Small Multifamily Investment Trends Report Q1 2024

Small Multifamily Investment Trends Report Q4 2023

Cap Rates Push Higher as Underwriting Standards Stabilize

Key Findings

  • Small multifamily prices fell 3.2% during the quarter.
  • Cap rates climbed 33 bps — the largest single-period jump since 2009.
  • Property-level cash flows remained healthy as rent collections continued to strengthen and expense ratios normalized.

Key Findings & Overview

As we enter the closing chapter of 2023, the small multifamily sector is in the midst of resetting and adjusting to new capital market realities. Even as the Federal Reserve has pumped the brakes on rate hikes over the past few months, financial market conditions have kept tightening as long-term interest rates have ascended. Nevertheless, distress remains limited even as valuations and measures of risk pricing are in flux, signaling a stabilization of conditions.

According to Trepp, the delinquency rate of multifamily loans in CMBS transactions stands at 1.9% through September 2023, the best mark of any commercial property type other than industrial. The trends seen in small asset classes are similar. According to Freddie Mac, 1.5% of small balance multifamily loans are nonperforming — an increase from the 0.7% measured in the summer of 2022 while still below the recent high of 1.7% in spring 2021. To place these figures in context, the multifamily nonperforming rate for loans on bank balance sheets reached 4.7% after the 2008 financial crisis, according to data reported by the FDIC.

While underwriting criteria for small multifamily properties remain tight in a challenging market environment, lending standards held steady in the third quarter of 2023. Market clearing prices continue to edge lower, though the pace of depreciation has slowed, and new deal activity is starting to pick up. Further, the operational profile of the small multifamily subsector has held strong, with rent collections remaining at healthy levels and expense ratios normalizing. While macroeconomic headwinds remain a constant challenge, the small multifamily sector has demonstrated its ability to bend rather than break.

Lending Volume

The $90.1 billion year-end 2022 estimate of new multifamily lending volume on loans with original balances between $1 million and $9 million1 — including loans for apartment building sales and refinancing — represented a modest deceleration from 2021’s record high of $102.1 billion (Chart 1).

To date, 2023 has seen a resetting in the level of small multifamily originations. The current annualized 2023 total is $36 billion, which puts this year on track to be the slowest for new originations since 2012. However, while the annualized total will remain muted, there are signs of activity starting to pick back up. Third-quarter activity was nearly three times higher than the first quarter of the year.

Sustained high interest rates have contributed significantly to the decline in small multifamily origination volumes this year, which has impacted the market in two distinct ways. First, it has widened the bid-ask spread — the difference between what a buyer is willing to pay and what a seller is willing to accept. With costs of capital rising, potential buyers have been requiring larger discounts. At the same time, a lack of multifamily sector distress has meant that few owners are motivated to sell if they do not receive an offer close to their perception of fair value. Driven by this disagreement in price, 2023 has seen a dearth of apartment sales.

The second way that high interest rates impact small multifamily originations is that they reduce the incentive for investors to pursue cash-out refinancing. When interest rates are favorable, borrowers often use accrued equity in their properties to finance subsequent acquisitions. However, in today’s higher-rate environment, a cash-out refinancing would likely result in a voluntary increase in debt servicing costs. After reaching a recent high of 75.6% in the third quarter of 2022, the refinancing share of originations fell in three consecutive quarters, dropping to 60.5% in the second quarter of 2023 (Chart 2). However, there were signs of improvement in the third quarter as the refinancing share of originations shot up to 72.7% — potentially signaling that borrowers are no longer waiting for a rapid return of accommodative interest rates.

Arbor Small Multifamily Price Index

As measured by the Arbor Small Multifamily Price Index2, small multifamily asset valuations are down 11.9% from the same time last year (Chart 3). Meanwhile, prices fell just 0.4% in the third quarter of 2023 — the smallest single-period movement in the past year.

Negative pricing pressures are not unique to either multifamily or the small asset subsector in this interest rate environment. The higher cost of capital means that potential buyers of all property types have larger required yields. However, the slowing pace of devaluation combined with an increasing pace of originations suggests that bid-ask spreads are starting to narrow — albeit at lower market clearing prices than a year ago.

Cap Rates & Spreads

As 10-year Treasury yields push up against their high-water mark of the past 16 years, cap rates across all commercial property types, including multifamily and the small asset subsector, are on the rise. In the third quarter of 2023, small multifamily cap rates averaged 5.8%, reaching their highest point in over four years (Chart 4).

After cap rates in this subsector reached their all-time low of 5.0% in the third quarter of 2022, they have subsequently increased in four consecutive quarters. Small multifamily cap rates jumped 17 bps during the third quarter alone and are up 76 bps from this time last year — the most substantial year-over-year increase since 2010. The small multifamily risk premium, measured by comparing cap rates to the yield on the 10-year Treasury, is the additional compensation that investors require to account for higher levels of risk. This risk premium compressed by 38 bps in the third quarter of 2023, landing at 161 bps (Chart 5). The declining risk premium comes as long-term Treasury yields have rapidly risen in recent months. If long-term interest rates hold up at current levels, it could mean more upward pressure for cap rates on the horizon.

Between 2016 and 2021, the small multifamily risk premium averaged 372 bps and never fell below 290 bps or rose above 441 bps. Its movement back to a more sizable range that is in line with recent patterns is a reasonable baseline outlook for the year ahead. Meanwhile, the cap rate spread between small multifamily assets and the rest of the multifamily sector, a measure of the risk unique to smaller properties, fell by a minuscule 3 bps during the quarter to finish at 53 bps (Chart 6).

Expense Ratios

Expense ratios, measured as the relationship between underwritten property-level expenses and effective gross income, are showing signs of improvement. Driven by increases in vacancies and operating expenses, the small multifamily expense ratio surged to start the year, reaching 44.7% in the first quarter (Chart 7). However, the surge was short-lived. Expense ratios fell in both the second and third quarters of 2023, settling at 40.1% — 394 bps below the first quarter of the year.

Rent Collections

In recent months, on-time rental payment rates in small multifamily properties have consistently been robust, according to Chandan Economics and RentRedi’s Independent Landlord Rental Performance Report. In September 2023, tenants paid their full rent on time in an estimated 83.2% of units — improving 173 bps from the same time last year (Chart 8).

Due to a resilient labor market, tenants’ ability to make on-time rental payments continues to be one of the small multifamily subsector’s biggest strengths. Even in a challenging economic environment, healthy property-level cash flows have limited distress.

