Research Report Category: Small Multifamily Investment Trends

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

Lending Volume

Arbor Small Multifamily Price Index

Cap Rates & Spreads

Leverage & Debt Yields

Outlook

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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
Chart 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.
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 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.

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

https://arbor.com/small-loans
855.962.3944

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 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

State of the Market

Lending Volume

Arbor Small Multifamily Price Index

Cap Rates & Spreads

Leverage and Debt Yields

Outlook

Download PDF

State of the Market

While the initial, unpredicted damage of the COVID-19 shutdowns has moved firmly into the rearview, local economies across the U.S. are still struggling to find the right balance of speed and safety in their return to normalcy. The labor market continues to recover, though the pace of the growth has started to slow. Between May and August, the civilian unemployment rate improved by an average of 1.6% each month. In September, this rate of recovery fell to just 0.5%, dropping the unemployment rate from 8.4% to 7.9%. Federal Reserve leaders have projected the return to pre-COVID levels of full employment by 2023.


According to the Bureau of Economic Analysis, the U.S. economy expanded at a 33.1% annualized growth rate in the third quarter, the highest reading ever. Of course, this comes after a -31.4% contraction in second quarter. Looking ahead, according to the WSJ Economic Forecasting Survey, the fourth-quarter GDP is forecasted to land at 3.8%.

 

Turning now to commercial real estate, the outlook is similarly improving for the months ahead. According to the Real Estate Roundtable’s Sentiment Index third quarter 2020 report, while respondents report conditions are worse today than one year ago, there was a marked improvement from when the same question was asked back in the second quarter (Chart 1). The majority of respondents were optimistic for the year ahead, with 62.0% expecting conditions to either be somewhat or much better in 12 months (Chart 2).

Chart 1
Chart2

Within the small multifamily sector, the pandemic remains an active disruptor of property-level cash flows. According to Freddie Mac, through August, 76.0% of loans in forbearance are tied to their Small Balance Lending program — a symptom of relatively fewer units per asset and a higher tenant-sensitivity to the ongoing recession. Investment sales remain elusive, though the participation of the agencies is sufficiently safeguarding market-level liquidity.

 

Small multifamily asset prices improved in the third quarter, jumping 1.3% from the second quarter, according to Chandan Economics. Overall, while small multifamily is working through its fair share of coronavirus-related pain, the agencies’ support and the sector’s resilient underlying demand fundamentals continue to reinforce a favorable long-term outlook.

Lending Volume

Annualized 2020 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 — ticked down to $52.1 billion through the third quarter. (All data, unless otherwise stated, is 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 50.0%.)

 

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 falls below last year’s annual pace by $7.1 billion and represents a 12.0% decline in lending activity (Chart 4).

Chart 3
Chart 4

When the full weight of the pandemic hit in March, buyers pulled back hard on the reins. Conversely, lenders that remained active, by and large, have maintained asset pricing at pre-pandemic levels. Cap rates in small multifamily acquisitions averaged 60 bps higher than refinanced assets in the third quarter alone. Moreover, falling interest rates have provided an opportunity for existing owners to reduce monthly debt servicing costs.

 

Together, these factors partially explain why refinancing activity comprised an outsized share of overall lending activity in the second and third quarters. Refinanced loans accounted for 78.8% of all small multifamily originations in the third quarter, up from an already elevated 73.9% in the second quarter (Chart 5). The refinancing ratio sat between 61.2% and 66.7% through 2019 and the beginning of this year.

Chart 5

Arbor Small Multifamily Price Index

As measured by the Arbor Small Multifamily Price Index, small multifamily prices stabilized in the third quarter of 2020, up 1.3% from the second quarter and 0.1% from one year ago (Chart 6 and Chart 7). (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 $1.0 million to $7.5 million. For the full methodology, visit arbor.com/asmpi-faq).
Chart 6
Chart 7

Moreover, revised second-quarter estimates indicate that national pricing of small multifamily assets held up better than previously reported. With the updated estimates, prices fell just 0.7% from the prior year.

 

The price stability of the small asset subsector is anything but happenstance. Instead, it reflects the sector’s deep pool of liquidity. Owners, across the board, are unwilling to capitulate to the demands of prospective buyers. The availability of refinancing capital has allowed owners to access their accrued equity without discounting their assets to meet market-clearing transaction prices.

Cap Rates & Spreads

National average cap rates for small multifamily properties narrowed by 16 bps in the third quarter of 2020, reaching 5.3% (Chart 8 and Chart 9). Similarly, estimates of second-quarter small multifamily cap rates were revised down to 5.5%, dropping 25 bps from the first quarter.
Chart 8
Chart 9

Observing small multifamily cap rates in the current market environment is a bit like figuring out which way the wind is blowing from the inside of a twister. Benchmark risk-free interest rates are down near their lowest record levels, which drags down all other market-level returns.


Pandemic-related uncertainty has introduced a new risk premium, offering a counterbalancing upward pressure. Simultaneously, if the effects of COVID-19 on property-level cashflows are observed and not theoretical, net operating income (NOI) would fall, causing cap rates to do the same. In addition to the above variables, the shifting center of gravity away from investment sales and toward refinancing in capital markets puts additional downward pressure on market average cap rates. The net effect of these competing market forces is a slight reduction in small multifamily cap rates.


