Odd LotsAnother Part of Commercial Real Estate Is in For a Reckoning
When it comes to commercial real estate, a lot of attention is obviously paid to offices. But it's not the only sector facing strains. Apartment buildings — or multifamily residential — may also be in for trouble. For years, rates were falling and rents were rising, and owning and operating apartments was a moneymaker. Then things went into overdrive with the pandemic, thanks to plunging rates, surging rents, and an explosion in new household formation. But all of that is reversing. Rates have surged. Insurance costs have surged. Operating costs have surged. The household formation boom didn't last. And in some areas of the country — particular in some Sun Belt markets — rents are actually falling. On this episode, we speak with Lee Everett, vice president of research and strategy at Waterton, on how a multi-family deal binge in 2021 will result in a huge hangover.
Hello, and welcome to another episode of the Odd Lots Podcast.
I'm Joe Wisenthal and I'm Tracy Alloway.
Tracy. When it comes to real estate troubles, you know, one surprising thing is, I guess how strong the housing market has remained this year despite the rate increases. When people talk about troubles in the real estate industry, though, it's mostly the conversation has been on commercial real estate.
Yes, and actually a specific segment of commercial real estate. So for obvious reasons, everyone has been very focused on what's happening to office properties. You know, the whole work from home trend means there's less demand for offices ostensibly. Meanwhile, higher interest rates are increasing expenses, and so that has been the predominant area of attention. But of course there's also the forgotten I call it the forgotten commercial real estate, which is actually multifamily residential, which counts as commercial real estate technically.
Right totally. And you know what we talk about residential, and we often talk about it in terms of just single family homes and what's happening to home prices specifically, and of course that's a huge part of the real estate industry and where people Live, but we talked about this in September, I think it was with Julia Coronado. One other big thing that's happened over the last several years is just this incredible boom in apartment buildings, multifamily dwellings, particularly across the Sunbelt.
Yes, so I remember this sort of twenty twenty twenty twenty one is just staggering amounts of construction of multifamily properties that were intended, I think, primarily to be rented out in super popular areas of the country like Texas or Arizona, places like that. Of course, since then, my understanding is that we've obviously seen an increase in interest rates. We've also seen or started to see a decline in rents, and so your cost of financing is going up while your income from rentals is actually going down. That seems like a bad combination.
Right, So a big question is like, who are I guess the bag holders, or maybe that's a question, or maybe that's when or how heavy is that bag? Because presumably, you know, no one anticipated the surge in financing costs, no one really anticipated the surge in inflation construction costs, and you know, rent growth had been one of those things that just like went up and up, it went wild during twenty twenty, twenty twenty one, twenty twenty two, one of the most dominant drivers of inflation overall. But supply and demand seems to be a real thing. And it seems as though, with this incredible boom and supply that we actually have seen some softening in rents.
Here's hoping.
But this is where we have to caveat that we never actually see the softening rents. None of us will ever have rent cut.
But some mythical unicorn like I have heard that rents go down. I have yet to experience it. Actually, you know, I just got my new lease agreement offer.
What's them?
I'll just say it's gone up, Joe. Okay.
See, let's put it this way. Charts exist on the Internet that show the line going down the other direction. Whether those charts are actually reflective of anyone's reality, that's a separate question. But I have seen charts that at least in some cities, again probably more Sun Belt boom cities Austin, Nashville, Atlanta, that rent prices have gone down. Okay, I've seen the charts.
Okay, I too have seen charts. Okay, let's keep going.
Well, so then the question is what is really happening in reality? And we sort of got to get a uperger check on. Okay, if rents are going down unexpected Lee, supposedly, if all these things have caught the industry by surprise, how big is that bag, who's holding it? And how much trouble could it be in? And I think we have to have this conversation because again, so much of the convo in the discourse has been about office.
It's all offices, all the time. So now we turn to the again the forgotten corner of commercial real estate.
Well, I'm very excited we have the perfect guest to discuss it, someone with a lot of experience in the multi family world. We are going to be speaking to Lee Everett, head of research and strategy at Waterton. It's a multi family investment manager. It's been around since nineteen ninety six. So Lee, thank you so much for coming into the studio and coming on odd lots.
Thank you very much. It's some pleasure to be here.