Leverage & Debt Yields

Underwriting standards remained tight during the third quarter of the year. Loan-to-value ratios (LTVs) improved slightly, rising 105 bps from 58.9% to 60.0% (Chart 9). Moreover, LTVs have now risen in two consecutive quarters, signaling that fears of sizable upcoming devaluations are calming. Nevertheless, current LTVs are exceptionally low and represent very tight underwriting standards compared to conditions seen as recently as early 2022. While small multifamily LTVs have improved from the first-quarter 2023 low by 167 bps, they remain down from first-quarter 2022 levels by a far more substantial 756 bps.

Average debt yields for small multifamily loans resumed their ascent in the third quarter, rising to 9.1% (Chart 10). Small multifamily debt yields have now risen in each of the past five quarters, and this pace of increase does appear to be settling down. Between the second quarter of 2022 and the first quarter of 2023, debt yields rose by 131 bps, notching an average quarterly increase of 45 bps in that time. In the following six months, small multifamily debt yields rose by a cumulative total of 17 bps.

The inverse of debt yields, the debt per dollar of net operating income (NOI), for small multifamily loans fell again during the quarter. Small multifamily borrowers secured an average of $10.96 in new debt for every $1.00 of property NOI, down $0.19 from the previous quarter and the lowest level since 2015.

Together, these two trends indicate that underwriting standards remain conservative as capital and real estate markets adjust to new economic realities. However, movements in both were marginal, offering hope that credit markets do not need to tighten further.

Outlook

Like all commercial real estate asset classes, the small multifamily market will continue to face challenges over the next several months. Even as the Federal Reserve is near or at the end of its monetary tightening cycle, markets broadly expect that the central bank will reduce short-term interest rates more slowly than they raised rates over the past year and a half. As we head into 2024, investors should watch for how a potential yield curve normalization could push long-term Treasury yields higher in the coming months, putting more upward pressure on cap rates. Despite the unsettling market impacts of high interest rates, the small multifamily sector has maintained operational stability, and there is momentum toward price stabilization. On balance, the small multifamily sector, which is bolstered by underlying tenant demand and healthy property-level cash flows, remains well-equipped to navigate through macroeconomic headwinds.

1 All data, unless otherwise stated, are based on Chandan Economics’ analysis of a limited pool of loans with original balances of $1 million to $9.0 million and loan-to-value ratios above 50%.
2 The 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 million to $7.5 million. For the full methodology, visit arbor.com/asmpi-faq.

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

About Arbor
Arbor Realty Trust, Inc. (NYSE: ABR) is a nationwide real estate investment trust and direct lender, providing loan origination and servicing for multifamily, single-family rental (SFR) portfolios, and other diverse commercial real estate assets. Headquartered in Uniondale, New York, Arbor manages a multibillion-dollar servicing portfolio, specializing in government-sponsored enterprise products. Arbor is a leading Fannie Mae DUS® lender, Freddie Mac Optigo® Seller/Servicer, and an approved FHA Multifamily Accelerated Processing (MAP) lender. Arbor’s product platform also includes bridge, CMBS, mezzanine, and preferred equity loans. Arbor is rated by Standard and Poor’s and Fitch. In June 2023, Arbor was added to the S&P SmallCap 600® index. Arbor is committed to building on its reputation for service, quality, and customized solutions with an unparalleled dedication to providing our clients excellence over the entire life of a loan.

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.

Small Multifamily Investment Trends Report Q1 2024

Small Multifamily Investment Trends Report Q1 2024

Cap Rates and Debt Yields Edge Up as Expense Ratios Normalize

Key Findings

  • Small multifamily valuations fell 12.2% year-over-year.
  • Cap rates ticked up again, rising slightly to reach 5.8% in the fourth quarter.
  • Debt yields increased for the sixth consecutive quarter, reaching a nine-year
    high of 9.3%.

State of the Market

The first quarter opens a new chapter for small multifamily real estate after a year where this subsector demonstrated its strength and resiliency amid stiff economic headwinds. With expense ratios normalizing and occupancy rates at healthy levels, the subsector is well-positioned to capitalize on positive momentum in the financial markets in 2024.

Despite elevated interest rates, multifamily had a strong fourth quarter. According to Trepp, the delinquency rate of multifamily loans in commercial mortgage-backed securities (CMBS) transactions stood at 2.6% through December — the best mark of any commercial property type other than industrial.

However, the economic environment continues to face challenges. Lending standards for small multifamily properties remain tight, and while cap rates ticked up in the fourth quarter, the combination of market conditions and historical precedent suggests they may still rise further.

Looking ahead, financial markets expect that the Federal Reserve will begin loosening its monetary tightening policy by its May 2024 meeting. When it begins lowering interest rates, the normalization of multifamily sector conditions will likely follow closely behind.

Lending Volume

The $90.1 billion year-end 2022 estimate of new multifamily lending volume on loans with original balances between $1 million and $9 million1 — including loans for apartment building sales and refinancing — represented a modest deceleration from 2021’s record high of $102.1 billion (Chart 1). Last year, however, the small multifamily originations market fully reset. The 2023 estimate was $40.7 billion, marking the slowest year for new originations since 2012.

The major factor contributing to declining origination volumes last year was sustained high interest rates, which impacted the market in two ways. First, it widened the bid-ask spread — the difference between what a buyer is willing to pay and what a seller is willing to accept. With costs of capital rising, potential buyers are requiring larger discounts. At the same time, a lack of multifamily sector distress has meant that few owners are motivated to sell if they do not receive an offer close to their perception of fair value. As a result, there was a sharp decline in apartment sales in 2023.

High interest rates also reduce the incentive for investors to pursue cash-out refinancing. When interest rates are favorable, borrowers often use accrued equity in their properties to finance subsequent acquisitions. However, in today’s higher-rate environment, a cash-out refinancing would likely result in a voluntary increase in debt servicing costs. After reaching a high of 75.6% in the third quarter of 2022, the refinancing share of originations fell for three consecutive quarters, reaching a low of 60.5% in the second quarter of 2023 (Chart 2).

Subsequently, the refinancing share of originations has started to normalize, averaging 72.7% and 66.8% in the third and fourth quarters of 2023, respectively — potentially signaling that borrowers are no longer willing to wait for a rapid return to accommodative interest rates.

Arbor Small Multifamily Price Index

As measured by the Arbor Small Multifamily Price Index2, through the fourth quarter of 2023, small multifamily asset valuations were down 12.2% from a year earlier (Chart 3). Meanwhile, quarter-over-quarter, prices fell by 4.0% in the final three-month period of the year.

Valuation declines in the small multifamily sector occurred as cap rates edged higher and property-level incomes remained effectively flat last year, according to Yardi Matrix.