Through the last three months, 10-year Treasury yields averaged just 0.65%, the lowest quarterly reading on record — a statement that has become a bit of a recurring trend in recent reports. As the state of the world became less certain, investors stepped up their preference for “safe-haven” assets, causing the price of Treasurys to rise and their yields to fall.


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 cap rates and Treasurys. The spread ticked down to 465 bps through the third quarter, falling from their recent high of 477 bps measured in the second quarter (Chart 10).

The cap rate spread between small multifamily and the rest of the sector fell to 24 bps through the third quarter of 2020, the slimmest margin on record (Chart 11).

Chart 10
Chart 11

The CARES Act’s expiration at the end of July and the absence of a new congressionally approved stimulus package to take its place had revived fears of widespread tenant performance issues. However, the worst-case scenario of expiring aid has not come to pass, according to a Chandan Economics analysis of the Census Bureau’s Weekly Pulse Survey.

The confidence of renters in their ability to pay their next rent payment rose over the third quarter, despite the tapering stimulus. During the final two weeks of the third quarter, the share of renters that responded with “high confidence” jumped to 47.7%, up from 38.5% during the first two weeks of the quarter (Chart 12). (Data for the last week of the third quarter 2020 is taken from the Census Bureau’s Week 15 Household Pulse Survey, which covers responses from September 16 through September 28. Data for the first week of the third quarter 2020 is taken from the Census Bureau’s Weeks 10 and 11 Household Pulse Survey, which covers responses from July 2 through July 14).

Chart 12

Notably, confidence in the ability to pay next month’s rent grew most substantially for lower-earning renter households. From the beginning to the end of the third quarter, an additional 7.9% of renter households earning less than $75,000 per year reported “high confidence” in their ability to pay next month’s rent. This compares favorably to renters earning more than $75,000 per year, which improved by a slightly lower 6.2%. However, confidence levels were already consistently high among the latter cohort.

 

Small multifamily units tend to be located further away from job centers compared to high-rise large multifamily properties. By extension, these properties tend to have renters with lower average income levels. Keeping an eye on different cross-sections of renters and how they weather the ongoing recession will continue to provide clues about risks in the small multifamily subsector compared to the rest of the apartment market.

Leverage and Debt Yields

Loan-to-value ratios (LTVs) averaged 67.3% on small multifamily loans originated during the third quarter of 2020, dropping a sizeable 71 bps from the second quarter. This is the second consecutive quarter of material declines in leveraging, as small multifamily LTVs fell by an even more impressive 247 bps in the second quarter (Chart 13).

 

Across the rest of the sector, LTVs similarly fell between the first and second quarters, dropping substantially by 358 bps, but have since started an upward climb. Between the second and third quarters, LTVs across the entire multifamily sector rose 51 bps to 71.2%.

 

According to Chandan Economics’ initial estimates, the LTV spread between small multifamily and all multifamily currently stands at 280 bps. A selection bias in the small multifamily subsector may partially explain these trends. By some estimates, as much as one-third of community banks that typically lend in the small multifamily space have pulled back on their originations due to the pandemic. As a result, lenders that are still active are fielding a larger number of requests, leading to greater selectivity and improved credit quality on new deals.

 

Debt yields, the ratio of NOI and loan balance, for small multifamily loans decreased by 16 bps to 7.7% in the third quarter of 2020, hitting the lowest reading on record (Chart 14).

Chart 13
Chart 14
For all multifamily properties, debt yields fell by 21 bps to 6.5%. The spread between small multifamily and all multifamily debt yields has moderated since the middle of 2017 and currently sits at 122 bps (Chart 15). Debt per dollar of NOI, the inverse of debt yields, rose for both small multifamily and all multifamily loans in the third quarter. Small multifamily borrowers are securing an average of $13.04 in new debt for every $1.00 of property NOI, up $.27 from the prior quarter and $1.06 from last year (Chart 16). Together, these trends may reflect the overweighting of refinancing transactions, and a selection bias that skews towards high-quality, well-performing assets.
Chart 15
Chart 16

Outlook

While so much about the macroeconomic road ahead remains uncertain, at least one debate from the early days of the shutdown appears settled: This is not a V-shaped recovery. Assuming the best-case scenario of vaccine approvals and availability, it will still take several months, if not longer, to put the crisis fully behind us. In short, living with the virus is, and will be, the status quo for the immediate future.

 

Despite headwinds caused by the pandemic’s recession, the small multifamily subsector is maintaining its penchant for stability. While small multifamily has a supportive set of defining market features behind it, a critical caveat is that buyers and sellers remain far apart in their opinions of fair value. Plus, the vulnerability of the small multifamily tenant base to labor market malaise remains a risk factor. Yet these areas of softness are considered transitory.

 

Small multifamily renters, especially those who are renters by necessity, are less likely to transition into homeownership over the near term. Moreover, the depth of liquidity made possible by agency financing is a powerful lifeline to existing owners, and it should continue to fortify the sector through the eventual end of the COVID-19 crisis.

Download PDF

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

https://arbor.com/research-reports/
855.962.3944

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.