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Pandemic’s Negative Impact and Benefits of Sustained, Low Interest Rates Remain at Odds in Multifamily Sector

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The uneven economic and geographic impact of the COVID-19 pandemic can be demonstrated by the performance of multifamily markets across the U.S. While many dense urban markets have seen weaker rent payment history since spring, particularly in places where the virus has hit hardest, some secondary and suburban markets have remained relatively stable.

The Urban Land Institute’s panel discussion, Trends and Outlooks: Where Are We Now and What’s Next for the Housing Industry?, included an analysis of the multifamily sector by moderator Tim Naughton, chairman and CEO of AvalonBay Communities, and panelist Mary Ann King, co-chair of Moran and Co., a national brokerage firm that focuses on multifamily and mixed-use developments.

“Multifamily transactions were essentially frozen in the spring and early summer, but now we’re seeing signs of life,” said Naughton.

While operating costs are weak overall, pricing is holding up, said King, which is a surprise to many multifamily industry observers.

“There are three main reasons for this disconnect,” said King. “First, the profile of properties that are actually trading now includes a large percentage of properties in suburban or secondary markets where operating fundamentals have been impacted the least by the pandemic. These are small markets where collections and occupancy have stayed strong. There may not be robust growth, but they may be up a little.”

In contrast, King said, very few properties are trading in big cities such as Los Angeles, Oakland or New York where operating fundamentals have been more seriously impacted, net rents are down, and concessions are heavy.

“Many of these municipalities passed laws that restrict the ability of landlords to evict for nonpayment of rent, so we have a new class of renters that we call squatters,” said King. “These downtown properties would trade at a significant discount of 10% to 15% compared to pre-COVID pricing, so they’re not trading.”

Pricing on multifamily buildings that are trading appears to be holding up because the only properties being traded are those in suburban locations with less of a bid-ask spread, said King.

A second reason for the disconnect between overall operating fundamentals and pricing is historically low interest rates.

“Even though rent growth has slowed and insurance and tax costs are up, the reduction in debt service costs has compensated for the weakness in these fundamentals,” King said. “Even though NOI is weaker, cash flows and IRRs are better because they’re offset by the best debt in our lifetimes.”

The third reason for the disconnect between pricing and operations, said King, is that cap rates have compressed, especially in the Southeast, and to a lesser extent, in the Mountain states.

“Cap rates have especially compressed in suburban markets that are showing strength,” said King. “Cap rates shrink when there’s more capital chasing deals than there are deals to satisfy that demand.”

King said that even the bigger institutional multifamily buyers are focused on smaller markets in the Southeast.

Prognosis for multifamily market

While King anticipates that suburban markets, especially in the Southeast and Mountain states, will see more of a V-shaped recovery in 2021, major urban markets may struggle longer due to their pipeline of projects delivering over the next two years.

“Transaction activity will rebound when it feels like we’ve hit bottom,” said King. “Investment activity in multifamily has been down 70% since COVID-19 started, but we’re starting to see markets open up. We’re seeing investment capital finding deals that haven’t been as stressed and closing deals.”

King anticipates the transaction market improving in 2021, but she thinks it will probably take two years to return to the transaction levels of 2019.

Multifamily starts are anticipated to drop off steeply in upcoming years. King quoted a recent forecast by Ron Witten, founder of Witten Advisors, that anticipates starts will drop from 400,000 in 2019 to 275,000 annually by 2023 to 2024.

“While Ron was a little more optimistic with that recent forecast than earlier forecasts, that’s still a big drop,” said King. “But the decline in starts will actually help the multifamily market recover, especially in the big urban markets.”

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