Freddie Mac noted in its 2024 Multifamily Outlook that the “stabilization of the interest rates, all else equal, should help buyers and sellers find the middle ground to get transactions done.” However, the report also cites slower-than-usual rent growth and sustained high interest rates as factors that could continue suppressing valuations in 2024.

Cap Rates & Spreads

Although 10-year Treasury yields started sinking in December 2023, they averaged a lofty 4.5% over the course of the fourth quarter, a 16-year high. As the so-called “risk-free” rate of return has risen, so too have market yields, including cap rates for small multifamily properties. In the fourth quarter of 2023, small multifamily cap rates averaged 5.8%, reaching their highest point since mid-2019 (Chart 4); after falling to an all-time low of 5.0% in the third quarter of 2022, they subsequently rose in five consecutive quarters.

For the most recent reading, small multifamily cap rates jumped nine bps between the third and fourth quarters of 2023. Moreover, small multifamily cap rates are 68 bps higher than they were at this time last year.

The small multifamily risk premium, best measured by comparing cap rates to the yield on the 10-year Treasury, approximates the additional compensation that investors require to account for higher levels of risk. This risk premium compressed 21 bps in the fourth quarter of 2023 to land at 135 bps (Chart 5). While cap rates have risen, the ascent has not matched the pace of increase of Treasury yields, leading to the risk premium compression.

For 2024, a rising risk premium from current levels is a reasonable baseline outlook. Since 2000, the small multifamily risk premium has fallen below 135 bps in only eight of 96 quarters. Further, between 2016 and 2021, the small multifamily risk premium averaged 378 bps while never dropping below 290 bps or rising above 455 bps. Meanwhile, the cap rate spread between small multifamily assets and the rest of the multifamily sector, a measure of the risk unique to smaller properties, fell just three bps during the quarter to finish at 43 bps (Chart 6).

Expense Ratios

Expense ratios, measured as the relationship between underwritten property-level expenses and effective gross income, have stabilized in recent quarters. Expense ratios hit a peak in the first quarter of 2023 (43.6%), driven by increases in vacancies and operating expenses (Chart 7). However, improvement has come quickly as expense ratios fell in both the second and third quarters, settling down at 39.9%. During the fourth quarter of 2023, expense ratios held flat, remaining at 39.9%.

Occupancy Rates

Occupancy rates within small multifamily properties receiving financing in the fourth quarter averaged a healthy 97.3% (Chart 8). While average occupancy rates declined 60 bps quarter-over-quarter, they remained up by 113 bps from the first quarter of the year. Further, the fourth-quarter average is directly in line with the five-year average for the sector.

Leverage & Debt Yields

Debt underwriting standards remained tight through the fourth quarter of 2023. Loan-to-value (LTVs) ratios slid by 89 bps between the third and fourth quarters, settling at 59.7% (Chart 9). Small multifamily LTVs have sat in a narrow range between 58.4% and 60.2% since the middle of 2022. Further, there has been no momentum to push LTVs back above the 67% levels seen before the Federal Reserve began raising interest rates in early 2022.

Average debt yields for small multifamily loans continued ascending in the fourth quarter of 2023, reaching 9.3% (Chart 10). Small multifamily debt yields have risen in each of the past six quarters and are up to their highest point in nine years. While both cap rates and debt yields have risen over the past year, debt yields have increased more substantially. Between 2015 and 2022, the spread between debt yields and cap rates averaged 277 bps, ranging from a low of 242 bps to a high of 311 bps. In 2023, this spread has held above 340 bps in every quarter and finished the year at 354 bps.

The inverse of debt yields, the debt per dollar of net operating income (NOI), for small multifamily loans fell again in the fourth quarter of 2023. Small multifamily borrowers secured an average of $10.70 in new debt for every $1.00 of property NOI, down $0.27 from the previous quarter and reaching its lowest level since 2014.

Outlook

With inflation easing, strong job growth, and interest rate cuts expected as early as spring, this quarter’s outlook for small multifamily includes a healthy dose of optimism. As we enter the new year, multifamily housing continued to demonstrate strength, maintaining the best investment prospects of any major commercial real estate property type, according to the 2024 ULI-PwC Emerging Trends in Real Estate Report. The small multifamily subsector prospects look bright, too, as its fundamentals, including tenant demand and liquidity support, remain sturdy. With the Federal Reserve potentially kicking off a series of interest rate cuts, small multifamily investors should anticipate an uptick in activity this spring as more buyers come off the sidelines.

1 All data, unless otherwise stated, are based on Chandan Economics’ analysis of a limited pool of loans with original balances of $1 million to $9.0 million and loan-to-value ratios above 50%.
2 The 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 million to $7.5 million. For the full methodology, visit arbor.com/asmpi-faq.

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

About Arbor
Arbor Realty Trust, Inc. (NYSE: ABR) is a nationwide real estate investment trust and direct lender, providing loan origination and servicing for multifamily, single-family rental (SFR) portfolios, and other diverse commercial real estate assets. Headquartered in Uniondale, New York, Arbor manages a multibillion-dollar servicing portfolio, specializing in government-sponsored enterprise products. Arbor is a leading Fannie Mae DUS® lender, Freddie Mac Optigo® Seller/Servicer, and an approved FHA Multifamily Accelerated Processing (MAP) lender. Arbor’s product platform also includes bridge, CMBS, mezzanine, and preferred equity loans. Arbor is rated by Standard and Poor’s and Fitch. In June 2023, Arbor was added to the S&P SmallCap 600® index. Arbor is committed to building on its reputation for service, quality, and customized solutions with an unparalleled dedication to providing our clients excellence over the entire life of a loan.

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.

Small Multifamily Investment Trends Report Q4 2023

Small Multifamily Investment Trends Report Q4 2023

Cap Rates Push Higher as Underwriting Standards Stabilize

Key Findings

  • Small multifamily prices fell 3.2% during the quarter.
  • Cap rates climbed 33 bps — the largest single-period jump since 2009.
  • Property-level cash flows remained healthy as rent collections continued to strengthen and expense ratios normalized.

Key Findings & Overview

As we enter the closing chapter of 2023, the small multifamily sector is in the midst of resetting and adjusting to new capital market realities. Even as the Federal Reserve has pumped the brakes on rate hikes over the past few months, financial market conditions have kept tightening as long-term interest rates have ascended. Nevertheless, distress remains limited even as valuations and measures of risk pricing are in flux, signaling a stabilization of conditions.

According to Trepp, the delinquency rate of multifamily loans in CMBS transactions stands at 1.9% through September 2023, the best mark of any commercial property type other than industrial. The trends seen in small asset classes are similar. According to Freddie Mac, 1.5% of small balance multifamily loans are nonperforming — an increase from the 0.7% measured in the summer of 2022 while still below the recent high of 1.7% in spring 2021. To place these figures in context, the multifamily nonperforming rate for loans on bank balance sheets reached 4.7% after the 2008 financial crisis, according to data reported by the FDIC.

