1. Bid/Ask Spreads
Ultimately, the spread between what sellers are expecting to sell for and what buyers are willing to pay is still too wide to incentivize an uptick in transaction volume. The beginning of 2023 has been relatively slow for commercial real estate because of this. Why are buyers not willing to pay what sellers want? Cost of debt is the main culprit. Interest rates are still on the rise as the Fed continues its valiant effort to taper record high inflation. SOFR sits at 4.55% as of 2/23, the highest it’s been since Covid.
Rent growth helped offset the pains of inflation for multifamily operators. However, in most markets, rent growth has slowed considerably which is resulting in the pendulum swinging from growing revenues to burdened operating expenses. Slower rent growth with accelerating expenses are making deals much harder to pencil out at yesterday’s prices.
Cost of debt and inflating expenses coupled with the unprecedented prices of 2021-22 are contributing to sellers holding out. Sellers want what they could’ve sold for a year ago and they’re willing to sit tight until that happens.
All that said, we’re starting to see a slight uptick in sellers bringing deals to the market. This could mean a compression of the bid/ask spread is coming soon. Once rates stabilize we believe buyers will feel more comfortable inching up and sellers will accept reality and inch down.
2. Distressed Opportunity Yet to be Seen
A few months ago, many commercial real estate pundits were predicting a windfall of distressed opportunities to flood the market. Many already coined the years of 2023-2025 “the greatest buying opportunity in a lifetime.” Mind you it’s still very early but so far we’re seeing little signs of distress.
The driver behind the above prediction stems from the unprecedented amount of uncapped floating rate bridge loans dished out in recent years. If indeed uncapped, interest rates for some deals could be as high as 9-10% today. If operators with no cap are able to weather the storm (or if they purchased a rate cap) there comes a point, usually 2-3 years after origination, when this type of debt comes due. Many bridge loans originated from 2019-2021 will be coming due this year which means operators are faced with decision to re-lever into longer term debt at relatively high rates or sell.
The other factor that could come into play is ability to effectively asset manage. Asset managers are keenly focused on occupancy and expense ratios. If communities can stay 90%+ full and expense (especially taxes and insurance) remain checked, many deals will do just fine.
3. Midwest Strength
The most recent Ten27 Weekly newsletter was all about this. According to CoStar, rent growth is expected to outperform pre-pandemic levels in a handful of our target Midwest markets. The limited supply and relative affordability of Cincinnati, Columbus, Kansas City, etc. will contribute to the steady growth in rents as we progress through 2023.
This is not to say Midwest multifamily won’t encounter challenges. But the challenges faced in the Midwest aren’t unique but rather common across the country as noted above; wide bid/ask spread, expense inflation, occupancy, lower-asset class collections, etc.
4. Continued Barriers to Entry into Homeownership
Across the country many individuals and families are feeling the pressure of high interest rates. According to FRED, number of new home sales have dropped almost -40% steadily since January 2022. Why? Because prospective buyers can’t afford monthly payments to own the home they desire. And most are willing to wait it out and continue renting rather than downsize their budget.
Many expect this trend to continue beyond 2023. What does this mean for multifamily? Renters will continue renting. Even though rent growth is tapering in most markets, the demand for rental housing is still massive and will only strengthen because barriers to homeownership are still widening.
5. Office to Multifamily Conversion
There’s an entire new niche in the world of multifamily investing; office-to-multifamily. Many of us are well aware of the pains experienced by office building owners due to the work-from-home revolution. Companies across the country abandoned their leased office space because 1) employees would rather work remote and 2) office space is expensive. Cities like New York, Chicago and San Francisco suffered greatly.
But, if there’s a silver lining for office owners it’s that demand for rental housing is off the charts and developers are willing to buy office building (usually dated, class B and below assets at a huge discount) and convert to apartments in an effort to satisfy this demand. And although large metros felt the most pain, we’re seeing conversions in small-mid sized metros as well such as Cincinnati, Jacksonville and Kansas City.
As always, we hope this is insightful. If you’re interested in learning how to invest or discussing some of our current investment opportunities, don’t hesitate to reach out!
Mitch and Kevin