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How Big is Small Cap Multifamily?

A closer look at the multifamily housing inventory in the United States and the size of the small cap investment opportunity.

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GENERAL: 800.ARBOR.10

Q1 2021
Small Multifamily
Investment Trends Report

Market Conditions Broadly Improve as Sector Begins Path Back to Normal

Key Findings

  • Small multifamily prices rose 2.3% quarter over quarter and 5.5% year over year
  • Origination volumes for 2021 are on pace to finish the year above 2019’s peak
  • Refinancing activity and credit conditions show signs of a return to pre-COVID levels

State of the Market

Noteworthy optimists in March 2020 had predicted that the domestic battle against the pandemic was going to see meaningful improvement in April. To their credit, they never specified in April of which year.

 

Progress on the public health front continues to gain momentum, boosting the near-term economic outlook. Through mid-April, more than half of all U.S. adults had received at least one dose of a COVID-19 vaccine, and daily deaths have fallen to nearly 700 nationally. We may remain far off from a non-socially distanced ticker-tape parade declaring the end of the pandemic, but guarded optimism is surely in order.

 

Market watchers are increasingly hopeful about the domestic recovery as economic tailwinds are starting to sync up. If anything, the biggest debate in policy circles right now is if the U.S. economy may actually overheat in the years ahead. Real GDP grew at an annualized rate of 6.4% for the first quarter of 2021, slightly below estimates but still a positive read. Through March 2021, the civilian unemployment rate dropped to 6.0% — an improvement of 8.8% from April 2020’s high (Chart 1).

 

Within small multifamily1, the start of the new year brought a reversal of some COVID-induced trends. Notably, loan-to-value ratios (LTVs) and debt yields, two metrics that saw hyper-variability due to increased risk aversion, have started to trend back toward their pre-pandemic levels. Despite the positive progress made thus far, there are still some challenges ahead for the small multifamily market.

 

While the amended 2020 Appropriations Bill and the passage of the American Rescue Plan Act earmark more than $50 billion in Federal aid for rental assistance programs, several industry groups like the National Multifamily Housing Council and Mortgage Bankers Association noted in a letter addressed to Treasury Secretary Janet Yellen that this assistance contains several shortcomings. The letter highlights the ineligibility of some low-income renters and “burdensome documentation requirements” that are “drastically slowing down the distribution of funding” as significant problem areas.

 

All else equal, small multifamily remains resilient heading into 2021’s warm weather months. According to Chandan Economics, small multifamily asset valuations are up an estimated 5.5% year over year, and cap rates are down to just 5.3%. Originations have started to recover, and the share of new lending volume going toward acquisitions increased for the first time in six quarters. Challenges are still a daily reality, but the balance of macroeconomic and small multifamily-specific tailwinds are finally starting to outnumber the headwinds.

1Chandan Economics defines small multifamily properties as those with 5 to 50 units and primary mortgages of $1.0 million to $7.5 million.

Lending Volume

Annualized 2021 estimates of new multifamily lending volume on loans with original balances between $1 million and $7.5 million2 — including loans for rental apartment building sales and refinancing — are on pace to finish the year at $60.2 billion (Chart 2). The current estimate would represent a 6.6% year-over-year increase, growing by a total of $2.7 billion (Chart 3). According to Chandan Economics, small multifamily originations reached an all-time high of $59.2 billion in 2019. In 2020, origination volumes fell by 2.9% — a drop-off that would have proven much worse had a surge in refinancing activity not buoyed loan production. Notably, 2021’s annualized estimate would mark an improvement not only from 2020’s total but also 2019’s pre-COVID peak.

Refinancing activity made up the bulk of new lending activity as buyers and sellers were far apart in their opinions of ‘fair value’ through much of last year. The refinancing share of small multifamily lending increased for five consecutive quarters, reaching a high of 78.5% in the fourth quarter of 2020 (Chart 4).

 

With the economic horizon starting to look less cloudy and an abundance of opportunistic capital seeking deployment, trades are starting to become more common. In first-quarter 2021, the refinancing share of small multifamily lending fell to 67.9% — just 90 basis points (bps) above where it stood one year ago and before the onset of pandemic-related financial conditions.

2All data, unless otherwise stated, are based on Chandan Economics’ analysis of a limited pool of loans with original balances of $1.0 million to $7.5 million and loan-to-value ratios above 50%.

Arbor Small Multifamily Price Index

As measured by the Arbor Small Multifamily Price Index3 , small multifamily posted solid gains in the first quarter of 2021, up 2.3% from the end of 2020 and 5.5% from one year ago (Chart 5 and Chart 6). Revised fourth-quarter estimates indicate that small multifamily prices surged more through late-2020 than previously reported. In the revised estimate, prices jumped 4.2% year over year. Moreover, in the three quarters following last year’s COVID-induced second-quarter dip, prices are up by 10.3%. An abundance of financing capital, a deep pool of buyers and the preservation of strong fundamentals in the face of pandemic-related distress are all factors that continue to support small asset pricing and have prevented any widescale valuation distress.
In the revised third-quarter estimate, prices jumped 4.1% year-over-year and fully erased second-quarter declines. The backstopping of agency liquidity has meaningfully supported small asset pricing throughout the pandemic. During an extended period of heightened buyer caution, the availability of refinancing capital has given property owners a viable alternative to selling into an imbalanced market.
3The Arbor Small Multifamily Price Index (ASMPI) uses model estimates of small multifamily rents and compares them against small multifamily cap rates. The index measures the estimated average price appreciation on small multifamily properties with 5 to 50 units and primary mortgages of $1.0 million to $7.5 million. For the full methodology, visit arbor.com/asmpi-faq.