While underwriting criteria for small multifamily properties remain tight in a challenging market environment, lending standards held steady in the third quarter of 2023. Market clearing prices continue to edge lower, though the pace of depreciation has slowed, and new deal activity is starting to pick up. Further, the operational profile of the small multifamily subsector has held strong, with rent collections remaining at healthy levels and expense ratios normalizing. While macroeconomic headwinds remain a constant challenge, the small multifamily sector has demonstrated its ability to bend rather than break.

Lending Volume

The $90.1 billion year-end 2022 estimate of new multifamily lending volume on loans with original balances between $1 million and $9 million1 — including loans for apartment building sales and refinancing — represented a modest deceleration from 2021’s record high of $102.1 billion (Chart 1).

To date, 2023 has seen a resetting in the level of small multifamily originations. The current annualized 2023 total is $36 billion, which puts this year on track to be the slowest for new originations since 2012. However, while the annualized total will remain muted, there are signs of activity starting to pick back up. Third-quarter activity was nearly three times higher than the first quarter of the year.

Sustained high interest rates have contributed significantly to the decline in small multifamily origination volumes this year, which has impacted the market in two distinct ways. First, it has widened the bid-ask spread — the difference between what a buyer is willing to pay and what a seller is willing to accept. With costs of capital rising, potential buyers have been requiring larger discounts. At the same time, a lack of multifamily sector distress has meant that few owners are motivated to sell if they do not receive an offer close to their perception of fair value. Driven by this disagreement in price, 2023 has seen a dearth of apartment sales.

The second way that high interest rates impact small multifamily originations is that they reduce the incentive for investors to pursue cash-out refinancing. When interest rates are favorable, borrowers often use accrued equity in their properties to finance subsequent acquisitions. However, in today’s higher-rate environment, a cash-out refinancing would likely result in a voluntary increase in debt servicing costs. After reaching a recent high of 75.6% in the third quarter of 2022, the refinancing share of originations fell in three consecutive quarters, dropping to 60.5% in the second quarter of 2023 (Chart 2). However, there were signs of improvement in the third quarter as the refinancing share of originations shot up to 72.7% — potentially signaling that borrowers are no longer waiting for a rapid return of accommodative interest rates.

Arbor Small Multifamily Price Index

As measured by the Arbor Small Multifamily Price Index2, small multifamily asset valuations are down 11.9% from the same time last year (Chart 3). Meanwhile, prices fell just 0.4% in the third quarter of 2023 — the smallest single-period movement in the past year.

Negative pricing pressures are not unique to either multifamily or the small asset subsector in this interest rate environment. The higher cost of capital means that potential buyers of all property types have larger required yields. However, the slowing pace of devaluation combined with an increasing pace of originations suggests that bid-ask spreads are starting to narrow — albeit at lower market clearing prices than a year ago.

Cap Rates & Spreads

As 10-year Treasury yields push up against their high-water mark of the past 16 years, cap rates across all commercial property types, including multifamily and the small asset subsector, are on the rise. In the third quarter of 2023, small multifamily cap rates averaged 5.8%, reaching their highest point in over four years (Chart 4).

After cap rates in this subsector reached their all-time low of 5.0% in the third quarter of 2022, they have subsequently increased in four consecutive quarters. Small multifamily cap rates jumped 17 bps during the third quarter alone and are up 76 bps from this time last year — the most substantial year-over-year increase since 2010. The small multifamily risk premium, measured by comparing cap rates to the yield on the 10-year Treasury, is the additional compensation that investors require to account for higher levels of risk. This risk premium compressed by 38 bps in the third quarter of 2023, landing at 161 bps (Chart 5). The declining risk premium comes as long-term Treasury yields have rapidly risen in recent months. If long-term interest rates hold up at current levels, it could mean more upward pressure for cap rates on the horizon.

Between 2016 and 2021, the small multifamily risk premium averaged 372 bps and never fell below 290 bps or rose above 441 bps. Its movement back to a more sizable range that is in line with recent patterns is a reasonable baseline outlook for the year ahead. Meanwhile, the cap rate spread between small multifamily assets and the rest of the multifamily sector, a measure of the risk unique to smaller properties, fell by a minuscule 3 bps during the quarter to finish at 53 bps (Chart 6).

Expense Ratios

Expense ratios, measured as the relationship between underwritten property-level expenses and effective gross income, are showing signs of improvement. Driven by increases in vacancies and operating expenses, the small multifamily expense ratio surged to start the year, reaching 44.7% in the first quarter (Chart 7). However, the surge was short-lived. Expense ratios fell in both the second and third quarters of 2023, settling at 40.1% — 394 bps below the first quarter of the year.

Rent Collections

In recent months, on-time rental payment rates in small multifamily properties have consistently been robust, according to Chandan Economics and RentRedi’s Independent Landlord Rental Performance Report. In September 2023, tenants paid their full rent on time in an estimated 83.2% of units — improving 173 bps from the same time last year (Chart 8).

Due to a resilient labor market, tenants’ ability to make on-time rental payments continues to be one of the small multifamily subsector’s biggest strengths. Even in a challenging economic environment, healthy property-level cash flows have limited distress.

Leverage & Debt Yields

Underwriting standards remained tight during the third quarter of the year. Loan-to-value ratios (LTVs) improved slightly, rising 105 bps from 58.9% to 60.0% (Chart 9). Moreover, LTVs have now risen in two consecutive quarters, signaling that fears of sizable upcoming devaluations are calming. Nevertheless, current LTVs are exceptionally low and represent very tight underwriting standards compared to conditions seen as recently as early 2022. While small multifamily LTVs have improved from the first-quarter 2023 low by 167 bps, they remain down from first-quarter 2022 levels by a far more substantial 756 bps.

Average debt yields for small multifamily loans resumed their ascent in the third quarter, rising to 9.1% (Chart 10). Small multifamily debt yields have now risen in each of the past five quarters, and this pace of increase does appear to be settling down. Between the second quarter of 2022 and the first quarter of 2023, debt yields rose by 131 bps, notching an average quarterly increase of 45 bps in that time. In the following six months, small multifamily debt yields rose by a cumulative total of 17 bps.

The inverse of debt yields, the debt per dollar of net operating income (NOI), for small multifamily loans fell again during the quarter. Small multifamily borrowers secured an average of $10.96 in new debt for every $1.00 of property NOI, down $0.19 from the previous quarter and the lowest level since 2015.

