Greg Cooper J.D.
September 25, 2023
As we are all painfully aware, multifamily transaction volume has plummeted, with estimates suggesting a decline ranging from 60 to 70% from its peak. The last instance of a decline of this magnitude was during the Great Recession of 2008 to 2012. However, unlike that period where the sanctity of the financial system was jeopardized, the economy now is robust, with full employment and consumers driving the economy forward. The main issue today is the pricing disparity brought about by the Federal Reserve's decision to significantly raise interest rates to temper an overheated economy. The bid-to-ask spread between what buyers are willing to pay and what sellers want has widened since Spring 2022, and remains significant through today. Although sporadic market distress exists, the majority of assets are generally performing well, and the fundamentals of multifamily housing remain strong. This performance has given little incentive for sellers to enter a declining pricing market. Now if you purchased between late 2020 and early 2022, have floating-rate debt with an expiring rate cap, or face a 5-year rate reset, there is a completely different story and we are now seeing more and more groups in this category willing to sell for less than what they purchased the asset for.
Most pundits feel the Federal Reserve has just one more rate hike planned for the November meeting, at which point there should be a pause. Subsequent actions depend on the signals from the Fed and the state of inflation. If inflation is believed to be controlled, the commercial real estate market should stabilize, setting a floor for declining asset prices. While today's fundamentals differ, the real estate cycle is familiar: a floor always establishes before an uptrend. Noteworthy is the prevailing interest rate environment aligns more closely with historical norms. Once the market stabilizes, market participants who have been hesitant will recognize this "new normal" and resume real estate transactions. Groups that made purchases based on optimistic, pre-rate hike projections will accept that projected income from rosy projections might not materialize. They will then likely sell and recycle their equity into new ventures that reflect the current environment.
Professional ownership groups essentially generate profits in a uniform manner. They earn acquisition and asset management fees, but the bulk of their income derives from the back end of the transaction, achieving their target returns and securing a promote fee. If substantial promote fees become untenable due to the new pricing environment—a situation not forecasted to alter significantly in the coming years—then realization will set in. As sales continue to establish lower benchmarks, professional managers will feel compelled to utilize the vast amounts of dormant capital and recycle the equity they already have tied up in deals that won’t perform as expected. The urgency to invest will intensify as interest rates remain elevated at historical norms. Eventually, this pressure should release a backlog of deals, and we can optimistically anticipate a return to a more typical deal flow by 2024. Hopefully this is light at the end of this very dark tunnel we’ve all been in.