Who are you and what is Waterton? And I just asked that at the beginning because I figure listeners might want to know why we're talking about.
My name's Lee Everett. As you stated, I've been in the industry now for roughly twenty years, the entire time focused on the residential sector, and I've touched everything from senior living to multi to single family, and primarily I've spent that time advising internally or externally as a consultant sea level executives on the multifamily sector. Today, I head up research at Waterton that's a multi family investment advisor with about fifteen billion AUM today. We operate in the top thirty markets in the US. We're primarily a value add shop, so we're buying, improving selling homes. Our funds are primarily closed end funds, so it's a controlled hold period and a controlled time.
You mentioned research, and you also mentioned that you were a consultant. What are the kind of things that you're hearing in the market right now.
I think it's it's dark days in general for a lot of the market right now, and it's primarily been driven by a capital markets event that we've never experienced in this industry. I tend to think that we're going to end up seeing the twenty one and twenty two vintage, which was the largest transaction volume years on record for multifamily by huge amounts, end up one of the worst vintages in the history of our industry in twenty twenty one. In the fourth quarter alone, over one hundred and fifty billion in apartments transacted.
Wait sure which quarter in twenty twenty one.
Q four Okay. Over the course of the year, over three hundred almost four hundred billion transacted. To put that in perspective, the previous high in twenty nineteen was under one hundred and ninety billion for an entire year. WHOA. So capital came into the space like we've never seen before now, this capital entrance, it was primarily driven by two things. The rent growth that you both have alluded to earlier. What we saw that year was over seven hundred thousand renter households form in the US. That is over two and a half times the prior record. As such, we ended up with rent growth that pushed over fifteen percent some markets Phoenix, other Sun Belt markets. You saw rent growth on new lease turns coming over twenty and thirty percent pretty consistently. And what was really crazy about this was there was a massive spike in renter incomes. So these rents were relatively affordable, as incomes were actually rising quicker than rents at this period.
Was that driven by people moving into the area and maybe doing more work from home and bringing higher salaries.
With them, or in many instances, yes, that's what would primarily drive the large renter income increases. And say a Las Vegas, where you're getting some la people that may not have been as wealthy there coming into a market where your meeting incomes like sixty thousand dollars eighty thousands, a lot wealthier relative to the median in Las Vegas. It also was driven by, frankly, a lot of household fractionalization that was pent up demand. You had people losing broommates, you had people moving out of their mom's house it had been there for a long period of time, I mean being frank In twenty twenty one, we had working age population losses as a country while we were generating all of these households. So the explosion in the labor force allowed people to form households, both as millennials that hadn't and this filled a lot of the suburban product, the single family rental product and such, and gen Z backfilled the city at an incredible rate. This wasn't like the millennials coming out of the GFC, where everybody had three and four roommates. Gen Z was living one, maybe two roommates at the most, and a ton of them were able to live alone in our major cities, and that just drove demand that we'd never seen real quickly.
Save the numbers again for twenty twenty one, what was the total for that year?
The total transaction volume? Yeah, it was between three hundred and fifty and four hundred billion.
And the previous high one nineties.
Yeah, it was around one ninety.
And when you say vintage, that's that's a very specific or I think of it as a specific term related to to CMBs, so commercial mortgage backed securities. So is the suggestion that the financing for these multi family properties was bundled and sold off as bonds.
It was bundled, but primarily as clos which I think we're going to need to get into because that's sort of the other side of the coin here. Was at the same time we had this vintage. First off, what I mean by that is deals that traded in that year or were purchased in that year, and you had basically a half a trillion dollars trade between the beginning of twenty one and the middle of twenty two. That vintage is everything that traded over that period. And while you had these soaring fundamentals I spoke about at the same time. So fur was zero, the tenure was zero to one, so financing was so easily available. You had people enter the space that had never been in the space before. They were projecting massive revenue growth, and they were able to buy it very low yields because of the low financing costs. Now, what were those low yields? Cap Rates in the space got down to, say, in Phoenix two for nineteen seventies and eighties vintage product that wasn't ideally located, you were looking at a three and a half percent cap rate.
Can you just remind me cap rates from what I remember?
Right?
Yeah, so maybe this has changed, but from what I remember, like less than five percent was considered pretty good, not that risky, and like more than seven percent is kind of bad. Is that right?
