Multifamily Sales Hit 4-Year Low: More Price Declines?

Dave:

Multifamily transaction volume is at its lowest point in four years. But why is that? Why is it hard to determine the value of multifamily properties today and why are so many investors sitting on the sidelines today? We’re talking about all things multifamily.

Welcome to On the Market. I’m your host as usual, Dave Meyer, and today we’re bringing on Xander Snyder. He is the senior commercial real estate economist at First American, and we’re bringing Xander on to discuss the downward trend of multifamily transactions and how that impacts cap rates and valuations. And we’ll also get into what you can expect to see for this asset class in the near future. Before we bring on Xander, just wanted to remind you all that. If you want to stay up to date with every episode of the show, make sure to search for on the market in your favorite podcast app and hit that follow button. Let’s bring on Xander Snyder, welcome to On the Market. Thank you for joining us

Xander:

Today. Thanks so much for having me, Dave. Looking forward to the conversation.

Dave:

Me too. Let’s start with multifamily transactions. My understanding is that we are sort of at one end of the extreme, so can you tell us where they are today and how transaction volume compares to previous periods?

Xander:

Sure. Well, transaction volume is at our currently at four year lows for multifamily properties. And I find that to be a somewhat remarkable statistic because four years ago we were in the early phases of the pandemic. It was hard to do much of anything at all. And now we’re kind of back there. I mean, this was before we knew how to do remote work. It was before we had figured out all of the things that are kind of commonplace to us now. And yet transaction volume release in space terms is at comparable levels or frankly even a little lower than it was in two Q3 Q 2020. So things are slow right now.

Dave:

I was going to ask you that because a lot of times when we compare current data to what was going on during the pandemic, it’s a little bit funky, but I’m actually looking at a chart that shows the transaction volume. And in all these charts that you see over Covid, there’s this one month leg down where everything just stopped and that happened in multifamily back in 2020. But what Xander is saying is that transaction volume right now is still actually lower than that shock decrease in transaction volume that we saw at the beginning of the pandemic. I just want to underscore that so everyone understands just how dramatic a change this is. And while we’re on the topic of just historical trends, or maybe you can tell us, has there ever been a period this low or is this sort of a unique time?

Xander:

There has been, but it’s sort of been in the aftermath of other crises that have existed in history. I think the comparable year for transaction volume to today is in the aftermath of the global financial crisis. It was either 2011 or 2012 where you need to go back to find multifamily volume quite this low again, in terms in unit terms. So it has been here before, but this is not a normal level. It’s certainly lower than it was last year, and it’s certainly lower than it was in the pre pandemic years. If you look at a five-year average from 2015 to 2019, you got to go back to the GFC to find apartment volume this low or at the aftermath of it rather.

Dave:

Okay. And is this happening across all quality class levels? In multifamily? It

Xander:

Is, but it’s happening to different degrees across different apartment qualities. So class A really surged in terms of units traded in 2021, and part of that was because people wanted to move out and get more space. The pandemic at that point seemed like it might be with us for a while, so that really drove a surge in demand for housing. And the more expensive units have fallen off in terms of transaction volume the most they have witnessed the largest decline. I think it’s something like 85% from peak, but class B and C have also declined. It’s just not by quite as much for reasons that might be obvious because if you can afford cheaper rent, then there’s going to be more demand for it.

Dave:

Got it. Okay. Thank you. And I know there are a lot of different factors going into the economy right now, but can you give us some of the primary reasons transaction volume is so low?