Together, these two trends indicate that underwriting standards remain conservative as capital and real estate markets adjust to new economic realities. However, movements in both were marginal, offering hope that credit markets do not need to tighten further.

Outlook

Like all commercial real estate asset classes, the small multifamily market will continue to face challenges over the next several months. Even as the Federal Reserve is near or at the end of its monetary tightening cycle, markets broadly expect that the central bank will reduce short-term interest rates more slowly than they raised rates over the past year and a half. As we head into 2024, investors should watch for how a potential yield curve normalization could push long-term Treasury yields higher in the coming months, putting more upward pressure on cap rates. Despite the unsettling market impacts of high interest rates, the small multifamily sector has maintained operational stability, and there is momentum toward price stabilization. On balance, the small multifamily sector, which is bolstered by underlying tenant demand and healthy property-level cash flows, remains well-equipped to navigate through macroeconomic headwinds.

1 All data, unless otherwise stated, are based on Chandan Economics’ analysis of a limited pool of loans with original balances of $1 million to $9.0 million and loan-to-value ratios above 50%.
2 The 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 million to $7.5 million. For the full methodology, visit arbor.com/asmpi-faq.

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

About Arbor
Arbor Realty Trust, Inc. (NYSE: ABR) is a nationwide real estate investment trust and direct lender, providing loan origination and servicing for multifamily, single-family rental (SFR) portfolios, and other diverse commercial real estate assets. Headquartered in Uniondale, New York, Arbor manages a multibillion-dollar servicing portfolio, specializing in government-sponsored enterprise products. Arbor is a leading Fannie Mae DUS® lender, Freddie Mac Optigo® Seller/Servicer, and an approved FHA Multifamily Accelerated Processing (MAP) lender. Arbor’s product platform also includes bridge, CMBS, mezzanine, and preferred equity loans. Arbor is rated by Standard and Poor’s and Fitch. In June 2023, Arbor was added to the S&P SmallCap 600® index. Arbor is committed to building on its reputation for service, quality, and customized solutions with an unparalleled dedication to providing our clients excellence over the entire life of a loan.

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.

Small Multifamily Investment Trends Report Q3 2023

Small Multifamily Investment Trends Report Q3 2023

Higher Interest Rates Drive Cap Rates Up as Cash Flows Remain Robust

Key Findings

  • Small multifamily prices fell 3.2% quarter-over-quarter.
  • Cap rates climbed 33 bps between the first and second quarters of 2023, the largest single-period jump since 2009.
  • Property-level cash flows remained healthy as rent collections were robust and expense ratios normalized.

State of the Market

Through the first half of 2023, capital market realities continued testing the resiliency of the small multifamily subsector. More than a year after the Federal Reserve began its monetary tightening cycle, commercial real estate investors are still adjusting to the higher cost of capital. While market disruptions have weakened performance, the scope of the impact has remained limited.

According to Trepp, the delinquency rate of multifamily loans in CMBS transactions stands at 1.6% through June, which is the best mark of any commercial property type other than industrial. The recent trends seen in small asset classes are similar. According to Freddie Mac, 1.3% of small balance multifamily loans are nonperforming — an increase from the 0.7% measured in the summer of 2022 though still below the recent high of 1.7% seen in spring 2021. To place these figures in context, the multifamily nonperforming rate for loans on bank balance sheets reached 4.7% after the 2008 financial crisis, according to data reported by the FDIC.

This year, the rapid recalibration of risk and pricing of small multifamily assets has been widespread. But, as buyers and sellers navigate new challenges, bright spots have emerged. Amid a corrective environment, the operational profile of the small multifamily subsector has held strong, with rent collection trending higher and expense ratios normalizing. While macroeconomic headwinds may not recede soon, tenant dependability, the core strength of small multifamily, has proven to be a powerful antidote to financial market storms.

Lending Volume

The $83.9 billion year-end 2022 estimate of new multifamily lending volume on loans with original balances between $1 million and $7.5 million1 — including loans for apartment building sales and refinancing — represented a modest 10.9% deceleration from 2021’s record high of $94.1 billion (Chart 1).

However, the annualized 2023 total illustrates a market that is starting to show renewed signs of movement. While the current 2023 estimate of $20.8 billion still represents the slowest pace since 2010, second quarter performance was a solid improvement on the first quarter’s reading of $15.5 billion.

One significant factor contributing to the drop off in new small multifamily originations has been the reduced incentive for investors to pursue cash-out refinancing. When interest rates are favorable, borrowers often use accrued equity in their properties to finance subsequent acquisitions. However, in today’s higher-rate environment, a cash-out refinancing would likely result in a voluntary increase in debt servicing costs. As a result, refinancings remained slow in the second quarter of 2023, accounting for just 59.1% of tracked small multifamily originations— a total decrease of 16.5 percentage points over the previous three quarters (Chart 2).

Arbor Small Multifamily Price Index

As measured by the Arbor Small Multifamily Price Index2, small multifamily asset valuations fell 3.2% quarter-over-quarter (Chart 3). Moreover, compared to the same time last year, prices were down 8.4%.

Negative pricing pressures are not unique to either multifamily or the small asset subsector in this interest rate environment. The higher cost of capital means that potential buyers of all property types have larger required yields. Data from recent quarters indicate that some seller capitulation is taking place, leading to higher cap rates and a softening of prices.

Cap Rates & Spreads

As 10-year Treasury yields continue holding at their highest levels in over a decade, cap rates across all commercial property types, including multifamily and the small asset subsector, have been rising. In the second quarter of 2023, small multifamily cap rates averaged 5.6%, reaching their highest point since mid-2019. After cap rates in this subsector reached their all-time low of 5.0% in the third quarter of 2022, they have subsequently risen in three consecutive quarters — and by a growing magnitude in each observation. Small multifamily cap rates jumped 33 bps between the first and second quarters of 2023, marking the largest single-period jump since 2009 (Chart 4).

The small multifamily risk premium, which is best measured by comparing cap rates to the yield on the 10-year Treasury, is a measurement of additional compensation that investors require to account for higher levels of risk. This risk premium rose again in the second quarter of 2023, jumping to 204 bps (Chart 5).

Between 2016 and 2021, the small multifamily risk premium averaged 372 bps and never fell below 290 bps or rose above 441 bps. These fluctuations happened as financial and real estate markets felt the ripple effects of higher interest rates. The risk premium fell as low as 130 bps in the fourth quarter of 2022 — its lowest level on record. As a result, recent premium increases represent a normalization of risk pricing as the spreads move back toward historical averages. Meanwhile, the cap rate spread between small multifamily assets and the rest of the multifamily sector, a measure of the risk unique to smaller properties, rose 26 bps during the quarter to finish at 56 bps (Chart 6).