You're backwards, am I? So the higher the cap rate, the higher your income to price ratio is. So it's NI over price, okay, and the less NOI you have over price. Essentially, the more risk you're taking on in the deal because you're relying far more on value to be driven by price growth rather than NI growth. And when you're buying it, say a three and a half cap a not ideally located property, you're very much relying on that income to price ratio staying the same or declining, especially if you're doing so with interest rates that are around two percent, which is what you're looking at at that period in time for short term floating rate debt, which is what really flooded the space, and this is what's become what fed these clos that have grown.
So there's all kinds of a million questions already, But why don't we actually just since you talked about the financing structure short term floating rate debt. So Tracy and I have done a number of episodes on credit and the looming maturity wall for corporation. Tracy, it's just I say looming, but there's not in the case of this, this has to be refinanced very quickly, like talk about this sort of Okay, someone does a deal, what are the terms, how far when do they have to pay it back? How does that work?
So these deals were primarily financed by debt funds, and what ended up happening was they were issuing what's called bridge loans. These bridge loans were meant for people who entered the space to be able to buy a property with floating rate high leverage. By high leverage, I'm talking seventy five to eighty percent, sometimes even higher. Now, when you're buying floating rate at a two to twenty five interest rate handle with eighty percent leverage, your returns look really good until that floating rate debt starts to move upward. And what we've seen today is a five hundred basis point increase in SOFA over since those that debt was done, So you're looking at five percent higher interest rates. The fundamentals that were there in twenty one are no longer there, so you have declining NI and as such, what you've seen is these bridge loans that need to be refinanced in twenty three, twenty four, and somewhat in twenty five, they don't pencil anymore. You were essentially to get this debt writing to a debt service coverage ratio in twenty one of about one point twenty five, and that's how much your income can cover your debt Today because of increase in debt costs, decreases in net operating income, and increases in another expenditure such as insurance, some of these buildings are looking at a debt service coverage ratio below seven, and that's very common, and that means these buildings can't pay their debt. And this is a mounting wall. I think in twenty four we're looking at about thirty four billion in clos that are going to need to be refinanced, another twelve and twenty five, and we've got another seven to nine to get through this year.
Wasn't the original pitch okay? So sure, these are financed with floating rate loans, so if interest rates go up, the cost of that financing is going to go up and put stress on the property itself. But wasn't it supposed to be able to raise rents to offset that?
Yes, and some properties did, many did, but ultimately people started to project rent growth to continue for longer than was rational. As I sort of described earlier, we had this household formation explosion in twenty twenty one, But ultimately what that was was it pulled some demand forward from twenty twenty two, and the massive apartment supply wave began to come to market in twenty one. And then on top of that, even if you raise rents today, insurance costs have gone up in such a way that it's deeply, deeply impacting the market. You're looking at renewals right now costing thirty to fifty percent additional every year. I've heard quotes of three thousand a unit to ensure in Florida right now, over one thousand in Texas. So you have massive increases on the cost side, debt increases that were never underwritten for, and rent growth that you achieved some of, but you're not going to achieve in the longer term, particularly with the nature of this product. A lot of it in markets like Phoenix was bought by syndicators, new people to the space, social media sensations, fundraising on LinkedIn, and people such as that this.
Is like real estate TikTok.
Yeah, Tracy, I was gonna say, you know, like it's been one of our recurring jokes over the year on the podcast, like what if we get into a trucking? What if we get into this? It sounds like a bunch of people took that joke literally and said, what if we get into.
X what if we became landlord?
Yeah, what if we get what if we became multi family landlords in Phoenix?
I have Can I just say right now, I have no desire to take that up neither.
Well, and I don't think these people really had that desire either or their ultimate goal was to flip these apartment buildings. They wanted to buy them, renovate them, use the bridge loan to get through that period, and then sell it to someone that would then use Agency Fanny or Freddie fineansing to hold the building long term. And whoever they sold to, they planned on being the true operator. Now a lot of these people that have no operating experience and entered the space are stuck being landlords and they had really aren't necessarily sure how to do that, So that's also hurting the revenue side. You have to have economies of scale, experience, vertical integration and such in order to be a landlord, and those structures don't exist at a lot of this new capital that entered our space.
