Examining The Multifamily Market in 13 Charts From 2023

We just recently held our 2024 Multifamily Market Outlook webinar and a big part of looking ahead is looking back at some of the key moments in 2023 that lead us to the assumptions we make looking forward. So for this blog, we are going to focus on recapping some of the highlights of 2023 and current trends that we believe will most profoundly impact our investment decisions in 2024.

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2023 was one of the most eventful years for the commercial real estate industry since 2008. An industry renowned for its cyclical nature, the industry had been riding high for nearly 12 years until the inevitable realities of the market took hold. The age-old adage rings true: what goes up, must come down. The shift began in 2022, fueled by the Federal Reserve's aggressive rate hikes, and was further intensified by a range of factors from basic operational challenges to wide-ranging global events.

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Looking back at the beginning of 2023, which feels like ages ago, there was a sense of optimism, spurred by a temporary decrease in the 10-year U.S. Treasury index – a key indicator for our sector – to 3.3% from a high of 4.25% in October 2022. However, this optimism was short-lived as the index climbed again, hitting over 5.00% in October. The financial markets were further shaken by historic bank failures in March, leading to a sharp drop in lending and transaction volumes. Consumers began to feel the pinch, and the predicted downturn in rental prices materialized. As the year progressed, a series of events unfolded, adding stress to the real estate capital markets. Here, I share my thoughts on the three most significant events of 2023 in the industry and what we might hope for 2024.

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Key Events of 2023:

Bank Failures: The downfall of Silicon Valley and First Republic banks – the second and third largest in U.S. history – had a profound and lasting impact. The aftermath saw a significant decrease in construction loan availability from regional banks, critical for many developers, leading to a drop in new construction projects.
Federal Reserve's Inflation Fight: The Consumer Price Index reached a peak of 9.1% in June 2022. Since then, the Federal Reserve has been clear about its intention to raise the Fed Funds rate as necessary to bring inflation down to its 2% goal. This rapid and sustained rate hike has particularly impacted real estate businesses and developers reliant on floating-rate loans, which are closely tied to the Fed Funds rate. Many pro formas from 2020, 2021, and early 2022 did not foresee these rate hikes, resulting in a need for significant additional capital to cover rising interest costs. While the approach to achieving economic stability needs precision, the December CPI at 3.3% suggests that the Federal Reserve's strategy is having an effect.
Political and Geopolitical Turbulence: On a brighter note, a government shutdown was averted in November, though the issue may resurface soon here in early 2024. The conflict in Ukraine, now almost two years ongoing, continues to affect material and energy prices, among other issues. The events in Israel on October 7th were among the most shocking and tragic in recent memory, contributing to regional instability and unpredictable challenges and risks. The concurrent presence of two major geopolitical conflicts adds a layer of economic uncertainty.

Economic Resilience

Apart from the early optimism in the bond market, many economists, including 7 out of 10 highly respected Bloomberg economists, predicted a recession in 2023. To the surprise of many, GDP surprised to the upside and the economy showed a strong level of resilience against the Fed's rate hikes. In my opinion, part of this resilience stemmed from a continuation of Congressional spending. We saw the Infrastructure and Semiconductor Bills spur economic activity which colliding against the backdrop of the Fed's rate hikes created a very unique economic environment in 2023.

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Multifamily Rents

Multifamily rental trends showed a significant amount of regional variance. If we look at the national rental rates we observed negative rent growth lead by certain markets in the West and South. The market most impacted were the markets that saw a heavy amount of new supply hitting the market outpacing the increased demand. This new supply came from projects that began from years prior when capital activity was much higher. The constriction of lending activity and transaction volume in 2023 tempered many new development projects so once again, we will see a slowdown in development and further dampening the national shortage of housing.

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The negative rent growth that was observed, often hit markets that saw unsustainable double digit rental growth in 2021 and 2022. With the slowdown of construction in 2023, and national housing shortage, we anticipate most of these markets to normalize back to a healthy 2-4% rental growth by the end of 2024.

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December saw the fifth straight month of negative rent growth. However, the national median rent is still almost $250 higher than it was three years ago.

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Many suggest that rental rates increased too quickly, too fast and we will need to see a further correction. However, the alternative of buying a home and making a mortgage payment has increased far more, making now one of the worst times in history to purchase a home. Fueling renter demand from would-be homebuyers.