Xander:

Sure. Well, the first one to point to is cost of capital. And that’s going to not be particularly, that’s not unfamiliar to folks at this point. Everything’s more expensive, higher cost of debt limits, buyer’s ability to pay top dollar for properties. It just limits what sorts of deals pencil out effectively. It also in addition, makes it a challenging refinancing environment. So for folks who have the opportunity to wait and see, maybe they have a fixed rate loan that doesn’t come due for another three to four years, they are probably not going to sell right now if they don’t have to because they won’t get top dollar for it. So that’s another downward pressure on volume. And lastly though, prices have corrected from peak, they’re still much higher than they were pre pandemic. And the fact that we’ve gone through so much inflation is part of the reason I like looking at transaction volume in terms of units because it kind of flattens out the impact to dollar measure transaction volume, but prices are still higher than they were. So higher cost of debt, higher prices, and a bunch of sellers or prospective sellers that don’t necessarily want to sell right now.

Dave:

That’s a really helpful overview, and I think I wanted to say it’s important to note that the higher cost of debt, higher interest rates on commercial loans only make deals pencil as long as prices don’t come down in a corresponding way. And it sounds like that’s exactly what happened. We have either stubborn sellers or sellers who can afford to be patient and they’re not going to sell into this adverse environment. And so we’re seeing a lot of, so that’s sort of driving the reduction in transaction volume here. Now is there demand? Do you see people wanting to buy properties but there’s just nothing to sell because kind of what we see in the residential market, but is there a different dynamic going on in commercial?

Xander:

There are absolutely buyers who want to buy, and I’ll say many are waiting patiently on the sidelines for a deal that makes sense. And what you said a moment ago really is a big part of buying real estate. If you can buy the right price, then the deal can make sense. I mean, you can buy an office building at a 90% discount if it’s 30% occupied, you might still be cashflow positive. So at the right price, plenty of deals make sense. The problem is can you get at the right price? So I think the dynamic right now is you have a lot of buyers that are hesitant to deploy capital. That might be changing now with the announcement that Blackstone made recently, that they’re kind of getting back into the market and they’re not going to try to time the bottom. But I think that a lot of sponsors are just being patient to make sure they can get the deal that they want and not accidentally get into a property that could find itself facing liquidity issues because the interest rate is too high. Something like that. Well,

Dave:

I want to follow up on that, but I hadn’t heard that. What did Blackstone come out and say?

Xander:

That they’re beginning to deploy capital again in about a billion dollar vehicle and that they think that there’s sufficient deals around right now and they caveated it with sufficient underwriting diligence and all of that. And I think that that is something that’s changed meaningfully from pre pandemic is that diligent underwriting is going to matter more now because it’s uncertain, but buyers are gradually beginning to enter the market, but they’re not going to do it in droves until the prices are low enough. And that’s part of the reason why volume remains low.

Dave:

And was this specifically a billion dollars into multifamily?

Xander:

That I don’t know. I would have to double check.

Dave:

Just curious. But yeah, it is interesting to see, and with someone, billion dollars doesn’t buy as much multifamily as you might think, but it does signal to the rest of the buyer pool that they’re going to be facing competition and it might spark some action on the part of other investors. So let’s go back to pricing. We’ve talked about how pricing is down a little bit still well above pre pandemic levels. And for those listening who might not be as familiar with commercial real estate or multifamily real estate, one of the ways that people price commercial assets is using the net operating income and something known as a cap rate, a capitalization rate, and a cap rate is not something that is set by any one individual, but it’s a sort of a measure of market sentiment and what buyers and sellers are willing to meet at. And during the pandemic cap rates were, correct me if I’m wrong, I don’t know if they were historically all time lows, but they were the lowest I’ve seen in at least 20 years. Is that right?

Xander:

That’s right. At least since about 2000, which is kind of as far back as a lot of the data goes. Oh,

Dave:

Okay. All right. So that means that for every dollar of rent that you were collecting, people were paying the most money basically ever that we have data for during the pandemic. What has happened to cap rates? Since interest rates started to go up,

Xander:

Cap rates have gone up as well, and I think it’s worth pointing out that there are a number of studies that actually show that the relationship between interest rates and cap rates is positive, but it’s lower than you might think it is. Nevertheless, cap rates have increased, and there’s really two drivers of that. When you think about a cap rate, it’s just net operating income over the value of the property. And so there’s two variables that can move cap rates. One is net operating income. If it goes up, your cap rate goes up. The other is price. If prices go down, your cap rate goes up. And the way I like thinking about it for folks who maybe haven’t heard of the concept of cap rates before is it’s essentially you’re buying an income stream and how much are you willing to pay for that income stream? So over the last three years, net operating income has, well, it’s corrected now, but for a period it was increasing and prices have been decreasing. That’s a formula for cap rates to increase.