Can I just ask you know, we're talking about all the various calculations that go into underwriting one of these things. So insurance cost, the cost of the actual money to build or buy the property, expected rental income, things like that, how do people normally make those estimates, or like what kind of data do they use to make presumably again in normal times, like rational forecasts for what all those moving parts might look like. And then I guess to your point about the oddity of twenty twenty one twenty twenty two, what were they looking at then?
So, first off, I think there was a lot of faith in the sector and lower for longer. Too much faith, frankly, i'd believe. And now if you believe in a soft landing and higher for longer, that's a very painful transition. And the reason that such a painful transition is cap rates or your yields historically have had a two hundred basis point spread to the ten year. So normally the risk free rate should be at a discount to a real estate rate, and that held when sofur was zero and you were buying at a three and a half cap rate today, in order to buy with a ten year even at four to three as it is today, historically that would tell you you're going in cap rate should be a six to three and your exit cap rate should be even higher than that in order to be concerservative. Those metrics really don't work for what was bought in that vintage. But today you want to go into a not have negative leverage, so you need to be able to afford your debt. That's where kind of that two hundred basis point spread comes into play. You want to be conservative based upon long term history, supply demand balance, population growth and all that, and you want to look at that as you get into rent growth, expense growth has become much harder to pay, so you want to be as conservative as possible there and a lot of the longtime players understood this and were frankly priced out of a lot of deals over twenty one and twenty two because of this. Now, what also happened back then was when you have twenty percent rent growth, people just plan on raising rents for five percent a year every year after they mark to market to that twenty percent. So I think it was a lot of looking at recent history instead of long term history. It was a lot of denial about interest rates that today we take into account in every underwriting. And frankly, again the more experienced players were but the newer capital didn't really understand that at the time. So the relationships of spreads, population growth, and supply demand, we're all just distorted. And they've come a lot clearer now. But even today, as you model that, people don't want to feel the pain on the sales side, so you have a massive bid ask spread still in the market today. That's why transaction volume I gave those huge numbers before last quarter transaction volume was only thirty billion, which is almost as low as it was at the bottom of the pandemic.
What happens when inexperienced operators are stuck holding the bag and have to be landlords.
Well, if they can't afford the property, they give the keys back. And that's where a lot of I think pain is going to be felt in this sector. There's a lot of debt fund colo issuances out there, and if the debt service coverage ratios don't pencil today, they aren't going to pencil any better tomorrow barring a major recession resetting rates, which ironically it would be probably the bailout for the sector at this point in time.
But actually, in your view, I mean, because the downside of recession is job laws and people not being able to pay the rent. But in your view, the greater stress is actually on the financing side rather than the rental income side.
Absolutely, okay, And I think these debt funds are going to end up holding the bag, one of the largest ones out there. I think I saw issued fourteen billion in debt over that period. I'm discussing today the book value on that's already in the low nines. And that's not using the most true current market data and some of the more sort of down projections you're seeing because rent losses are occurring in some places such as Austin and things Place and places such as that, and those sort of losses are just going to continue to grow over the next couple of years as this supply works its way through the system.
This is what I wanted to ask. Actually, you mentioned mark to market earlier. How often are these loans marked to market? And again, what are the sort of numbers that are going to feed into that.
So initially when I was talking mark to market, that was on the rent side, and this is that's something that doesn't happen that often. But everybody was buying buildings in twenty one and essentially assuming they could immediately raise the brands by twenty percent, marking them to market. Now, on the debt side, they aren't marked to market nearly as quickly as you'd like. Even on the valuation side, I think your cap rates are moving upward way more slowly than you'd expect. On the bank side, there's a lot of mark to market left to happen, and I guess the roundabout way of answering your question is it's happening, but not nearly quickly enough. On the debt fund side, it's going to mostly happen as these workouts happen, as these refinancings happen, and as this debt comes do in this wall of maturities, and the wall of maturities is real. On this short term debt, they're going to be able to extend somewhat. But these people that couldn't afford interest rate caps, that didn't have the reserves for it, that's going to mature and it's going to hurt.
What's the catalyst for a lot of these to take losses? Is it like eventually they have to mark to market, although I'm still unclear like what the trigger is for having to do that or eventually they have to refinance and maybe they can't get the financing. Is that the thing that starts sparking losses because otherwise, as we've seen for the past year or so, it feels like they could just sort of string it out for a very long time.
