Whether you are just beginning your investing journey or are looking to take your portfolio to the next level, Arbor stands ready with our talented team and decades of expertise. Given our vast experience and national footprint of successful deals, we are familiar with many common commercial real estate investor questions, such as the ones answered in this article.
With the macroeconomy maintaining its underlying strength and a handful of rate cuts expected by the Fed within the next 18 months, green shoots of optimism within the multifamily sector are multiplying. Even as high interest rates impede normal operations, stabilization is underway while the sector’s long-term prospects remain unwavering. In this deep dive, our research teams will explore the tailwinds underpinning the multifamily sector’s short- and long-term outlook.
FHA® Interest Rate Reduction (IRR) Refinance of Existing HUD-Insured Loan Arbor provides this program to reduce the interest rate on qualified existing HUD-insured multifamily loans. The HUD-insured loan remains in place, with reduced payments based on the new rate, the current balance, and the remaining term. The existing prepayment penalty must be paid in full. V041624
FHA®220 Mortgage Insurance for Rental Housing for Urban Renewal and Targeted Redevelopment* Arbor provides FHA-insured, long-term, fixed rate financing for new construction and substantial rehabilitation of multifamily projects nationwide. This program provides for both construction and permanent financing for projects in urban renewal areas and other areas where local governments have undertaken designated revitalization activities. Applications are typically processed in two stages (preliminary application followed by firm application). Affordable/rental assisted projects and HUDexperienced development teams may request a “straight to firm” application, saving significant time by eliminating the preliminary application stage. V020224
After the volume of newly issued multifamily permits hit a 37-year high in 2022, multifamily completions surged another 22.3% last year. As the sector continues to gain strength, its growth has remained concentrated in the southern and western regions of the country, according to an analysis of new data from the U.S. Census Bureau’s Survey of Construction.
During the post-global financial crisis (GFC) cycle, a disproportionate share of new multifamily construction was of high-rise units in properties with amenities. However, the tides have turned. The rising cost of homeownership has brought the need for more affordable housing development in the U.S. to the top of many legislative agendas. In this deep dive, our research teams utilize data from the U.S. Census Bureau’s Annual Survey of Construction to show how and why the characteristics of new multifamily properties continue to evolve alongside shifting market needs.
On balance, the SFR sector continues to demonstrate strength amid economic turmoil, attracting increased attention from the broader multifamily investment community.
LGBTQIA+ Pride Month is recognized in June, but its lessons are timeless. During a recent conversation between Tres Seippel, Director, Construction Management at Arbor, and Dr. Sam Chandan, Founder of Chandan Economics, Founding Director, NYU Chen Institute for Global Real Estate Finance, and Co-Chair of the Real Estate Pride Council, Seippel shared why it is more important than ever for the industry to embrace visibility and show support for employees who identify as LGBTQIA+ or other diverse backgrounds.
Small Multifamily Investment Trends Report Q4 2022
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.
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.
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.
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, 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).
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.
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.
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.
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