Research Report Category: Small Multifamily Investment Trends

State of the Market

Compared to one year ago, macroeconomic conditions are in a markedly better place. However, the recovery has not been without its fair share of challenges.

The total size of the U.S. economy eclipsed its 2019 peak in the second quarter of 2021, reaching $19.4 trillion (measured in inflation-adjusted, 2012 dollars). According to the Bureau of Economic Analysis’ preliminary estimate, the U.S. economy grew at seasonally adjusted annual rate of 2.0% in the third quarter of 2021 — well below the 6.7% rate observed in the prior quarter. Looking ahead, the Congressional Budget Office forecasts the U.S. economy will expand by a healthy 5.0% in 2022, before settling back into the long-term trend of sub-2% growth.

Supply chain disruptions, labor shortages and rising inflation top the list of concerns keeping policymakers and business leaders up at night. According to the Bureau of Labor Statistics (BLS) Consumer Price Index, prices of goods and services are up an average of 5.4% from one year ago through September — the highest mark in more than a decade.

The multifamily sector is already demonstrating why it is often considered an ideal hedge against inflation headwinds. Unlike most other commercial leases that tend to have multi-year terms, most rental housing units’ leases are one-year long, allowing landlords and property managers to absorb inflationary pressures by adjusting rents. According to RealPage, through August 2021, effective asking rents were up 10.3% from a year earlier.

A longer-term uncertainty for the multifamily sector is how work from home (WFH) adoption will impact rental demand. The luxury of living close to work and having a shorter daily commute is an amenity that has historically commanded higher rents. The ability to work remotely allows workers to expand the number of markets and neighborhoods they consider when choosing where to live. As a result, remote-work tenants are less tied to one specific location and are less likely to pay a close-to-work rent premium.

Understanding where there are high concentrations of workers who are capable of transitioning into remote work may offer some clues about where rental demand may fall and where it is most likely to hold up. According to a recent BLS study, the ability to telework is most common among workers with a bachelor’s degree or higher (Chart 1). According to a Chandan Economics analysis of the U.S. Census Bureau’s latest American Community Survey, 71.8% of householders in small multifamily properties (under 50 units) hold less than a bachelor’s degree, well above the 58.7% observed in large multifamily properties (50 or more units).

Taking these above trends together suggests that small multifamily properties may be less affected by an impact from WFH because a smaller portion of these tenants can work remotely. They are therefore more likely to be locationally tied to their place of work.

As the report details, small multifamily assets continue to retain the stability that has become a defining hallmark for the sector. Small multifamily asset pricing continues to set new highs, and annual origination volume is on pace to do the same through the end of 2021. Cap rates have settled near record lows, and risk premiums are in line with their pre-pandemic levels. The small asset multifamily sector benefits from a unique set of stabilizing tailwinds as market demand for affordable, market-rate units remains robust and sector-level liquidity continues to be abundant.

Lending Volume

Annualized 2021 estimates 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 — are on pace to finish the year at $59.4 billion (Chart 2). The current estimate would represent a modest annual increase of about $2.0 billion from last year’s total, or a 3.4% growth rate. According to Chandan Economics, small multifamily originations reached an all-time high of $59.2 billion in 2019. If current annualized estimates hold up through the fourth quarter of this year, 2021 will narrowly eclipse the 2019 high watermark by 40 basis points (bps).

Refinancing activity has fallen considerably from its 2020 peak, though it remains elevated compared to pre-pandemic conditions. The refinancing share of multifamily lending ticked up to 70.3% in the third quarter of 2021, rising from 67.3% and 68.0% in the first and second quarters of this year, respectively (Chart 3). Still, the third-quarter reading sits well below the 79.7% peak observed in the third quarter of 2020.

The refinancing share of originations rose as investors locked in rates ahead of potential monetary tightening and an expected rate rise. The Federal Open Market Committee’s median forecast for 2022’s year-end federal funds rate jumped from 0.1% at the June meeting to 0.3% in September. Multifamily asset owners with higher debt servicing costs than prevailing market interest rates are likely recognizing the closing window for locking in lower rates, leading to a rush in refinancing demand.