Dave:

Got it. Yeah, and I want to make sure everyone understands that when you say cap rates going up, that actually means that you are willing to pay less for the income stream. Just to be clear, the lower the cap rate, the more you are paying for every dollar of rent. And so just generally speaking, sellers like low cap rates, buyers like relatively high cap rates because that means they can pay less for every dollar of income. We have to take a quick break, but stick around. We have more from Xandr on pricing rents and how we expect cap rates might change right after this. Welcome back. I’m here with Zander Snyder, and we’re talking about the latest in commercial multifamily. Let’s jump back in now. Can you tell us, zander, where cap rates sit today, at least on a national level?

Xander:

Yeah. Cap rates for multifamily are now right around 6% or a little above 6%. That is up from, I think the low is about four and some places I saw cap rates below four during 20 21, 20 22. So while a 3% increase might not seem like much, that’s a huge difference in terms of valuation decline. So that’s already happened. I think it’s possible that multifamily cap rates could continue to go up and we can get into discussions about why that is. But I think one of the fundamental things, and you pointed this out, is that cap rates can be used as a valuation tool. So if you know the income of a property but you don’t know what it’s worth because it hasn’t sold in 10 years, it hasn’t traded, you can use cap rates to estimate what it’s worth. And if you don’t have a lot of comparable transactions to see what other buildings cap rates are, it becomes very difficult to value that asset. And that I think is the dynamic that is really in play right now across the country. Well,

Dave:

Particularly what you told us at the top, that there’s fewer and fewer buildings being sold, so there are less comps, there are less understanding what things are actually trading for, and maybe does it become this sort of cycle where we have fewer transactions so people don’t know how to value the deals that they are considering, which leads to fewer transactions, and we get into this downward cycle. I

Xander:

Don’t necessarily think that’s going to happen. I think what will happen is prices will correct, and part of the reason prices haven’t corrected as much is because of that sellers who are able to wait and see, there’s kind of like a friendly term in real estate, you say motivated sellers, and all that means is sellers that don’t have a lot of options, right? That’s where a buyer’s going to get a deal because for some reason or another, maybe for non-economic reasons that seller needs to sell and they need sure of close and they need the liquidity and they need that more than a high price. I think that as mortgages continue to mature and there’s a lot of mortgages coming due this year and next year, it will remove that wait and see option for a lot of sellers, and that will motivate further price declines, which will result in an increase in volume.

Dave:

So do you think this is creating a situation where investors who maybe have invested in a syndication and are participating in a bigger deal should expect longer hold times for their multifamily asset as these sellers just wait and see rather than trying to exit according to their original business plan?

Xander:

Yeah, I think that’s entirely possible. So it doesn’t mean that the overall returns will necessarily be lower, but you need to wait if a building is struggling right now to get a better sale price on it. I think the other aspect of it is you have a lot of funds right now that have raised capital that haven’t deployed it. People talk about dry powder, which is the amount of cash sitting on the sidelines. There’s a lot of that. Now, I personally know a sponsor that raised and a close ended fund in 2021 and then sat on treasury bonds for about two and a half years before they bought their first building because there weren’t good deals. So I think there’s two aspects of it that are keeping volume low right now, and it’s worth thinking about both sides of the equations essentially. You

Dave:

Mentioned a bit earlier that you thought cap rates may keep rising. Could you tell us more about that?