Expense Ratios

Expense ratios, measured as the relationship between underwritten property-level expenses and effective gross income, are showing signs of improvement. Driven by increases in vacancies and operating expenses, the small multifamily expense ratio surged to start the year, reaching 44.7% in the first quarter (Chart 7). However, during the second quarter, this expense ratio retreated 231 bps quarter-over-quarter to settle at 42.4%, close to its 2019-2022 average.

Rent Collections

On-time rental payment rates in small multifamily properties have consistently been robust in recent months, according to Chandan Economics and RentRedi’s Independent Landlord Rental Performance Report. In June 2023, full rent was paid on time in an estimated 82.6% of units — improving 153 bps from the same time last year (Chart 8).

Thanks to a resilient labor market, tenants’ continued ability to make on-time rental payments continues to be one of the small multifamily subsector’s biggest assets. Even in a challenging economic environment, healthy property-level cash flows will likely continue to limit small multifamily property owners and lenders from experiencing distress.

Leverage & Debt Yields

While signals are mixed, debt underwriting standards remained tight through the second quarter of this year. Loan-to-value ratios (LTVs) slid in four consecutive quarters through the first quarter of 2023. After a dramatic drop of 501 bps between the fourth quarter of 2022 and the first quarter of 2023, average small multifamily LTVs reached 59.7%. However, in the second quarter, LTVs bounced back to 63.8% (+409 bps). While the quarter-over-quarter improvement is significant and encouraging, current LTV levels remain historically low. Aside from the first quarter of 2023, which was an outlier due to low transaction activity, small multifamily LTVs were lower in the second quarter than at any point since 2013 (Chart 9).

 Average debt yields for small multifamily loans remained at 9.0% in the second quarter of 2023 (Chart 10). After debt yields jumped by 95 bps in the first quarter — the largest quarterly jump in 15 years — they edged 3 bps higher, demonstrating the effect of tight underwriting standards. The inverse of debt yields, the debt per dollar of net operating income (NOI), for small multifamily loans fell slightly. Small multifamily borrowers secured an average of $11.14 in new debt for every $1.00 of property NOI, down $0.03 from the previous quarter and the lowest level since 2015.

Together, the trends in LTVs and debt yields indicate that underwriting standards remain conservative as capital and real estate markets adjust to new economic realities.

Outlook

Like all commercial real estate asset classes, the small multifamily market will continue to be challenged over the next several months. While the Federal Reserve signaled it is near the end of its monetary tightening cycle, interest rate normalization is likely to take time. Looking a year ahead, there is a greater than 65% chance the federal funds rate will sit higher than 450 bps in July 2024, according to the CME Group’s FedWatch tool. Given the interest rate outlook, Fannie Mae forecasts that multifamily cap rates will continue rising through the rest of 2023 and into early 2024. At the same time, it forecasts that net operating growth will remain positive for the foreseeable future — underscoring the present decoupling of asset-level operations and financial market conditions. If all things remain equal, negative pricing pressures are unlikely to abate through the second half of the year. Still, small multifamily, strengthened by its healthy property-level cash flows, remains well-equipped to overcome macroeconomic headwinds.

1 All data, unless otherwise stated, are based on Chandan Economics’ analysis of a limited pool of loans with original balances of $1 million to $7.5 million and loan-to-value ratios above 50%.
2 The 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 million to $7.5 million. For the full methodology, visit arbor.com/asmpi-faq.

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

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.

Small Multifamily Investment Trends Report Q1 2023

Small Multifamily Investment Trends Report Q1 2023

Cash Flows Remain Resilient as Valuations and Cap Rates Feel
Interest Rate Pressure

Key Findings

  • Small multifamily prices slid 2.6% from the previous quarter, as new purchases and originations activity slowed.

  • Cap rates posted the largest quarterly jump since 2009, finishing at 5.4%.

  • Debt yields rose and LTVs plummeted as lending standards tightened amid financial sector volatility.

State of the Market

Through the first quarter of 2023, the small multifamily subsector lies in a unique position, battling financial sector headwinds on one side while benefiting from structural tailwinds on the other.

After the failures of Silicon Valley Bank and Signature Bank in March, lenders, especially regional banks with less stringent capital requirements and greater interest rate risk exposure, have become more conservative. As a result, new purchases and originations of small multifamily properties saw much lower levels of activity than in previous quarters.

The recent banking sector distress has been primarily driven by the Federal Reserve’s ongoing monetary policy tightening cycle. In the 13 months ending in March 2023, the Federal Reserve hiked interest rates a total of 475 bps in nine different policy meetings. Over the short term, the economy must learn to adapt to higher interest rates.

At its May 2023 meeting, the Fed raised rates by 25 bps as expected. However, some relief may be on the horizon. Markets are betting that the Fed will begin cutting interest rates by the end of the summer. Similarly, the central bank has communicated that it foresees a less stringent interest rate environment in the short term, with the federal funds rate expected to average 4.3% in 2023 and come back down to an average of 2.5% over the longer run.

Despite significant headwinds, the small multifamily subsector is weathering the ongoing storm impacting the commercial real estate industry. A challenging environment for homebuyers combined with a resilient labor market has created an economic climate where there is more demand for rental housing units, and tenants are, by and large, maintaining their ability to pay rent. As noted by Freddie Mac in their 2023 multifamily outlook, so long as the labor market remains healthy, “tailwinds will keep the multifamily market performing in 2023,” albeit at “more modest levels compared with the prior few years.” While financial market conditions could restrain new activity, the structural health profile of small multifamily households remains largely intact — a factor that should allow the sector to limit distress between now and when a period of interest rate normalization arrives.

Lending Volume

The year-end 2022 estimate of new multifamily lending volume on loans with original balances between $1 million and $7.5 million1 — including loans for apartment building sales and refinancing — fell to $83.9 billion (Chart 1).

The 2022 estimate indicates there was a modest 10.9% deceleration from 2021’s record high of $94.1 billion. Initial estimates of small multifamily lending in 2023 reflect a market environment that is currently in a pause. The annualized level of small multifamily lending activity during the first quarter came in at just $15.5 billion — which would represent the lowest annual total on record since 2010.

A significant factor contributing to the drop off in new small multifamily originations has been the reduced incentive to engage in cash-out refinancing. Borrowers often use accrued equity in their properties to finance subsequent acquisitions. However, cash-out refinancings in today’s market environment would likely mean a voluntary increase in debt servicing costs. Refinancings accounted for just 53.4% of tracked small multifamily originations during the first quarter of 2023 — a 15.6 percentage point decrease from the previous quarter (Chart 2).