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%.

Arbor Small Multifamily Price Index

As measured by the Arbor Small Multifamily Price Index², small multifamily asset valuations continued to improve in the third quarter of 2021, notching solid quarterly and annual gains of 2.3% and 2.9%, respectively (Chart 4 and Chart 5).

Compared to the crisis-low point reached in the second quarter of 2020, asset valuations are up by a healthy 12.2%. Moreover, valuations are up by 7.7% over where they were at the onset of the pandemic.

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.

Cap Rates & Spreads

National average cap rates for small multifamily properties were effectively flat in the third quarter of 2021, remaining at 5.2% (Chart 6). Small multifamily cap rates compressed considerably during the post-Great Recession expansion, declining from a cyclical high of 7.6% in 2010 to their current range near 5.2%. Since the second quarter of 2020, small multifamily cap rates have sat in a narrow range between 5.2% and 5.4%.

The small multifamily risk premium, a measure of additional compensation investors require to account for higher levels of risk, is best measured by comparing cap rates to 10-year Treasury yields. The small multifamily risk premium averaged 389 bps in the third quarter of 2021, up from 359 bps the previous quarter, as Treasury yields dipped by 27 bps and cap rates increased by a marginal 3 bps (Chart 7).

After reaching as high as 466 bps in the second quarter of 2020, risk premiums slid for four consecutive quarters, reflecting a normalization of risk pricing. The cap rate spread between small multifamily assets and the rest of the multifamily sector, a measure of the risk of smaller properties, declined to 16 bps in the third quarter of 2021 (Chart 8). The “small” versus “all” multifamily cap rate spread hit an all-time high of 121 bps in 2010, and the current reading represents a new all-time low.

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. Further, the renter-by-necessity profile of small multifamily renters will likely be perceived as a more reliable source of demand as the impact of WFH adoption and suburban flight are absorbed into the multifamily sector.

Leverage & Debt Yields

Loan-to-value ratios (LTVs) on newly originated small multifamily loans fell sharply during the pandemic, from a high of 70.9% at the end of 2019 to a low of 66.4% at the end of 2020 (Chart 9). In 2021, with the small multifamily sector already in recovery mode, credit risk measures have been slow to return to their pre-pandemic conditions. Through the third quarter of 2021, small multifamily LTVs averaged 66.5%, marking the second straight quarter of declines and returning the metric to just 9 bps over its 2020 low.

Debt yields for small multifamily loans rose by 17 bps to 8.0% in the third quarter of 2021, undoing some of the post-shutdown reversion seen over the previous two quarters (Chart 10). Debt per dollar of NOI, the inverse of debt yields, fell for small multifamily loans in the third quarter. Small multifamily borrowers were securing an average of $12.52 in new debt for every $1 of property NOI, down 28 cents from the previous quarter.

The entrenchment of lower LTVs and higher debt, in part, reflects tighter underwriting standards as lenders sought to reduce relative risk within their portfolios. However, as lenders become increasingly convinced of the small multifamily sector’s return to health, underwriting standards are likely to see some easing.

The latest Federal Reserve Senior Loan Officer Opinion Survey (SLOOS) signals that an easing of underwriting standards may already be underway. Surveyed in the second quarter of 2021, a net 18.1% of senior loan officers reported easing underwriting standards for multifamily lending — a major shift from the same period one year earlier when a net 64.3% reported a tightening of underwriting standards. If underwriting standards continue to ease, it is likely that LTVs would rise and debt yields would fall from their current levels.

Outlook

Heading into the third quarter, the major uncertainty for the small multifamily sector was the timing of the national eviction moratorium’s conclusion and how its end would impact evictions. While the national eviction moratorium has since been lifted, many statewide moratoria are still in place. As a result, long-term developments remain to be seen.

