Not Even the Multi-family Asset Class is the Safe Haven it Once Was

Warren Buffett once compared interest rates to Newtonian physics when he suggested “interest rates are to asset prices…[what] gravity is to the apple.” In fact, he went further declaring “interest rates power everything in the economic universe.” And of course, he is right: take commercial real estate as an example where nearly all acquisitions are financed using leverage typically with five to seven year mortgages. As those loans mature and need to be refinanced at rates now roughly double the rate of the initial loan, trouble ensues. In the last 17 months, the Fed has increased rates 11 times and is likely to keep going if we are to believe the Fed Chairman, Jerome Powell, hell bent on getting inflation back down to 2% (we aren’t there yet). According to CoStar, the value of multi-family buildings across the country have fallen 14% for the year ended June 2023, and why is that? As interest rates increase so does the investment yield, or capitalization rate, investors demand (which is typically higher than the cost of capital) resulting in a decline in asset values. In other words, if an investor can get a 5.25% yield on their money risk free, then the required yield with any amount of risk would need to be higher than that. 

So, how bad are things for apartment landlords? Mortgage delinquencies remain low but they are increasing (owners have defaulted in Los Angeles, San Francisco and Houston against thousands of apartments and even, Blackstone, the largest alternative asset manager defaulted on 11 apartment buildings in Manhattan though they say these buildings have unique issues). According to veteran real estate finance executive (and perhaps someone interviewed immediately after viewing the film Oppenheimer), Peter Sotoloff, multi-family property owners are facing a “hydrogen-bomb scenario” that the market may be overlooking. In the last decade, multi-family mortgages have doubled to about $2 trillion, according to the Mortgage Bankers Association and, more troubling still, is that nearly $1 trillion of that debt is set to come due between 2023 and 2027, according to real estate data provider Trepp. Not only is rental growth slowing from its peak, but investors borrowed up to 80% of the purchase price, in some cases, and certain private real estate firms turned to floating rate debt and add to those growing insurance premiums, higher property taxes, and fuel costs, the economics won’t work upon refinancing if rates remain where they are today. Exacerbating the situation further is the recent struggles of regional banks (with depressed loan portfolios due to mark-to-market requirements) that are less likely to lend today than in the past when they were a crucial source of real estate funding.

With multi-family properties, there are three fundamental pillars that matter most: 1. ownership’s ability to increase rents, 2. controlling and/or decreasing expenses, and 3. interest rates. With lower interest rates and increased competition amongst buyers before the Fed’s tightening, investors stretched overpaying for properties with the assumption they could increase rents faster than the rise in expenses but most groups—including sophisticated ones—underestimated the dramatic increase in interest rates. And perhaps they could be forgiven as the Fed for a long time called inflation transitory and suggested it would self-correct. That turned out to be wrong and here we are but such are the unforgiving whims of capitalism.

The next several years will be revealing as these multi-family loans come due and much will depend on interest rates at that time as well as the availability of capital more generally. In many ways, multi-family properties are facing the same financial challenges that other asset classes are, including office, retail and hotel-hospitality (as well as publicly traded equities). And this should come as no surprise to those who understand that interest rates power everything in the economic universe. The nonagenarian Warren Buffett has no doubt seen it all…at least twice. We should listen more often. 

Putzier, Konrad, and Will Parker. “A Real-Estate Haven Turns Perilous with Roughly $1 Trillion Coming Due.” The Wall Street Journal, 12 Aug. 2023, www.wsj.com/articles/a-real-estate-haven-turns-perilous-with-roughly-1-trillion-coming-due-74d20528. 

Levine, Richard B. “Investors Bid up Prices for Multifamily Buildings as Rents Steadily Increased.” A Real-Estate Haven Turns Perilous With Roughly $1 Trillion Coming Due, The Wall Street Journal, 7 Aug. 2023, https://www.wsj.com/articles/a-real-estate-haven-turns-perilous-with-roughly-1-trillion-coming-due-74d20528. Accessed 15 Aug. 2023.