If things had gone as the business community expected last year, we would be in the midst of a recession. Although we are certainly not out of the woods, the Fed has so far succeeded in putting off our day of economic reckoning—and there is a growing, although far from universal, consensus that we might avoid it altogether.
The economy is showing unexpected strength, and the jobs market is robust despite a succession of rate hikes, which have dampened inflation, although not as much as the Fed would have liked.
As we continue past the midyear mark, this uncertainty and economic push and pull continue to shape the outlook for multifamily—supporting fundamentals but depressing transaction volume.
Multifamily Fundamentals Remain Solid
For the multifamily sector, the factors driving this uncertainty come with both positives and negatives. With unemployment at historic lows, multifamily fundamentals are solid. While rent growth has come down from its post-pandemic highs, rents are growing roughly in line with historical averages, and occupancy has stabilized in the mid-90s, also the norm for the last 30 years.
The reasons are straightforward. The continued strength of the labor market is stimulating new household formation especially among younger age groups. High mortgage rates have virtually shut down the existing-home market, adding to the pool of would-be renters. And all of this is happening against the background of a longstanding housing shortage.
Looking ahead, the construction backlog created by the pandemic should be absorbed relatively quickly in most markets. It is likely to produce only transient pressure on rents even in such cities as Colorado Springs, Colorado; Nashville, Tennessee; and Austin, Texas, which, according to Freddie Mac, have more than 14% of their current inventory under construction.
Volatility and Uncertainty Slow Transactions
The market for multifamily properties is another story. Rate hikes have made transactions harder to pencil out, and volatility has made buyers and sellers more hesitant to come off the sidelines. When interest rates fluctuate so sharply, deals that made sense on Monday might not work on Tuesday.
Furthermore, uncertainty about the future remains. Market players have been watching the Fed raise rates for almost 18 months—and there is no conviction, even among optimists, that the end is in sight. While increases for the moment are now just 25 basis points, the Fed has not taken additional hikes off the table, much less talked about lowering rates.
And if the inverted yield curve is an indication, the pessimists have not changed their minds. Among other factors, they point to the resumption of student loan payments, rising credit card debt, and spending stipulations in the congressional debt limit agreement as support for their view that a recession is still a possibility.
In essence, there are divergent opinions about whether there’s a shoe out there waiting to drop. The economic outlook has become a Rorschach test, reflecting the preconceptions of the observer as much as the data.
This lack of clarity about interest rates—and even the future of the economy—is the reason that the gap between buyers and sellers has remained so stubborn. Buyers do not want to offer yesterday’s prices, and sellers do not want to sell at today’s bid. Unless sellers have a compelling reason to sell, they are sitting tight and waiting. The result, according to Freddie Mac’s Midyear Multifamily Outlook, is that transaction volume will decline to about $370 billion this year, down roughly 17% from 2022. Other commentators believe it will fall further.
In my view, interest rates will remain relatively elevated for the rest of the year, and the economy—barring some external event—is heading either for a soft landing or will avoid a recession altogether. If this happens, rates are likely to decrease somewhat but not at a level we would have seen if there had been a recession. The pre-pandemic days of virtually free money are behind us, at least for the foreseeable future.
Regardless of what happens, I believe it will require a period with little or no rate movement to bring all these divergent viewpoints closer together and provide the stability needed to reignite the market for multifamily properties. When that happens, there will be no shortage of capital. Except for commercial banks that have reduced their commercial real estate originations, there are lenders, equity providers, and mezz capital providers, in abundance, ready and willing to invest in multifamily.
Insurance Costs Approach the Prohibitive
This doesn’t mean that multifamily will be totally out of the woods. Expenses are growing faster than inflation. According to RealPage, expenses rose 7.8% year over year in May, compared with 4% growth in inflation. The primary culprit is insurance, especially in densely populated areas like the Southeast, Texas, and California that have seen an increase in destructive weather events. These are also the hottest markets, where valuations—and replacement costs—continue to rise.
According to the National Multifamily Housing Council’s 2023 State of Multifamily Risk Survey and Report, the cost of multifamily property insurance rose 26% year over year, leading 61% of survey respondents to increase their deductibles. And as insurance companies institute policy limitations that reduce their exposure, owners find themselves paying more for less.
Insurance costs are having a number of consequences for multifamily transactions. For some buyers, sharply rising insurance costs—and the assumption that they will continue to rise—can make the difference between pursuing a deal or not. And when buyers decide to go ahead, it often takes longer to find insurance that meets the needs of owners, lenders, and other interested parties.
Insurance is not a problem that will solve itself. Government has an interest in incentivizing a more robust and reasonable insurance and reinsurance market for multifamily housing, but it will be a challenge to devise a sustainable system capable of achieving the mix of risk and return that all parties can tolerate.
Underlying Demographics Remain Favorable
Even in the face of rising expenses, significant opportunities remain for multifamily investors and developers. Although the preponderance of new supply is destined for the South and Southeast, there is no sense that these markets are cooling down. For instance, Austin, which is slated to receive the most deliveries of any city in 2023, has been the fastest-growing city in the United States for the last 12 years and is now the nation’s 10th-largest city. City demographers believe that Austin will grow an additional 23% between 2020 and 2030.
There are also opportunities in less well-known markets. As Austin illustrates, the top 20 cities for multifamily investing have changed significantly over the last 20 years, and the workforce mobility accelerated by the pandemic suggests that more change is coming. Investors would be wise to look at up-and-comers in the lower ranks of the top 20 and dip into the next 20, getting into markets while their cap rates are relatively high.
These opportunities demonstrate that while multifamily has its challenges, it is considered a desirable asset class for good reason. Multifamily continues to attract the attention of lenders and investors because of favorable demographics and an underlying housing shortage, both of which, for better or worse, will support the market for the foreseeable future.