So the issue with string it out become how bad the debt service coverage ratios are today. So you have to have a really motivated lender, and these lenders have so much debt out in the space today, it's going to be difficult to do this for everyone. One of the larger syndicators that got themselves in trouble in the Phoenix area has done around six hundred and fifty million in workouts over the last year and a half.
Wow in workouts. So like taking care of troubled loans.
Yes, And that's where you're going to mark to market these things, is the loans get worked out, as they get refinanced, as they get brought back, and the trigger is either people not being able to pay their debt service, which is happening. I've been in New York for the week and seeing friends in the industry, and these are friends that work on the lender side, and they're getting keys given back to them all over the country already, So this is something that's starting to happen. Another friend just mentioned a deal he just bought New York for less than the construction loan. So there's pain and we're starting to see it. People are calling us that have been able to finish developments because the equity partner pulled out and they're offering chances to getting low and every bid that we place today is frankly low. And that's because we believe the market has more pain as this marked market happens. But the events haven't fully cascaded because not all of the loans have been dealt with. And the other thing people like to do is extend and pretend in our sector, But I don't think that's going to be as viable going forward because it's really hard to extend and pretend if your debt service coverage ratio is a zero point six. Wow.
Talk to us a little bit more about supply specifically. So one thing that's happening is I maybe perversely, I imagine as supply chains have eased over the last couple over the last year or so, probably had a lot of projects that we're moving slowly that finally finished and opened the doors, and so you have on the one hand this looming maturity wall the next few years, and then, as you mentioned, more supply hitting the market into a weak market, and multifamily construction had a very good decade, even going into COVID is my understanding, and then it just took off in twenty twenty one. Talk to us about those dynamics.
Yeah, there's been for over the last year, more than a million units under construction, and if you think about that in terms of the total housing market, you had what one point eight million total housing units under construction. So the majority of the housing instruction in our country at this point in time is the multifamily product. And between construction backlogs over the pandemic and then the low interest rate environment allowing tons of shovels to get into the ground for development, we just blew out records and we're at levels last seen in the early seventies and we're close to surpassing, if not haven't surpassed those levels. So supply is hitting and mass and the way it's hitting is typically in limited sub markets. In limited market a downtown Nashville has the majority of all of Nashville's supply, and right now you can't throw a baseball there without hitting three cranes, similar to a downtown Austin. These nodes within these markets are going to be fine in the long term, but this glut of supply is just overwhelming demand in the short term, and this is something we haven't seen for a long period now. The flip side is low interest rates, where the catalyst for that explosion, the higher interest rate environment has actually been driving starts down over the course of the last year, and we've seen a massive slowdown in starts. So as it looks currently through mid twenty five, you're going to continue to have really accelerated deliveries. You're going to continue to have some fundamental challenges. But late twenty five into twenty six you should start seeing a lack of supply in the market again again, that is without a reset of interest rates, and.
Then rents can go up exactly. Okay, well, on this note you mentioned or sorry, let me say that. Well, on this note, if owners are handing back the keys to multifamily properties and you know, presumably maybe someone else is buying them, you know, another institutional investor or something like that, but could you ever get a situation where a multifamily property is like divided up and sold off as single family units? Like could could the multi Yeah? Could it become like could it? Could it become owned by people.
You could convert to condo? It happened. I think back in five oh six during that rush, A lot of the challenge is going to be and I don't want to sort of state this too aggressively, but multi family construction is typically not going to be at hot as high as the level as a condo construction quality, yes, and that has to do with supply chains, economic economies of scale, the design of the units, and I don't know that it's as natural a transition as you would think now In the same point, these condos are still going to be really expensive too, so the switch off isn't going to be ideal. But what we are seeing and we get phone calls for this all the time now, is on the new developments, the senior debt or the construction loan doesn't quite go far enough because they can't get as much leverage as they had expected. So they're calling other players in the institutional world, such as ourselves, and looking for mes financing or preferred equity to fill a piece of the debt stack to get them over that hump. And that debt is highly accreative in terms of how it's pricing right now because of the demand but also because of some of the risk for the new supply. So that's been a big change in the space. Is this sort of aggressive appetite to plug the financing gap with preferred equity?