The look ahead is one of gradual progress for the small multifamily sector. Most indicators for the sector are in recovery or fully recovered. WFH adoption and increased demand for suburban housing options may prove to have a marginal impact on multifamily demand. However, small multifamily properties, which cater to moderate-income households who are more likely to rent by necessity, are well-insulated from downside pressures.

On the horizon, there could be more upward pressure on cap rates than there has been over the past decade. Higher levels of inflation are passing through to higher rents, boosting property-level incomes. Additionally, the Federal Reserve is signaling that it will begin a monetary policy tightening cycle over the next year — a development that should push up benchmark interest rates. If benchmark interest rates do rise, small multifamily buyers are likely to respond by increasing their required acquisition cap rate. At the same time, agency support and a high degree of market liquidity may limit the amount of observed upward pressure on yields. All else equal, small multifamily continues to boast solid operating fundamentals, a deep pool of liquidity and a reliable tenant base that signal a generally positive outlook for the market.

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 Q2 2021

Q2 2021
Small Multifamily
Investment Trends Report

Small Multifamily Sector Returns to Normalcy as the Recovery Takes Hold

Key Findings

Small multifamily cap rates continued to edge down, sinking to 5.2%, down from 5.3% last quarter
Acquisitions drove a larger share of lending volume as refinancings settled near pre-crisis levels
Asset prices rose 10.2% year over year and 1.3% quarter over quarter

Table of Contents

State of the Market

From the second quarter of 2020 to the second quarter of 2021, the U.S. has gone from experiencing all-out public health and economic crises to a recovery mode so robust that the debate du jour is whether policymakers are letting the economy run too hot.

The 2021 macroeconomic recovery is gaining steam as it comes back from the 3.5% annual decline it suffered in 2020, which was the largest contraction in the post-war era and the outcome of historic volatility in quarterly GDP figures. Inflation-adjusted GDP grew at a 6.4% annualized rate in the first quarter of 2021. According to the Federal Reserve Bank of Atlanta’s GDPNow projection, second-quarter growth is forecast to land near 7.9%.

According to the U.S. Bureau of Labor Statistics, labor market progress has become more consistent. The three-month moving average for job gains gradually increased from 518,000 to 567,000 between March and June 2021. Additionally, June’s employment increase of 850,000 positions represented the highest level of job growth since August 2020 and still nearly four times the monthly average seen through the recovery following the last recession.

By some measures, the U.S. multifamily sector is an industry in recovery — by others, it is already shaking off the rust and moving into expansion. After dipping slightly during the depths of the COVID-19 recession, the value of new multifamily construction put in place returned to growth mode by July 2020, and it has broken its all-time high record for the past nine months in a row (Chart 1). As a comparison, after reaching a high point in 2007, it then took the value of new multifamily construction more than eight years to eclipse pre-Great Recession levels.

Trends within the small multifamily sub-sector match the broader industry, with measures of health ranging from ‘in recovery’ to ‘fully recovered.’ Driven by ample liquidity and continued downward pressure on cap rates, valuations of small multifamily assets are gaining momentum. The balance between refinancings and acquisitions is settling back into its pre-pandemic norms, reflecting a stable interest rate environment and the return of active buyers.

However, challenges remain. Some operators may still see some COVID-related distress. Smaller mom-and-pop landlords who are subject to the CDC’s eviction moratorium are asymmetrically impacted by the Federal policy. Since these landlords typically have fewer units, a non-performing unit diminishes a greater share of potential income than if the same non-performing unit were to reside in a larger multifamily property.

In a June letter addressed to the Biden Administration signed by 12 of the nation’s leading rental housing advocacy and trade groups (including National Multifamily Housing Council, Mortgage Bankers Association and others), industry leaders commended the Federal Government’s role in staving off a rental housing crisis. However, they urged the Administration to suspend the CDC’s eviction moratorium. The letter states, “the continuation of a nationwide, one-size-fits-all” approach at this point will only place “insurmountable levels of debt on renter households and prevent recovery in the housing sector.” Despite these calls, CDC Director Dr. Rochelle Walensky extended the eviction moratorium by another month. However, it came with the announcement that it

was intended to be the final extension, setting up an expiration of the moratorium on July 31.

