 2021 when the office world was still very remote. While the importance of face-to-face collaboration and mentoring opportunities offered by in-person work cannot be understated, I’m extremely confident in our ability to pivot successfully in the face of future disruptions.
There are also some takeaways related to asset management. While there was general concern that the market would see a significant number of deferral requests and/or defaults, our portfolio held up remarkably well during the pandemic. Many borrowers inquired about forbearance, but only a handful deferred payments. This just goes to show just how resilient the multifamily asset class can be and that there are opportunities to be found and lessons to be learned in any market cycle.
MBA Newslink: Chad, what type of transactions are still getting done as the market sorts out price discovery?
Chad Musgrove: Sponsors flushed with cash are seeking out well located assets in good markets that are higher quality. We are still seeing these assets trade at tight cap rates relative to current capital costs. This trend will continue with a flight to quality due to delayed or cancelled construction starts which will lead to tighter supply fundamentals in the next five years. Lower-quality assets have not traded but we’d expect those to do so at wider cap rates which in turn could signal more distress within the capital markets.
Carl McLaughlin is Vice President, responsible for loan servicing operations and loan administration for Multifamily. He joined Freddie Mac as a mortgage purchase analyst in the Single-Family Division in 1999. Over the years, he supported Single-Family Purchase and Acquisition, Single-Family Data Quality and Mission/Affordable Housing. He later became an operational risk manager, where he helped manage, and eventually directed, operational risk across various Single-Family and Multifamily operational risk types and internal organizations, identifying risks and controls, measuring, and reporting on the risks, monitoring and holding capital for these risks, and establishing sound governance over operational risk. Since 2011, Carl has led the Multifamily division’s servicing of various new loan and securitization offerings and oversees the Division’s role of Master Servicer for certain K-Deals.
John C. Lloyd oversees servicing and asset management for NewPoint Real Estate Capital. His 30 years of experience also includes commercial real estate appraisal. Lloyd was with Barings Multifamily Capital prior to the launch of NewPoint, where he guided portfolio growth, in conjunction with Mass Mutual, to exceed $39 billion in international loans stretching from Canada to Europe.
Prior to Barings, Lloyd served as the Managing Director at C-III Asset Management (Centerline Capital and ARCap) for over 12 years. His responsibilities included supervising the Primary Servicing and Asset Management team that serviced over 14,000 loans totaling more than $223 billion. This portfolio included over $11 billion in Fannie Mae, Freddie Mac and Ginnie Mae loans.
Chad P. Musgrove is a Senior Vice President at M&T Realty Capital Corporation (MTRCC), having joined in June 2022. He originates multifamily affordable and conventional loans nationwide via the DUS, Optigo, and HUD platforms. Based in Miami, he currently oversees Agency production for MTRCC in Florida & the Sunbelt while providing structured finance solutions via the capital markets for non-multifamily commercial real estate. Musgrove has directly been involved in structuring more than $3 Billion in loans throughout his career.
Prior to joining MTRCC, Musgrove was an Associate Director at Lument for over a decade having worked for its predecessor firms Hunt Real Estate Capital & Centerline Capital Group. He began his tenure in New York and relocated to Miami in 2014 to expand the company’s Agency footprint across Florida, the Southeastern U.S. and nationally. He also spent time in the payments finance sector as an Associate Consultant within the Industry Roundtable division for Auriemma Consulting Group, where he was responsible for business development with C-suite professionals while consulting on corporate finance & strategy related to mortgage banking debt collections.
Musgrove is a sitting board member of Rebuilding Together Miami-Dade and the Real Estate Lenders Association Miami and volunteer for various non-profit organizations such as Omega Psi Phi Fraternity and 100 Black Men.
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(Views expressed in this article do not necessarily reflect policies of the Mortgage Bankers Association, nor do they connote an MBA endorsement of a specific company, product or service. MBA NewsLink welcomes your submissions. Inquiries can be sent to Editor Michael Tucker or Editorial Manager Anneliese Mahoney.)