So are there I guess you it sounds like in others. Is there is there a brewing sort of industry of opportunistic distressed investors who are bundled or getting capital together to take advantage of some of this pain that already that you're seeing.
Yeah, we have been fundraising. We are sitting on the sidelines, and I think it's fair to say there's blood in the water and the sharks are waiting to swim. At this point, there's going to be opportunities through this pain that I don't think the sector's seen since the Great Recession in terms of opportunities for true, true, discounted and distressed purchases. You're seeing lenders already calling other players where people can't make the debt service coverage and being like, can you come in, Will you come in at a discount? Will give you X off par if you come in and can buy us and just bail us out of this bad situation. So there's one hundred percent going to be a lot of the more established institutions trying as hard as they can to take advantage of this market disruption.
Lee Everett, that was great. That was very It's very jarring. And when you like when you discussed the sort of like the raw math of it of rates going up, rents not penciling, household formation nothing like it was in twenty twenty one, inward migration, nothing like it was in twenty twenty one. All this sort of you know TikTok or podcast and realtors insurance costs. That's something that we talked about with the Howard Hughes CEO as well, which is just sort of this wild dynamic. Could see why more pain, more pain is on the web. So thank you so much for coming on my.
Pleasure, Tracy.
I'm really glad we had that conversation. It's we don't really say perfect storm as much as we used to when we used to talk supply chains.
No, we just did on the the Wind Energy episode, that's true, we're bringing it back.
This really Yeah, this one really does seem like a perfect storm of just all kinds of different things going on.
Yeah.
Absolutely, And I do think it's it's funny isn't the right word, but uh, it is intriguing the degree to which people saw, like the post pandemic period, which I think any reasonable person would have thought, like, there are weird things happening right now, Like you have this huge migration. Interest rates are super low because we've just had, you know, an emergency basically the economy just shut down. And yet it seems like some extrapolated that very short and dramatic period of developments to like it's going to keep going for the next five years.
And you know, this is actually something that's striking to me is how we see this from industry to industry to industry. Everyone sort of fell into this to some extense. You certainly saw it tech, for example, with all of the oh, it's all e commerce now and no one is gonna everything is gonna be shopping online, and you know, eventually like those trends basically reverted to trend or Netflix shooting up, and then people realizing actually it's gonna go back to roughly the old trend, which is an upline, and it might be an upline and multi family too, but it got so far deviated. But it is weird. I mean, like you figure there's not going to be multiple migration waves from San Francisco to Las Vegas like that was. You sort of knew that had to be a one off almost by definition. And yet you get the impression that people saw the lines going up and they wanted to play.
Yeah. I'm still amazed. I mean Lee mentioned this, but like the amount of construction in Austin that's like still going on. Yeah, And if you think that like in twenty twenty one, it would have been even more. I can't imagine they really were booming of sunbet people.
If you people with a Bloomberg or I guess Fred to just pull up that US multifamily units started for rent, and you see it trending up very clearly from December two thousand and nine to twenty twenty, and then it just shot up, you know, exploded in twenty twenty one and twenty two to levels that really haven't seen in about you know, thirty five, thirty five years or something it's pretty striking. And so, yeah, it all came together well, and I thought Lee did a great job of putting it all together.
Yeah.
Absolutely, And it is going to be interesting to see how much of these deals get worked out. Now. I couldn't believe that one number from like just one institutional entity, like six hundred and fifty million in workouts. That's crazy.
And the fact that keys are already being sent back is really interesting. And so it's not I mean, we talk about the loom is here. I mean, the bigger wall may still be coming, but obviously for some players it's already hit.
The nature of the maturity wall is that it's always looming. It's always even when it's here, it's still looming. All right, shall we leave it there?
Let's leave it there.
This has been another episode of the Odd Thoughts podcast. I'm Tracy Alloway. You can follow me at Tracy Alloway Wisenthal.
You could follow me at the Stalwart. Follow our producers Carmen Rodriguez at Carmen Arman, dash Ol Bennett at Dashbot and Kelbrooks at Kelbrooks. And thank you to our producer Moses Ondam. For more Odd Loots content, go to Bloomberg dot com, slash odd Lots, where we have transcripts, a blog, and a newsletter and you can chat about all of these topics in our Discord. Folks in there twenty four seven talk about all these things, including a real estate channel. Check it out Discord dot gg, slash.
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