All else equal, the small multifamily recovery is well underway. The second half of 2021 has a firming outlook for the small asset sector. Macroeconomic tailwinds and the sunset of the CDC’s eviction moratorium will take the reins from the reliable underlying demand and the agencies’ (Fannie Mae and Freddie Mac) support that kept small multifamily going during the pandemic-related recession.

Lending Volume

Annualized 2021 estimates of new multifamily lending volume on loans with original balances between $1 million and $7.5 million¹ — including loans for rental apartment building sales and refinancing — are on pace to finish the year at $57.1 billion (Chart 2). The current estimate would represent a 0.5% annual decline, or a decrease of about $315 million (Chart 3). The current 2021 annualized estimate is a downward revision from the $60.2 reported last quarter, reflecting the impact of a normalizing pace of refinancings. According to Chandan Economics, small multifamily originations reached an all-time high of $59.2 billion in 2019. In 2020, origination volumes only fell by 2.9% — a drop-off that would have proven much worse had a surge in refinancing activity not buoyed loan production.

Refinancing activity continues to make up the bulk of new lending activity, though the balance between refinancings and acquisitions has fallen back in line with pre-crisis levels, averaging 67.3% and 68.0% in the first and second quarters of 2021, respectively (Chart 4).

With the interest rate environment proving more stable in 2021 than it had in 2020, the overwhelming rush to refinance has normalized.

Last year, as buyers and sellers were far apart in their asset value assessments, operators turned to mortgage lenders to pull equity out of their properties. Moreover, rapidly falling interest rates meant that operators could also lower their monthly debt servicing costs through refinancing. After rising for four consecutive quarters, the refinancing share of small multifamily reached a high watermark of 79.7% in the third quarter of 2020.

¹All 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%.

Arbor Small Multifamily Price Index

As measured by the Arbor Small Multifamily Price Index², small multifamily asset valuations continued their trajectory of improvement in the second quarter of 2021, notching solid quarterly and annual gains of 1.3% and 10.2%, respectively. (Chart 5 and Chart 6).

The robust annual growth is in part due to base effects, where declines in asset values measured last year make this year’s data appear particularly strong. Nonetheless, on average, small multifamily valuations have already more than recovered from the COVID-19 disruption, rising 5.8% above their pre-pandemic mark.

²The 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.

Cap Rates & Spreads

National average cap rates for small multifamily properties continued their long-term trend of steady declines in the second quarter of 2021, shaving off 12 basis points (bps) from the previous quarter and settling at 5.2% (Chart 7). Small multifamily cap rates have, except briefly during the pandemic, compressed since 2011, falling an average of 21 bps annually. Through second-quarter 2021, small multifamily cap rates are down 18 bps from one year ago, in line with 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 360 bps in the second quarter of 2021, down from 397 bps the previous quarter, and a pandemic-triggered 468 bps one year ago (Chart 8). These risk premiums have now sunk for four consecutive quarters as widespread fears have continued to ease with the recovery.

The cap rate spread between small multifamily assets and the rest of the multifamily sector, a measure of the idiosyncratic risk of smaller properties, shaved off 14 bps from the previous quarter, settling at 23 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 18 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

Between the first quarter and fourth quarters of 2020, loan-to-value ratios (LTVs) on newly originated small multifamily loans cratered from a high of 70.6% to a low of 65.3% (Chart 10).

