Investing in GP Fund vs deal by deal
June 19, 2024
The real estate market is experiencing a major shift as ample new supply comes onto the market while demand softens. This is leading rents to decline across many major markets, sending some commercial real estate investors into panic mode trying to support their highly leveraged properties.
After hitting record-high rents and occupancies in 2021 during a time of incredibly low mortgage rates, the market drove a supply response kicking off massive new construction. Now with over 1 million apartment units underway across the US, it is the highest level of construction since the 1980s. Making matters worse, the rapid rise in mortgage rates has quickly priced many renters out of home buying. As ample new high-end rental supply delivers while demand cools, rent growth is poised to turn negative.
For real estate investors, especially those focused on apartments, this is an ominous sign. With such a large portion of property revenue driven by rents, a decline can quickly leave investors unable to support their property debts. The result is a growing risk of losing properties to foreclosure or being forced to dump for whatever the market will bear.
In this article, we’ll explore:
Let’s dive in.
The seeds that grew into today’s supply glut were planted back in 2020 and 2021. At first, the pandemic drove many to leave dense urban apartments for suburban homes they could rent or buy. This was aided by mortgage rates falling to unprecedented lows below 3%, while the flexibility of working from home opened up more neighborhoods to call home.
The sudden surge in housing demand kickstarted a development boom, hoping to capture sky-high rents and near 100% occupancies. New construction takes time however, often 15 months or more for an apartment community to complete.
Just as massive new supply finally starts coming to market, the landscape has completely changed. Mortgage rates have shot up from 3% to over 8% in little over a year, suddenly making home buying unaffordable to most. On the rental side, with over 1 million apartment units underway, there is simply too much new supply in the pipeline relative to demand in most metros.
While home prices have corrected rapidly in recent months, actual apartment rents take longer to materially adjust downwards due to longer 12-month leases. As a result, rent declines are just getting started in many markets.
Several factors have combined to cause rents to decline rapidly and create uncertainty among real estate investors, as outlined in our video:
The Metroplex area, for example, saw record-high occupancy rates in 2021 nearing 97%. The incredibly high demand and strong rental rates prompted developers to start massive new construction projects. An average of 15 months is generally needed to complete an apartment community.
What was supposed to help meet soaring demand in 2021 is instead hitting the market in 2022 and 2023—just as demand cools off because of higher interest rates making owning more expensive once again. As a result, the market is suddenly oversaturated with impressive new Class A luxury rentals while many renters are deciding to double up with roommates or move back home with family instead.
Many commercial apartment assets utilize high leverage, with loans covering 65-80% of the purchase price. As properties are entirely income-producing assets, they are highly sensitive to changes in Net Operating Income (NOI).
NOI = Gross Rental Revenue – Operating Expenses
With such massive exposure to property debt from leverage, investors rely on driving NOI higher over time via rent increases to expand profit margins. This also supports property appreciation over time.
However, when unit rents decline, it quickly Has a dramatic impact on NOI. Making matters worse, many properties utilize floating rate debt tied to short-term Treasury rates, which have risen over 400 basis points in 2022.
As NOI gets squeezed from both sides, investors can get into trouble covering their monthly loan payments. In some cases, the debt service coverage ratio (DSCR) could fall below 1.0x on actively managed assets, signaling a non-performing loan.
While each situation differs, broadly three options exist for stressed owners:
Clearly, for most commercial real estate investors, declining rents paired with higher debt costs are creating a painful reality. And in many fast-growing coastal markets, there is simply too much supply set for completion to rely on a fast rent rebound.
Most commercial real estate loans have variable interest rates that fluctuate based on market indexes. This floating rate debt gave investors an advantage when rates kept dropping—until now.
As the Federal Reserve approved aggressive rate hikes in 2022 to fight inflation, floating rate debt suddenly became the enemy. Interest costs for most multifamily owners are skyrocketing at the exact same time their rental income is falling.
Making matters worse, apartments are commonly financed with short-term 5-7-year loans. This means owners have to refinance frequently. Just to keep up with rising debt payments, they need to increase NOI dramatically. Without hiking rents substantially at turnover, defaulting on balloon payments is a real possibility.
The inability to pay off maturing loans may force fire sales simply to salvage some equity before a full foreclosure. And new appraisals factoring in declining rents and higher vacancies make refinancing difficult. Hence the panic among overleveraged owners as terms expire on debt originated when conditions were much more favorable.
Apartment rents have a notable weighting in the Consumer Price Index (CPI) used to track overall inflation levels. However, due to longer 12-month rental contracts, current quotes can lag market conditions by a year or longer.
In other words, when your lease expires in today’s market, there’s an increasing chance your rental rate declines versus last year. Now scale that trend across tens of millions of units and the impact can become sizable.
Declines in renewal rates translate to lower CPI growth with a 12-18 month lag. With U.S. inflation still running dangerously hot, a cooling contribution via housing could provide relief to stretched consumer budgets.
If there is a silver lining to the carnage hitting portions of U.S. commercial real estate, renters are benefiting with more bargaining power than seen in over a decade. With brand new high-end communities being completed, and more on the way, renters can often upgrade quality, amenities, and space without busting their budget.
Consider a hypothetical example. An individual currently lives in a 10-year-old “Class B” community paying $2,000 a month. A brand new “Class A+/AA” community just finished next door, with superior amenities and apartment finishes. Due to excessive supply hitting the market, new move-in rates are just $2,150 a month.
By leaving their existing unit to upgrade to the newer asset next door, the renter boosts the quality of life while still keeping housing costs reasonable. Now imagine that dynamic replicated across millions of apartment units in the coming years.
Suddenly instead of runaway housing costs, renters have negotiating leverage and options. And having flexibility provides peace of mind during periods of economic uncertainty like today.
After over a decade of smooth sailing across U.S. commercial real estate, the tide is clearly shifting in many markets. A heavy supply pipeline combined with deteriorating demand growth looks poised to push rents lower after years of overheated increases.
For highly levered asset owners focused on multifamily apartments and office space, the current environment could mean navigating treacherous waters. Being forced to sell or default on properties at a loss has significant financial implications.
But for renters seeking quality housing at an affordable cost, the clouds may be finally parting after years of gloom. New supply aimed at the top end will enable renters to upgrade their quality of life, likely with negotiating power on their side during lease renewals.
While volatility continues rattling U.S. real estate in the near term, taking advantage of market nuances can lead to big long-term gains on both sides of the owner-renter equation.
Due to the typical 12-month lease term, the full effect of the declining rents may not be apparent yet. Once leases start getting renewed at lower base rates later in 2023, there could be a more visible negative impact on inflation. It will likely take 6-12 months for the reduced rental rates to be fully reflected in the Consumer Price Index (CPI) calculation.
There is often a lag between market data analysts’ reviews and the actual real-time economics. This applies both on the way up and on the way down. Just as the Fed’s rate hikes didn’t immediately curb rising prices and seemed to have little effect for much of 2022, the declining rents from new supply and reduced demand won’t become fully clear right away either to policymakers.
To conclude, the real estate investing environment has seen a dramatic shift over the past year. After overbuilding combined with slowing demand, rents are likely set to decline nationally for the first time in over a decade. For highly levered investors concentrated in multifamily apartments, quickly declining NOI could spell trouble covering property debts.
However, all is not lost. During periods of volatility, keeping perspective and strategically navigating challenges leads to long-term success. For renters, upgrade housing quality without overspending as concessions roll out. And for investors, tactically asset managing through temporary trouble can yield impressive future gains.
With insight, planning, and proper perspective, consumers and business owners can each thrive during this market correction in U.S. real estate.
June 19, 2024
May 27, 2024
