High interest rates scrambled the plans of apartment investors since they began to rise in March 2022.
Few potential buyers have been willing to pay the high prices common before interest rates rose. But few sellers have been willing to lower their prices, with many thinking interest rates would not stay so high for so long.
The deadlock between buyers and sellers may finally break in 2024. The owners of thousands of overleveraged apartment properties have short-term loans that are about to reach the end of their terms. These borrowers are unlikely to find new loans large enough to repay their debts—unless they contribute more of their own capital. Many may be forced to sell. A growing number of companies plan to make big, new investments in distressed apartments in 2024.
“Anyone that has a pending capital event or loan maturity in the next 12 months is going to have a lot of difficulty,” says Brennen Degner, CEO of DB Capital Management. “We’re building dry powder.”
Meanwhile, many conventional apartment investors are just hoping to get through 2024 relatively unscathed. Rents are likely to keep growing at more historical rates, though not as quickly as operating costs like insurance.
Survive Until 2025
Investors Management Group does not plan to buy or sell apartment properties in 2024—though the firm is watching carefully for unexpected opportunities. It checks regularly with brokers, lenders, and principals.
“In the next six to 12 months, I don’t really see transactions happening,” says Neil Schimmel, founder and CEO of Investors Management Group.
Instead, Schimmel plans to improve the income from his portfolio of 22 properties, totaling over 5,000 apartments, largely by improving resident retention. “We’re into capital preservation right now,” he says.
Investors spent just $97.4 billion to buy apartment properties in the United States from January through October 2023. That’s down 64% from the same period the year before, according to MSCI.
Several potential investors say they are unlikely to buy apartment properties at cap rates less than 6% in 2024. Across the United States, cap rates averaged 5.2% for apartment acquisitions closed over the 12 months that ended in October 2023, according to MSCI. That’s up more than 50 basis points from the lowest average cap rates recorded in 2022. But it’s still significantly more than most buyers are willing to pay, because of the high interest rates offered for permanent financing.
While other potential buyers and sellers argued over price, DB Capital Management came to agreement with three different owners. In October, it signed three letters of intent to acquire apartment properties in Texas, Colorado, and Utah in separate transactions, at cap rates ranging from 5.25% to 5.5%.
The three deals were not yet in contract when long-term interest rates, which had been rising steadily, suddenly jumped even higher.
The yield on 10-year treasury bonds peaked at more than 5% on Oct. 19. That’s up from 4.4% the month before. It’s also up from less than 2% in March 2022, just before officials at the Federal Reserve began to raise interest rates to fight inflation.
DB Capital’s three deals fell apart. The firm still plans to acquire apartment properties in 2024. However, it will wait until sellers accept cap rates between 6% and 6.5%—even though long-term interest rates have moderated.
“This inherent risk and volatility needs to be priced into the deal,” says DB Capital’s Degner.
Revitate Buys Off-Market
Revitate Cherry Tree is also seeking to buy apartment properties at cap rates of roughly 6%. For deals like this, the company focuses on off-market transactions with motivated sellers in the Midwest.
As of December, Revitate Cherry Tree had plans to buy three to four properties within 30 to 45 days, as capital flows into its Revitate Cherry Tree Fund II.
“To produce a list of six to eight deals that we can transact on, we’ve probably reviewed 100,” says Chris Marsh, general partner with Revitate Cherry Tree.
These properties are often older and smaller than the properties institutional capital is willing to buy in a single transaction, especially in the Midwestern towns where Revitate is building its portfolio.
For example, in May, the firm bought Tuscany Bay, a 96-unit multifamily property in Lawrenceburg, Indiana, approximately 26 miles from Cincinnati. The cap rate was roughly 6%.
“Institutional buyers are not chasing 96 units in Indiana,” says Marsh. “It’s not a big enough check size for them. But we are happy to patiently aggregate apartment portfolios in our target.”
Revitate aims to buy properties at cap rates roughly equal to the interest rate on its permanent financing. It earns relatively low interest rates from Fannie Mae and Freddie Mac lenders by committing to keep the rents at its workforce housing properties relatively low. Improved management should improve the cash-on-cash return from Revitate’s properties to about 7% or 8%.
Other investors have been able to acquire properties by avoiding today’s high interest rates altogether.
Excelsa Properties only bought one apartment property in the last 12 months. In August, it announced the acquisition of Concord Park at Russett, a 335-unit mid-rise community in Laurel, Maryland.
The deal only worked because Excelsa assumed an existing loan with a fixed interest rate of 3.4%. The loan also allows Excelsa to make smaller payments, covering just the interest, for the six years left on the loan’s original, seven-year term.
“That allowed us to project a very strong internal rate of return,” says David Fletcher, managing director and head of acquisitions for Excelsa.
Excelsa hopes to be much more active in 2024—acquiring between three and five apartment properties as sellers lower their expectations on price. “Everybody in the market understands that things are trading below brokers’ guidance,” says Fletcher.
But with prices falling for apartment properties, few owners are selling unless they have to.
“If you’re selling right now, you’re desperate,” says Investors Management Group’s Schimmel. “You’ve got problems.”
DB Capital Management has an intimate understanding of the problems faced by some sellers. It has four properties in its portfolio bought using floating-rate, short-term loans provided by debt funds that covered up to 75% of the value of the properties in 2021 and 2022. When those properties are eventually refinanced, the new permanent loans will almost certainly be much smaller than the expiring loans.