For a sense of scale, between the end of 2011 and the start of 2020, small multifamily LTVs rose an average of exactly 1.0% annually, making the pandemic-induced 5.3% drop-off appear particularly severe. Now in 2021, with the small multifamily sector already in recovery mode, LTVs have started the process of reversing their freefall and climbing back to their pre-pandemic conditions. Through the second quarter of 2021, LTVs on small multifamily loans averaged 66.2%, up 23 bps from the previous quarter and up 90 bps from their recent low of 65.3% measured in fourth-quarter 2020.

Debt yields — the ratio of net operating income (NOI) and loan balance — for small multifamily loans fell by 25 bps to 7.8% in the second quarter of 2021, the most sizable decrease in six quarters (Chart 11). After shooting up by 53 bps in late-2020, small multifamily debt yields have now fallen for two consecutive quarters and are only 21 bps above their all-time low. Debt per dollar of NOI, the inverse of debt yields, increased for small multifamily loans in the second quarter. Small multifamily borrowers were securing an average of $12.78 in new debt for every $1 of property NOI, up 39 cents from the previous quarter.

Outlook

The COVID-19 pandemic and subsequent recession offered a rare jolt of volatility for a sector that has proven reliable as they come since post-Great Recession. With the recovery taking hold, getting back to the small asset sector’s steady progress is downright exhilarating. A recent Arbor Realty Trust-Chandan Economics analysis indicates that transaction volume across the multifamily sector is improving on last year’s drop-off, with the Sun Belt already running ahead of its pre-pandemic pace in 2021.

Some uncertainty exists around vaccination rates and the path of the virus. Vaccine hesitancy will likely prevent many U.S. communities from reaching local herd immunity. The rise of Delta variant, and the specter for others like it, may mean that the COVID-19 threat will persist long beyond the full resumption of our pre-pandemic lives. Even with the uncertainty, days of empty streets in Times Square and crowded lines at mass testing sites, thankfully, appear firmly behind us.

All else equal, between a growing pool of returning buyers and the end of the CDC’s eviction moratorium, the ingredients for sustained expansion are falling into place, and the outlook for the small multifamily is both positive and improving.

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

Small Multifamily Investment Trends Report Q1 2021

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

Table of Contents

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/articles

Small Multifamily Investment Trends Report Q4 2020

Q4 2020
Small Multifamily
Investment Trends Report

Small Multifamily Prices Rise as Refinancing Activity Remains Robust

Key Findings

Small multifamily prices rose 1.6% quarter-over-quarter and 2.0% year-over-year
Origination volume finished the year down 6.1% from 2019 levels
Refinancings remained elevated, accounting for 78.5% of small multifamily originations in the fourth quarter

Table of Contents

State of the Market

If there is one thing that most Americans can agree on, it’s that 2020 will not be missed. As the calendar flips to 2021, the US finds itself at a moment of both peril and promise. Daily new infections topping 200,000 has become commonplace through the first few weeks of the year. Still, there is hope that 2021 will be a year of gradual recovery. According to the WSJ Economic Forecasting Survey, a number of economists believe the COVID-19 vaccines will have a substantial impact on a labor market rebound. Within commercial real estate, the latest Real Estate Roundtable Sentiment Index results suggest the industry expects a more supportive set of economic conditions in the year ahead (Chart 1). When the full weight of the pandemic hit in March, the swift passage of the CARES Act helped to lessen the immediate damage of an unparalleled economic shock. In the first 10 weeks of the crisis alone, nearly 41 million people filed for first-time unemployment benefits. The inclusion of disaster relief unemployment benefits as part of the CARES Act helped safeguard the ability of renters to pay their monthly rent. In turn, the circular flow of rental payments, mortgage payments and mortgage availability remained unbroken, allowing the multifamily market to function. Through the fourth quarter, the financial health of renter households is still a pressing concern. The labor market recovery has transitioned from a period of slowing improvement to a period of outright reversal, and the winter months ahead will likely prove challenging. The expiration of many of the market-fortifying features of the CARES Act further fuel anxieties. According to the U.S. Census Bureau’s Household Pulse Survey, the share of U.S. renter households with either high or moderate confidence to pay their next rent bill slipped from 72.4% at the beginning of the quarter to 65.1% near the end (Chart 2).¹