Cap Rates & Spreads

National average cap rates for small multifamily properties shaved off 2 bps in the first quarter of 2021, settling at 5.3% (Chart 7). Since the start of 2011, small multifamily cap rates have followed a long-term trend of compression, falling an average of 20 bps annually. Through first-quarter 2021, small multifamily cap rates are down 34 bps year over year, outpacing the post-Great Recession trajectory.

 

The small multifamily risk premium, a measure of additional compensation demanded by investors to account for higher levels of risk, is best measured by comparing cap rates to 10-year Treasury yields. The credit quality of the U.S. government is perceived as unmatched, making the price it pays for its debt an approximation for the risk-free interest rate. The small multifamily risk premium averaged 399 bps in first-quarter 2020, as cap rates ticked down, and Treasury yields rose considerably (Chart 8). The risk premium surged to 470 bps in second-quarter 2020 as a global ‘flight to safety’ increased the prices of government bonds and suppressed their yields. The risk premium has fallen since, declining for three consecutive quarters.

The cap rate spread between small multifamily assets and the rest of the multifamily sector, a measure of the idiosyncratic risk of smaller properties, held effectively unchanged in first-quarter 2020, dropping just a single basis point to 38 bps (Chart 9).

 

The small versus all multifamily cap rate spread hit an all-time high of 121 bps in 2010 and an all-time low of just 19 bps in third-quarter 2020. Over time, the yield structure of small assets has come to look more like the rest of the sector as liquidity has improved and technological adoptions have added operational efficiencies.

Leverage & Debt Yields

LTVs on small multifamily loans have started to increase after their COVID-induced decline, as lenders’ risk appetite shows signs of returning. Small multifamily LTVs hit a high of 70.6% in the first quarter of 2020 and proceeded to drop by 230 bps in the second quarter, 71 bps in the third and 232 bps in the fourth (Chart 10). In the first quarter of this year, small multifamily LTVs averaged 65.9%, a 66 bps increase from the prior quarter. LTVs had risen steadily during the previous real estate cycle. With the first-quarter 2021 rise, current small multifamily LTVs are back in line with levels last seen in mid-2014. Across the rest of the sector, LTVs surged in the first quarter of 2021, climbing by a substantial 297 bps to 69.6%. According to Chandan Economics’ initial estimates, the LTV spread between small multifamily and the rest of the sector reached 368 bps in first-quarter 2021, the highest level as part of the post-2010 dataset.
Debt yields — the ratio of net operating income (NOI) and loan balance — for small multifamily loans fell by 7 bps to 8.1% in the first quarter of 2021, erasing some late-2020, COVID-related changes in underwriting (Chart 11). The trend was similar for all multifamily properties, which saw debt yields fall by a weighty 41 bps, settling at 7.2%. The spread between small multifamily and all multifamily debt yields climbed to 91 bps in the first quarter, rising by 34 bps quarter over quarter (Chart 12).
Debt per dollar of NOI, the inverse of debt yields, increased for both small multifamily and all multifamily loans in the first quarter. Small multifamily borrowers are securing an average of $12.37 in new debt for every $1 of property NOI, down 14 cents from this time last year but up by 10 cents from the previous quarter (Chart 13).

Outlook

As noted in last quarter’s report, reaching herd immunity remains the single-most important factor for a sustained economic recovery. The most recent McKinsey projection (as of March 2021) reflects an improving outlook and now forecasts that the U.S. will hit the critical threshold in third-quarter 2021. Vaccine hesitancy and the potential for variants to cause surges in cases are risk factors worth keeping an eye on, but through mid-April, more than half of U.S. adults have received at least a first dose of a COVID vaccine, fueling near-term optimism.

 

As the small multifamily sector heads into the middle of 2021, the CDC’s continued national eviction moratorium remains a sizeable roadblock on the hopeful path back to normalcy. While the moratorium is a challenging factor for all multifamily operators, the effects asymmetrically impact mom-and-pop owners. Nonperforming units in smaller apartment buildings make up a more significant percentage of forgone potential income. Even still, the scale of nonperformance has not measured close to initial fears. Opportunistic investors spent the early days of the crisis stockpiling capital to deploy into distressed assets. The relative infrequency of distress and the overabundance of capital are leading to competitive pricing, softening the blow for owners who find themselves in involuntary sales. All else equal, the small multifamily sector remains well positioned to return to health and exit the crisis from as strong of a position as it had entered.

For more multifamily research and insights, visit arbor.com/blog

Disclaimer All content is provided herein “as is” and neither Arbor Realty Trust, Inc. or Chandan Economics, LLC (“the Companies”) nor their affiliated or related entities, nor any person involved in the creation, production and distribution of the content make any warranties, express or implied. The Companies do not make any representations regarding the reliability, usefulness, completeness, accuracy, currency nor represent that use of any information provided herein would not infringe on other third party rights. The Companies shall not be liable for any direct, indirect or consequential damages to the reader or a third party arising from the use of the information contained herein.