As the risk premium goes, so goes our industry.
The first-quarter transaction and capital markets figures for multifamily—now snaking their way into headlines—offer a snapshot of an industry descending the peak, providing a window of opportunity for sellers that hasn’t been seen since 2007.
The question is, to what extent will this market cycle be “déjà vu all over again.?"
“You can observe a lot just by watching,” said the American philosopher Yogi Berra, and those same headlines we read (and I wrote) back in the wee months of 2008 are now popping up again; variations on a theme of semi-curbed enthusiasm.
Here’s what I mean, a sample of the multifamily news stand:
- Cap Rates Reach an All-Time Low
- 20XX Poised to be Busiest Year Ever for Multifamily Sales
- Loan Leverage in CMBS Falls for First Time since 20XX
- Construction Lenders Tap the Brakes
Do you want to take a guess when those headlines were written? Me neither. It’s not an entertaining game, but the gist is clear.
That last headline is particularly telling since, as we all know, the capital markets serve as the brake pedals in the new construction market—a developer would build all decade long if they could get the money to do so.
But history has an almost snarky way of repeating itself—sometimes in the same way a greasy meal “repeats” on you an hour later. And though it’s been said many times many ways: As an industry, we tend to have 10-year cycles, but two-year memories.
More than a third of the $38.6 billion in first-quarter transaction volume was portfolio deals—including Starwood’s acquisition of Landmark Apartment Trust and a quarter of Equity Residential’s portfolio, as well as 7,000 affordable housing units.
Tellingly, Starwood is looking to be a longer-term holder on many if not all of these assets.
But those deals alone skew the numbers of the apparent year-over-year “growth” in volume, since many of these deals were struck in 2015 and spilled over into the new year. A closer look at more recent data shows that March deal volume actually shrunk 14% year-over-year, according to Real Capital Analytics.
When you take the portfolio deals out of the equation, individual, one-off sales dropped by nearly twice as much, 26%, year-over-year in March.
But here’s the red flag: the average cap rate for individual sales of over $6 million came in at a minuscule 4.7%, "… fully 50 bps lower than the last low point for cap rates seen in the expansionary cycle of 2006-07,” wrote RCA.
If you’re not just a little afraid, you’re not paying attention.
But wait, you say, the risk premium—that spread between cap rates and the yield on the 10-year Treasury note—is still healthy enough to make bread-and-butter deals pencil out.
In some secondary markets and assets—particularly in the Midwest and Sunbelt—that’s definitely the case. But it’s safe to assume, we can’t make that case in our biggest markets and best assets.
If the average cap rate was 4.7% in March, and the 10-Year Treasury hovered around 2% (it reached as high as 2.24%), you’ve got an average risk premium of more than 220 basis points (bps), depending on the day you lock-in that loan.
And that’s a healthy premium—in the last cycle, the metric got as skinny as 90 bps before all hell broke loose. Compare that with the long-term historical average of 300 bps and you get a glimpse of just how ridiculously overheated the industry was last decade.
But we're heading in the wrong direction: Coming out of the recession, the premium ballooned out to between 400 and 500 bps. That too wasn't going to last long.
Trouble is, the premium keeps shrinking below the historical average, even as we speak. And keep in mind, that average 4.7% cap rate figure is a national number representing a hyper-local profession—a dismal bellwether, perhaps, but a bellwether nonetheless.
This cycle has its very own cornucopia of dynamics that make it quite distinct from the last peak.
Since multifamily is such a highly fragmented market—and so heavily dependent upon government-backed financing—an apples-to-apples comparison of last decade is difficult.
But some trends are unmistakable: just as transaction velocity—and investor yields—get squeezed, so too does access to capital.
Private-label conduits, some of whom led “a race to the bottom” for rates and terms during the last cycle, now account for less than 10% of all multifamily mortgages today. It wasn’t supposed to be like this—at the onset of the year, conduits were projected to issue as much as $125 billion this year, but given global volatility, they’re now expected to dole out just $40 billion this year, according to the National Multifamily Housing Council (NMHC).
In 2007, by contrast, conduits issued $230 billion.
But that’s the permanent loan world—new construction lenders are starting to get ants in their pants too, and tap the brake pedals some more.
You can forgive them for acting, well, like bankers. More than 300,000 units came on line last year—310,300 to be exact, according to the NMHC—and that figure is expected to be surpassed this year. So, it’s no wonder that many stakeholders are seeing a pull-back in new construction lending.
“Adding to the banks’ cautious approach is a December letter from three federal banking regulators expressing concern over construction lending activity,” wrote Dave Borsos, the NMHC’s vice president of capital markets.
All of which leads me to believe that while we’ve begun our descent—as transactions and access to liquidity decelerate—it should be a relatively soft landing. Underwriting is so much stronger today than it was a decade ago, and the scars from 2009 left an indelible mark on a banker’s sense of trust.
We learned our lesson the hard way, but we learned it just the same.
The question that will determine just how much turbulence we can stand is, can we remember?