Xander:

Sure. I think it’s two things. It’s a function of prices and a function of income. I think prices can continue to decline for the reasons we’ve been talking about. Lower prices result in higher cap rates. I also think that it’s possible that operating income on average continues to grow at modest levels, but there’s a lot of pressure on net operating income margins right now, and that’s a conversation that we can have. But even if NOI remains stable, doesn’t increase, doesn’t decrease, and prices decline, that results in higher cap rates. I just don’t think we’re done with price declines in the multifamily market quite yet.

Dave:

What will bring an end to price declines

Xander:

More buyers entering the market?

Dave:

Yeah, more demand. It’s

Xander:

Really that simple, right? When enough buyers can say, ah, that’s a deal that I want, they’ll enter The market demand for those properties which can be measured with transaction volume will increase and that’ll stabilize cap rates.

Dave:

This is a subjective question. I don’t know if you want to answer, but I have been surprised at the pace of price declines. I thought it would’ve gone faster. Given everything going on and that you’ve been describing, is this sort of what you’ve been expecting?

Xander:

What I’ve been expecting, it’s a good question. I think it’s hard to say what exactly we were expecting to happen in mid 2021 now because there are still so many uncertainties and I think there are still a lot of uncertainties in the market. But if you use a historical analog to today, I think the global financial crisis is not the right one. I think probably the savings and loans crisis is a better one for reasons related to rapid rise in interest rates and banks having to attract depositors while not themselves being able to increase their interest income. So if you look at the s and l crisis, the price declines were less steep than in the global financial crisis, but they lasted much longer. Commercial property prices declined for something like nine consecutive quarters in the GFC 16 consecutive quarters in the s and l crisis, but at trough during the GFC prices has declined by about 30% year over year. The trough in the s and l crisis was about 10, 11%, and part of that is a function of the slow workout of these loans that we’re now beginning to see. It’s already happening. And so I think that there are differences between today and the SNL crisis, but that slowness of the prior crisis is part of what’s playing out right now.

Dave:

That’s some great historical context. Thank you for explaining that. Xandr, you talked a little bit about NOI and whether it will stay flat, increase, decrease. Can you tell us a little bit more about your forecast or thoughts on rent?

Xander:

Yeah. First, it’s going to vary substantially by geography because supply coming online varies substantially by geography. I put together a scatter plot that plots excess supply and demand versus rent growth, and there’s a very clear negative relation, happy to share that after the show, but what essentially what’s going on across the country is a lot of supplies coming online. It’s not all happening in the same place as evenly, but that’s going to moderate rent growth. Then on the expense side, you have a bunch of pressures as well. You have rising insurance premiums, you have rising property taxes in a lot of places. So that is a formula for margin compression, declining rent growth, and higher expenses. It’s a challenging operating environment right now because there is so much that’s outside of the control of individual operators that they really need to try to focus on what they can do. Sound operating is very important in the current environment.

Dave:

That’s a really good point. Yeah, I think a lot of people who got into multifamily over the last couple of years were citing the rapid increase in rents that we saw from 20 21, 20 22. But not only has that slowed down and inflation has driven up the cost of a lot of operating expenses, but as Xer just said, we all know this is happening in the residential market too. We’re seeing just crazy increases in insurance premiums and taxes are also going up. So this is really compressing the net operating income of a lot of commercial assets, which is going to probably continue to drive down prices. Alright, time for one more quick break. Stay with us.

Welcome back to On the market. Let’s pick up where we left off. Xander. I’m curious, there’s this dynamic in multifamily that’s been going on. I’d love to pick your brain on. We’ve seen in 20 20, 20 21 a huge increase in multifamily construction when prices were going up and there was a lot of demand for new apartments. People started building, but building a multifamily property takes time. And so we’re in this period, we’ve talked about it quite a lot on the show where multifamily supply is increasing rapidly. We all know that’s happening. It’s pushing downward pressure on rents and it’s probably going to keep going at least for a little while. I’m curious your opinion on what this means for the long term because the construction pendulum has sort of swung back in the complete other direction and now no one’s building multifamily permits just seem extremely low. So does that mean in a couple of years we’re just going to have no supply of multifamily and rents are going to shoot up again?