Reinforcements, however, are on their way. After months of legislative inaction, the 2021 Consolidated Appropriations Act passed both congressional chambers on December 21 and became law on December 27. The newly approved spending earmarks $900 billion for additional COVID-19 relief aid, including a partial reinstatement of the disaster unemployment benefits and a $25 billion Emergency Rental Assistance program. While the rental assistance program is undoubtedly a welcome sign to struggling renters and landlords alike, a RealPage analysis of the program indicates that the $25 billion is likely not enough to address all concerns. Moreover, the analysis suggests the allocation process is not well-aligned with state and local needs.

According to Chandan Economics, small multifamily asset pricing has recovered from the early spring — a positive symptom of the market’s deep pool of liquidity. While cap rates remain exceptionally low by historical standards, they did jump by their widest quarterly margin since 2009. All else equal, the ongoing pressures created by the pandemic and continuing recession are not overly affecting the small asset subsector compared to the rest of the multifamily market, and targeted agency support has, to date, been effective in avoiding worst-case scenarios.

¹The first survey of Q4 2020 is taken from the Census Bureau’s Week 16 HPS, which covers responses from 9/30 through 10/12. The last survey of Q4 2020 is taken from the Census Bureau’s Week 21 HPS, which covers responses from 12/9 through 12/21.

Lending Volume

Estimates of new multifamily lending volume on loans with original balances between $1.0 million and $7.5 million — including loans for rental apartment building sales and refinancing — finished 2020 at $55.7 billion.² In 2019, small multifamily originations reached an all-time high of $59.2 billion, according to Chandan Economics’ post-financial crisis market tracking and model estimates (Chart 3). The current estimate represents a $3.6 billion shortfall and a 6.1% decline in lending activity (Chart 4). Notably, a significant surge in refinancing activity muted the severity of 2020’s drop-off.

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%.

Buyers pulled back in second-quarter 2020, with multifamily transaction volume for the quarter falling 67% from the year prior, according to Real Capital Analytics. While buyers have started to return in recent months, the pace of recovery remains slow. The prospect of finding distressed deals has kept many would-be buyers on the sideline.

Lenders, meanwhile, have remained active. The availability of refinancing capital has meant that property owners with expiring mortgages, or simply those that want to access their accrued equity, are not disposing of their assets from a disadvantaged position. Refinancing activity as a share of total small multifamily lending ranged from 61.2% to 66.7% between first-quarter 2019 and first-quarter 2020. Since the onset of the pandemic, the refinancing share has soared, reaching a new high of 78.5% in the fourth quarter (Chart 5).

Arbor Small Multifamily Price Index

As measured by the Arbor Small Multifamily Price Index, small multifamily prices improved during the fourth quarter of 2020, up 1.6% from the third quarter and up 2.0% from one year ago (Chart 6 and Chart 7).³ Revised third-quarter estimates indicate that national pricing of small multifamily assets recovered more through the summer months than previously reported.

Cap Rates & Spreads

National average cap rates for small multifamily properties jolted up by 12 basis points (bps) in the fourth quarter of 2020, reaching 5.4% (Chart 8 and Chart 9). The quarter-over-quarter increase marks the biggest single-period jump since 2009. However, evidence suggests the rise is due to climbing benchmark interest rates rather than an evolving perception of sector-level risk.

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 risk-free interest rate is embedded within the yield structure of all other market returns, including cap rates. Investors require additional compensation when accepting additional risk. We can infer this risk premium in small multifamily by looking at the difference between asset cap rates and 10-Year Treasurys.

Despite increased concerns over property-level operations during the pandemic, 10-year Treasurys rates sank to new lows. As both occurred in tandem, small multifamily cap rates moved like a rope in a game of tug of war. On net, falling Treasury rates won out, and cap rates ticked down in the second and third quarters. In the fourth quarter, growing optimism about the economic recovery in the year ahead led Treasury yields to do the unthinkable: rise (albeit marginally). Treasury yields averaged 0.86% in the fourth quarter — a 21 bps rise from the previous quarter.