DB and its partners will be able to contribute extra equity to keep the properties. But not every overleveraged owner will have that capacity, says Degner.
“I do not think that 100% of the assets that need to be refinanced will be able to do so,” says Jim Simmons, CEO and founding partner of Asland Capital Partners.
Asland is closely observing potential opportunities to buy discounted apartment properties—ranging from the loan portfolio of Signature Bank, which failed in early 2023 and was seized by the Federal Deposit Insurance Corp., to overleveraged rent-stabilized properties in New York City.
Apartment properties totaling $7.5 billion were “distressed” at the end of 2023’s third quarter, according to MSCI. That includes properties with publicly reported financial problems such as bankruptcies or defaults, in addition to properties already owned by banks. Another $65.7 billion in apartment properties were “potentially distressed,” for reasons such as late payments or forbearance, according to MSCI.
It’s also possible, however, that many banks will not force overleveraged owners to sell their properties. “Lenders are not incentivized to take write-downs on their balance sheet,” says Simmons. “They are more incentivized to ‘extend and pretend.’”
Investors like Asland may still find opportunities to partner with owners of apartment properties to reduce the amount of their debt.
Gray Capital Plans to Provide ‘Rescue Capital’
In December, Gray Capital was on the brink of making its first investments in distressed apartment properties.
Gray Capital is likely to close “rescue capital” investments on three overleveraged apartment properties in early February, says CEO and co-founder Spencer Gray. The company is now underwriting about a dozen of these potential deals.
Gray was surprised to find that it has—so far—relatively little competition to make these deals. Because many overleveraged apartment properties are valued at less than $50 million, the amount of preferred equity they need is often $5 million or less—not enough to interest many institutional investors.
Underwriting these potential investments is giving Gray Capital a close look at the types of properties that are struggling.
“Every one is completely different,” says Gray.
They include a new development in Florida, now fully occupied after rushing to lease-up. The floating interest rate in its construction loan has risen to 9.5% from 4%, but the property qualifies for a much smaller permanent loan than its current construction loan. Gray Capital is also considering providing preferred equity to a 1970s apartment complex in Dallas and a portfolio of 1980s and 1990s apartment buildings in Florida.
However, some properties have suffered with inexperienced managers. “Some projects that we’ve seen are so far gone that injecting some preferred equity is really not going to save the deal,” says Gray. “There’s definitely a dumpster fire that’s burning.”
Income From Rents Won’t Help Much
Apartment investors won’t get much help from rent growth as they try to close deals in 2024.
“There’s going to be limited rent growth for the next year or year and a half,” says Excelsa’s Fletcher.
Apartment rents were expected to be just 0.9% higher at the end of 2023 than they were the year before, on average, according to RealPage.
That average increase in rents is often not enough to make up for growing operating costs. All regions, especially those threatened by flooding and major wind and hail exposure, have seen insurance costs more than double or even triple.
“It blows apart all the value you created,” says Degner.
Rents are likely to grow another 2% in 2024, according to the Urban Land Institute Real Estate Economic Forecast for Fall 2023, which surveyed 46 economists and analysts at 39 leading real estate organizations in October.
At workforce housing properties, fewer residents whose income and credit history qualify them to sign a lease after the disruptions of COVID and price inflation in the recovery are applying, says Fletcher.
“We’re seeing more residents unable to pay or late pay, and we are seeing concessions rising in our markets,” says Investors Management Group’s Schimmel. “Many renters across the United States in the last three years have had a $300 to $500 increase. We don’t have to hit these peak rents. We want to retain more of our tenants.”
At more expensive Class A properties, apartments will compete for residents against hundreds of thousands of new apartments planned to open this year.
Developers were in the process of building over 1 million apartments as of late 2023, according to RealPage. More than half of those—670,000—are slated to be completed in 2024.
That would be the most new apartments to open in a single year in more than four decades—even if thousands of those apartments are delayed, RealPage notes.
Few Developments Will Start in 2024
This year, many developers will finish apartment projects they started before interest rates rose. But few developers will start construction in 2024.
CP Capital started construction on seven new apartment developments in 2022. Starting new developments has become much more difficult for firms like CP Capital as interest rates rose in 2022 and 2023.
The firm did not start construction on any new apartment developments in 2023 but focused instead on executing on the existing assets within its portfolio.
The firm had planned to break ground on several new properties in 2023. Some were held up by common development challenges like entitlements and permitting delays in local municipalities. Others were canceled as yield requirements changed since interest rates continued to be higher than expected for even longer than expected.
“They weren’t necessarily as attractive or economically viable anymore given current market conditions,” says Logan King, director of investments at CP Capital.
The firm plans to start construction on two apartment properties in early 2024. While it doesn’t have other construction planned for the rest of the year, it remains open to pursuing additional opportunities.
“There will be very few development starts in 2024,” says King. “However, we remain optimistic about the long-term performance of the sector in 2024 and beyond due to its strong fundamentals and a persistent supply-demand imbalance.”
Developers across the United States struggle to find financing to start construction on apartment projects. Developers started construction on 40% fewer apartments in the first three quarters of 2023 than the same period the year before, according to MSCI.
Other apartment investors like Excelsa Properties are now focused on buying existing apartment properties rather than developing new ones. The cost of development is still too high, including financing, land, and materials.
“If we can buy a brand-new property right now and take the risk on lease-up, that’s a lot easier and a better risk-adjusted value than breaking ground,” says Excelsa‘s Fletcher.