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Cap Rates

In 2023, we observed a notable increase in multifamily cap rates, with the national average reaching 5.2% by Q3. This rise in cap rates was a significant shift from 2022 averages of around 4.25% to4.5%, and 3.30% to 3.50% in 2021. The rise in cap rates was driven in part by borrowing costs outpacing them, creating a scenario of negative leverage in certain deals.

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Looking ahead, it is common practice to use the U.S. 10 Year Treasury index to suggest where cap rates should fall. This is because the 10 Year Treasury is largely considered the "risk-free" rate, and if I can get a 4% risk-free rate for my investment, I am going to command a premium to acquire real estate because of the perceived risks. So if we can get a 4% risk-free rate, perhaps for investing in commercial real estate we would like to see a 150 - 250 basis point premium on that suggesting cap rates should fall in the 5.5% - 6.5% range. This is a heavily debated topic and there are a lot of academic studies to contradict this argument. My personal favorite study on this topic was in the fall 2020 issue of the Linneman Letter. If you have the time and find this topic interesting for predicting cap rates (you should), I suggest reading this study. It suggests that just because there is a loose correlation between interest rates and cap rates, it doesn't mean that the interest rates cause cap rate movement. In fact it suggests and provides evidence that the availability of capital and the flow of funds to commercial real estate are the better predictors.

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Inflation and Labor

We all know about the Fed's fight against inflation in 2023. The big question was whether or not a soft landing would be achievable or if as an economy we were headed for a hard landing.

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By the end of 2023, the CPI reading was 3.35% in December down from it's June 2022 high. And it appears that we have avoided a deep recession for now. However, I would suggest that instead of the many economists being flat out wrong about a recession in 2023, I would suggest they were simply early and I anticipate a mild recession by late 2024, deepening into 2025. For us, I am watching delinquency rates on loans secured by real estate as an indicator of an upcoming recession. Delinquency rates are still quite low, though there has been a slight uptick.

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The Fed provided some mixed messages in December as to if rate hikes will continue or not. Many took the comments as we will see rate cuts potentially in 2024, but I am not convinced it will be as quick as some investor may hope. In addition to the Fed's stance on reaching their 2% CPI target, they are focused on the labor market as well which remains strong but it is loosening.

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2023 saw a continuation of wage growth, a trend influenced by a persistently tight labor market. Private industry wages and salaries rose 4.5% over fiscal 2023, according to the U.S. Bureau of Labor Statistics. Despite some cooling, labor market tightness remained significant in 2023. As of August, it was still 32% higher than December 2019, right before the onset of the pandemic.

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Wage inflation is a double edge sword for Multifamily as it is helpful for residents to be able to afford their rent payments, and it also increases our operating costs.

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Distress Signs

As mentioned above, we are watching delinquency rates closely as a predictor of recession and also for potential distress in the commercial real estate market. We have already began to see signs of distress from borrowers with floating rate debt. Many of these borrowers already had to issue capital calls or look for cash-in refinance options to cover their increased debt obligations.

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Many who bought multifamily investment properties in 2021 and 2022 overpaid and overleveraged their purchases with floating rate loans. At the same time, rent growth has retreated. From Q3 2023 through 2025, a record number of commercial mortgage-backed security(CMBS) multifamily loans will come due, and overleveraged investors trying to refinance are finding that their deals no longer work at today’s higher mortgage rates.

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In 2024 and 2025, there is a wave of loan maturities that were originated at record low interest rates. These projects are going to find themselves in a very different lending environment than what was likely in their pro formas.

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Investors with the capital to invest and the capability to navigate the distressed market may find exceptional opportunities.

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Why We Remain Optimistic About Multifamily

Housing is an essential asset.

America has had a housing undersupply problem since the Great Recession.

We’re currently facing a housing supply shortage between 5.5 million and 6.8 million units, according to the National Association of Realtors. We need to build 4.3 more apartments by 2035 to meet demand, the National Multifamily Housing Council estimated. This undersupply is growing due to low multifamily starts in 2023 and will persist in 2024 as lenders continue to pull back.

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As well, multifamily investment returns have exceeded the average 25-year S&P returns over the past 25 years and provide higher dividends and tax efficiencies, including depreciation and more.

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The world is uncertain, but it remains a mistake to stay out of the market, and this will continue to be true in 2024.

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