With small multifamily cap rates rising by less than Treasurys in the fourth quarter, the risk premium narrowed to 452 bps (Chart 10). The spread is down by 21 bps from its recent high of 473 bps set in second-quarter 2020. The risk premium measured between small multifamily and the rest of the multifamily sector recovered slightly in the fourth quarter, doubling from 21 bps to 42 bps (Chart 11). Moreover, the fourth-quarter average brings the spread directly in line with the average set over the 12-months ending March 2020.

Leverage & Debt Yields

Loan-to-value ratios (LTVs) on small multifamily loans continued their vertical descent in the fourth quarter, averaging 65.2%. After topping out at 70.6% in first-quarter 2020, LTVs proceeded to fall by 237 bps in the second quarter, 71 bps in the third quarter, and 232 bps in the fourth quarter (Chart 12).

Across the rest of the sector, LTVs resumed a sliding trajectory in the fourth quarter as well. Average LTVs for all multifamily properties dropped by a substantial 346 bps from the previous quarter, reaching 66.5%. From the high point reached in the fourth quarter, LTVs for all multifamily properties are down 614 bps. According to Chandan Economics’ initial fourth-quarter estimates, the LTV spread between small multifamily all multifamily stood at 131 bps, nearly half of the 246-bps spread measured in the previous quarter.

Debt yields — the ratio of net operating income (NOI) and loan balance — for small multifamily loans jumped by 53 bps to 8.2% in the fourth quarter of 2020, the highest level seen since third-quarter 2019 (Chart 13). The trend was similar for all multifamily properties, where debt yields rose by an appreciable 88 bps to 7.5%.

The spread between small multifamily and all multifamily debt yields fell to 64 bps in the fourth quarter, the lowest level on record (Chart 14). Debt per dollar of NOI, the inverse of debt yields, fell for both small multifamily and all multifamily loans in the fourth quarter. Small multifamily borrowers are securing an average of $12.24 in new debt for every $1 of property NOI, down 84 cents from the prior quarter and 6 cents from last year (Chart 15).

Outlook

Reaching herd immunity is the single most important factor for a sustained recovery, and the continued vaccination rollout credibly brings that reality within sight. The most recent McKinsey projection (as of November 2020) forecasts that the U.S. will hit herd immunity and a return to somewhat “normal” life around the third or fourth quarter of 2021. While there is hope on the horizon, the labor market may see further deterioration in the months ahead. After months of slow progress, more jobs were lost than added in December, and a reprieve may not come until the spring. As long as there is a labor market in crisis, the financial wellbeing of renters will remain a concern. Still, according to NMHC, renters have, with some local exception, successfully prioritized their monthly rent obligations so far during the pandemic.

The success of small multifamily operators in 2021 will likely be increasingly sensitive to local factors. One of the biggest open questions heading into the new year is whether or not the outflowing pour of residents from high-priced markets into less expensive metro areas and suburbs will continue at such a robust pace. All else equal, there is little evidence to suggest that the small asset subsector nationally is underperforming the market for larger properties. Moreover, small multifamily renters are often less transient and are less likely to transition into homeownership, preserving short-term apartment demand. The small multifamily sector outperformed downside projections from the early spring, and its penchant for stability does not appear at risk, even as 2021 may prove to be a bit darker before the dawn.

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

Small Multifamily Investment Trends Report Q3 2020

Q3 2020
Small Multifamily
Investment Trends Report

Small Multifmaily Maintains Its Penchant for Stablitity

Key Findings

Small multifamily prices recovered, up 0.1% year-over-year
Annualized origination volumes decreased 12.0% in 2020
Refinancings accounted for nearly 4 in 5 small balance loans

Table of Contents

Leverage and Debt Yields