Arbor Small Multifamily Price Index

As measured by the Arbor Small Multifamily Price Index2 , small multifamily asset valuations fell 2.6% quarter-over-quarter. Still, thanks to a runup in prices through mid-2022, prices were 7.4% higher than a year earlier (Chart 3).

Negative pricing pressures in the current environment are not unique to either multifamily or the small asset subsector. An effect of the Federal Reserve’s fight against inflation is higher costs of capital. As a result, potential buyers of all property types have higher required yields that need to be met before a deal can begin to make sense. While multifamily owners seemed content to hold firm on pricing last year, late-2022 and early-2023 data indicate that some seller capitulation is taking place, leading to higher cap rates and a softening of prices.

Cap Rates & Spreads

For the first time in over a decade, cap rates across all commercial property types are rising, including multifamily and the small asset subsector. The Federal Reserve is in the midst of one of its most rapid monetary tightening cycles in history and its full effects are still filtering through the economy. Multifamily cap rates are just one of the many risk pricing measures that investors are re-evaluating in real-time. After small multifamily cap rates reached a record low of 5.0% in the third quarter of 2022, they have since risen in two consecutive quarters, rising to 5.4% during the first quarter of 2023 (Chart 4). Measured quarter-over-quarter, small multifamily cap rates rose by 25 basis points — the largest single increase on record since 2009.

The small multifamily risk premium, which is best measured by comparing cap rates to the yield on the 10-Year Treasury, is a measurement of additional compensation that investors require to account for higher levels of risk. In the first quarter of 2023, this metric rose for the first time in a year and a half, increasing to 173 bps (Chart 5).

Quarter-over-quarter, the small multifamily risk premium jumped by 43 bps — its largest increase since mid-2019. The cap rate spread between small multifamily assets and the rest of the multifamily sector, a measure of the risk unique to smaller properties, fell 6 bps during the quarter, to finish at 30 bps (Chart 6).

Expense Ratios

Expense ratios, measured as the relationship between underwritten property-level expenses and effective gross income, jumped significantly, rising 427 bps quarter-over-quarter to 45.5% (Chart 7). This sharp increase likely reflects a recent slowdown in rent growth, which was flat for multifamily properties during the quarter, according to Yardi Matrix. A slowdown in rent growth has historically impacted the amount of income a property generates — putting downward pressure on effective gross income and increasing expense ratios. 

Rent Collections

On-time rent payments in small multifamily properties reached their highest levels since the onset of the pandemic, according to Chandan Economics and RentRedi’s Independent Landlord Rental Performance Report. In March 2023, full rent was paid on time in an estimated 85.5% of units — improving 197 bps from the month prior (Chart 8).

More on-time rent payments signal that, despite financial market turbulence, economic distress has not substantially filtered down to rental households. Tenants have maintained their ability to pay rent, and as a result, property-level cash flows appear to be secure.

 

In this environment of economic uncertainty, the resilient underlying health of rental households is among the most reassuring factors for the small multifamily sector. As long as the cash flow ecosystem between tenants, property owners, and lenders remains intact, the probable range of downside scenarios will remain limited.

Leverage & Debt Yields

While the equity side of the capital stack has shifted to reflect economic and financial market volatility over the past half-year, the debt side has maintained a conservative stance since the onset of the pandemic. Even so, the first quarter of 2023 showed that underwriting standards have room to tighten further. Loan-to-value ratios (LTVs) have slid in each of the past four quarters as lenders are increasing their requirements for how much capital borrowers need to have at risk. Small multifamily LTVs fell to 60.6%, dropping by a substantial 439 bps from the prior quarter (Chart 9).

Debt yields for small multifamily loans averaged 9.0%, rising 99 bps from the previous period — the largest quarterly jump in the history of Chandan Economics’ post-global financial crisis tracking (Chart 10). The inverse of debt yields, the debt per dollar of net operating income (NOI), fell for small multifamily loans. Small multifamily borrowers secured an average of $11.18 in new debt for every $1 of property NOI, down $1.38 from the previous quarter and reaching the lowest level since 2015.

Together, these LTV and debt yield trends indicate that underwriting standards remain conservative amid heightened economic uncertainty and financial sector volatility. To protect against distress, lenders are working in larger equity and property-income cushions.

Outlook

The small multifamily subsector will continue to be tested over the next several months. However, the asset type has developed structural fortification to ensure it will bend rather than break. The Mortgage Bankers Association found that delinquencies in the multifamily sector have remained negligible, reporting a mere 20 bps increase during the first three months of 2023. Moreover, according to the Federal Reserve Bank of New York’s recently released 2023 SCE Housing Survey, the share of renters who anticipate buying a home in the next three years has fallen to a nine-year low (42.2%) — a factor that should continue to support demand for rental housing. The intersection of the small multifamily subsector and naturally occurring affordable housing (NOAH) is a potential tailwind to watch. With every state in the U.S. not having enough affordable housing to meet demand, public support for the small multifamily subsector is substantial and growing, including from Fannie Mae and Freddie Mac. All things being equal, balance sheet asset valuations and new deal volume will likely continue to show sensitivity to sustained higher interest rates over the short term, although the intact structural demand profile of the sector will enable it to absorb downside pressures better than many other commercial real estate asset classes.

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

1 All data, unless otherwise stated, are based on Chandan Economics’ analysis of a limited pool of loans with original balances of $1 million to $7.5 million and loan-to-value ratios above 50%.

2 The 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 million to $7.5 million. For the full methodology, visit arbor.com/asmpi-faq.

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.

Small Multifamily Investment Trends Report Q4 2022

Small Multifamily Investment Trends Report Q4 2022

Valuations Flatten as Cap Rates Start to Rise from Record Lows

Key Findings

  • Small multifamily originations reached $80.7 billion in 2022, the highest annual total after 2021’s record high.
  • Cap rates inch higher from record lows, ticking up to 5.1%.
  • Debt yields rise and loan-to-value ratios (LTVs) hold near post-pandemic lows as lending standards remain tight.

State of the Market

During a volatile 2022, the Federal Reserve’s ongoing monetary tightening cycle began to accomplish its intended goal. Inflation came down for six consecutive months through December 2022. Although slowing inflation has generated optimism, the central bank has stated that it may still need to raise interest rates again in 2023.

How changing economic conditions will impact the small multifamily sub-sector is only now beginning to become clear. The Mortgage Bankers Association’s 2023 forecast noted that cap rates appear “to be reflecting past market conditions that have changed significantly over recent months.” If elevated interest rates are sustained, commercial real estate pricing, including within the multifamily sector, is at risk of market fluctuations.