Xander:

I don’t think we’re going to have no supply, but we’re going to have a lot less supply. And I mean, it is for the reason you said unfortunately, construction is something you can forecast with relative ease, relative accuracy. It takes a year to get permitting and entitlements done 1224 months to build a building depending on what kind of building it is, right? You can figure that based on when construction starts happen. We have a lot more supply coming to market this year and next year there’s fewer than a million apartments, just a little under a million apartment units under construction right now. So I don’t think that there will be no supply. I think that there will be less supply, and it has to do with how much construction is underway now versus how much new construction is beginning. And if you look at the total number amount of units under construction nationwide, it just peaked recently at about a million units and is now declining.

But as you pointed out, starts and permits are falling and unlike some other things in the macro economy, it’s fairly possible, fairly easy to predict when completions of construction projects will happen. Entitlements might take a year with permitting, and then maybe it’ll take 12 to 24 months to finish a property depending on the type of property. So the current pipeline of supply coming to market will eventually be fully delivered. And the future pipeline of supply that depends on current starts is declining. So I think in the short term, we’re going to have a period of oversupply in a lot of markets, but in the long term, if you look at a national level, we still have a housing shortage of several million units, and these estimates vary from about 2 million to five and a half million units of housing shortage. And there are currently about 1.7 million units of housing, so apartments and single family homes under construction right now. So in the long term, what that means is if all of the under construction units came to market tomorrow, which they won’t do, we’d still have a shortage. So I think eventually that dynamic takes back over from the oversupply dynamic again with variations between geographies.

Dave:

Could you just tell us a little bit about some of the geographies that you think have the most oversupply right now?

Xander:

Yeah, several Sunbelt markets, a good number of southeast markets, so places on the eastern seaboard, Florida, Atlanta, places like that. And then certain markets in the southwest. Phoenix is one of them that is more oversupplied than some other southwestern markets. On the other end of that, you have Midwestern markets like Chicago and Minneapolis, places like that, and northeastern markets like Boston that don’t have a ton of supply coming to market, and as a result, they’re still seeing moderate but positive rent growth.

Dave:

Yeah, that makes sense. And I’ll just throw Denver in there where I invest a lot and it has a lot of oversupply. It’s just unbelievable. Xander, this has been super informative. Thank you. I’m just curious, before we go, is there anything else you want to share with our audience about what to expect for the rest of 2024 or into 2025 for the multifamily market?

Xander:

Sure. I think that folks have probably heard of this expression by now, stay alive until 2025. I think there’s some truth in that. I think what that implies is that we are in a transition year and investing in real estate is a long-term enterprise. So you have to look past when the cycle ends because all of the challenges that exist now will also provide opportunities for buyers to get in at the beginning of a market at a low cost basis. But I don’t think we see that recovery really happen more completely until next year. I think it’ll be 2026 until money really starts to be made again and activity picks back up. So focus on the things that are inside of your control limit the expenses where you can double check those bills, make sure you’re not getting overpaid. Make sure you don’t have a water leak. This stuff happens and it can cost, it does hundreds of thousands of dollars. So focus on the stuff that’s in your control. Make sure you have enough cash and liquidity on hand and keep your eye on the long run. Great.

Dave:

Well, thank you so much, Sandra. We appreciate all your insights, and if anyone wants to learn more about Xander or the research that he’s done, we will make sure to put a link to all of that in the show notes or the show description, depending on where you’re watching. Thanks again, Xander.

Xander:

Thank you. Dave.

Dave:

On the Market was created by me, Dave Meyer and Kaylin Bennett. The show is produced by Kaylin Bennett, with editing by Exodus Media. Copywriting is by Calico content, and we want to extend a big thank you to everyone at BiggerPockets for making this show possible.