However, as noted in Arbor’s Special Report Spring 2023 by Arbor Chairman and CEO Ivan Kaufman and Sam Chandan, Founder of Chandan Economics, growing storm clouds in the multifamily sector are not reflective of any structural change in the profile of demand or supply but rather are a cyclical feature. Moreover, while multifamily and the small asset sub-sector are not immune from disruption, there are significant supporting factors that should limit distress. Debt underwriting standards have remained tight since the onset of the pandemic, which should curb the scope of mortgage defaults. Further, the structural undersupply of quality affordable housing options will continue to support tenant demand, and Fannie Mae and Freddie Mac will continue to buttress liquidity.

On balance, while the small multifamily sector remains in a fortified position entering 2023, it will likely feel reverberations from ongoing macroeconomic instability.

Lending Volume

The year-end 2022 estimate of new multifamily lending volume on loans with original balances between $1 million1 and $7.5 million — including loans for apartment building sales and refinancing — fell to $80.7 billion (Chart 1).

 

The 2022 estimate represented a 14.3% annual decline from 2021’s record high of $94.1 billion, which reached lofty highs on a wave of pent-up investment demand and the anticipation of monetary tightening. Looking ahead, Freddie Mac forecasts that overall multifamily origination volume will fall again in 2023, in the range of 4% to 5%.

Even as small multifamily originations came down significantly in 2022, they remained elevated compared to any year other than 2021. 2022’s originations total measured 40% higher than 2020’s mark and 36% higher than 2019’s pre-pandemic record high of $59.2 billion.

 

The resilience of refinancing activity is one factor that has kept small multifamily originations at an elevated level. During the fourth quarter, loans originated for the purpose of refinancing accounted for 69.0% of small multifamily lending activity (Chart 2), despite higher financing costs. For 2022 overall, refinancings accounted for 69.4% of small multifamily lending activity, up from 63.5% in 2021.

Arbor Small Multifamily Price Index

As measured by the Arbor Small Multifamily Price Index2, small multifamily asset valuations were flat in the fourth quarter of 2022, growing by 0.2% (Chart 3).

However, prices rose by 10.1% year-over-year (Chart 4).

Multifamily properties, which have an average lease of one year, have demonstrated an ability to withstand inflationary pressures due to their positive cash flows. Still, benchmark interest rate increases in the year ahead will be critical for small multifamily pricing. If Treasury yields remain elevated, new multifamily buyers will increasingly require higher property-level yields — a condition that could be satisfied through either strengthening cash flows or declining asset values.

Cap Rates & Spreads

As benchmark interest rates climbed in 2022, an inflection in small multifamily cap rates seemed likely to follow. Even as the cost of capital reached its highest levels since before the 2008 financial crisis, small multifamily cap rates approached new all-time lows as recently as the third quarter of 2022. However, cap rates have now shown some sensitivity to softening economic conditions. National average cap rates for small multifamily properties climbed to 5.1% in the fourth quarter of 2022, rising 13 bps from the prior quarter (Chart 5). This was the largest single-period increase since 2009.

 

The small multifamily risk premium, a measure of additional compensation that investors require to account for higher levels of risk, is best measured by comparing cap rates to the yield on the 10-year Treasury. The average small multifamily risk premium fell in the fourth quarter of 2022, sliding down to 130 bps. Even as cap rates rose last quarter, Treasurys rose faster, causing this spread to narrow by a substantial 60 bps. At the end of the year, the small multifamily risk premium sat at its lowest level since the third quarter of 2007 (Chart 6).

 

The cap rate spread between small multifamily assets and the rest of the multifamily sector, a measure of the risk unique to smaller properties, remained flat between the third and fourth quarters of 2022, holding at 36 bps (Chart 7).

Expense Ratios

Expense ratios, measured as the relationship between underwritten property-level expenses and effective gross income, have increased over the past two years — reflecting that when operating costs surge, it still takes time for rent rolls to adjust. After rising to a high of 43.5% at the end of 2021, expense ratios improved in 2022, dropping 95 bps during the fourth quarter to finish the year at 41.3% (Chart 8).

 

Rent Collections

On-time rent payments in small multifamily properties remain at healthy levels. At the start of January 2023, an estimated 81.0% of units had paid their full rent on time — improving 89 bps from the month prior (Chart 9). After a brief dip during the pandemic, on-time payment rates have been above 80% for 15 consecutive months. Despite mounting economic anxiety and a bear market for equities, rental households have maintained their ability to pay rent. As a result, small multifamily owners’ property-level cash flows have built-in security.

Leverage & Debt Yields

While the equity side of the capital stack is just now beginning to reflect the changing economic landscape, the debt side has been signaling the prudence of a conservative adjustment to risk-taking. LTVs have slid substantially this year as lenders have increased their risk requirements. While small multifamily LTVs did rise by 8 bps to land at 65.4% in the fourth quarter of 2022, they remain lower than at any point during 2020 and 2021 (Chart 10). Moreover, current small multifamily LTVs sit 234 bps lower than at the beginning of 2022 and 523 bps lower than their first-quarter 2021 peak (70.5%).

Debt yields for small multifamily loans averaged 7.9% in the fourth quarter of 2022, rising a substantial 17 bps from the previous period (Chart 11).

 

The inverse of debt yields, the debt per dollar of net operating income (NOI), fell for small multifamily loans. Small multifamily borrowers secured an average of $12.58 in new debt for every $1 of property NOI, down 28 cents from the previous quarter.

Together, these LTV and debt yield trends indicate that underwriting standards have remained conservative amid increased economic uncertainty. To protect against distress, lenders are building in larger equity and property-income cushions.

Outlook

The small multifamily sector remains in a resilient position heading into 2023, even as it faces cyclical challenges from a high-interest rate environment. The combination of a rent-by-necessity tenant base and declining access to affordable homeownership should continue to strengthen tenant demand. Balance sheet asset valuations are likely to show some sensitivity to higher interest rates. If Treasurys remain elevated, cap rates will need to rise to restore sufficient risk premiums. However, thanks to the strength of the labor market, renters have maintained their ability to pay their rent. As long as property-level cash flows remain stable, the scope of distress within the small multifamily sector should remain limited. While the year ahead may present challenges, the small multifamily sector boasts stabilizing fundamentals that should allow it to absorb business cycle headwinds.

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

1 All data, unless otherwise stated, are based on Chandan Economics’ analysis of a limited pool of loans with original balances of $1 million to $7.5 million and loan-to-value ratios above 50%.

2 The 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 million to $7.5 million. For the full methodology, visit arbor.com/asmpi-faq.

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.