Aug 7, 2023
Apartment buildings, once considered a secure investment in the real estate sector, are now encountering significant hurdles in the current troubled commercial-property landscape.
Apartment buildings, once considered a secure investment in the real estate sector, are now encountering significant hurdles in the current troubled commercial-property landscape. Investors had driven up prices for multifamily buildings, attracted by consistent rent increases and the promise of high returns. Many investors assumed they could rapidly raise rents to manage their accumulated debt.
While office spaces and malls suffered due to remote work and online shopping trends, rental apartments maintained low vacancy rates. However, the primary challenge for the apartment sector isn't a lack of demand—rents have soared since 2020—it's the impact of increasing interest rates.
The sudden spike in debt costs from the previous year is now jeopardizing many multifamily property owners across the nation. Apartment-building values experienced a 14% drop in the year ending June, following a 25% rise the previous year. This decline is comparable to the drop seen in office property values.
Although mortgage delinquencies in the multifamily category remain relatively low, they are on the rise. Borrowing costs have doubled, rent growth has slowed, and building expenses are escalating. Some types of rental-apartment debt are flagged as being at risk of default.
Prominent figures in the real estate finance industry, like Peter Sotoloff, warn of a potential "hydrogen-bomb scenario" for apartment landlords. Outstanding multifamily mortgages have more than doubled in the last decade, reaching around $2 trillion, posing a significant challenge compared to office debt.
Investors are realizing that the risk of apartment defaults is a substantial concern that deserves more attention. Defaults have already occurred in Los Angeles, Houston, and San Francisco, and even well-established real estate players like Blackstone are dealing with challenges related to Manhattan apartment buildings.
Apartment buildings historically enjoyed a reputation for being a less risky investment in the commercial real estate sector. They performed reasonably well during recessions, as people turned to rentals. Inflation also permitted landlords to raise rents higher than usual, enhancing building values.
However, the rapid rise in interest rates has caused a downturn in building values, prompting landlords to refinance at higher rates. Additionally, the emergence of new private real estate firms funded by floating-rate debt is adding competition to the multifamily market, while facing difficulties in achieving projected rent increases.
Despite the challenges, there are still reasons for optimism among apartment landlords. Government-backed lending from Fannie Mae and Freddie Mac offers stability in lending sources, even as traditional banks step back. Housing shortages and high rents are expected to persist, and a decrease in interest rates could lead to a swift rebound in property prices.
Nevertheless, there are concerns of oversupply due to a high number of new apartment buildings entering the market, particularly in the high-end rental segment. Moreover, apartment-building values are particularly sensitive to higher interest rates, as they closely correlate with the price of 10-year Treasury notes.
Even seasoned real estate investors, including Veritas Investments, have experienced vulnerabilities in this challenging environment. The multifamily real estate sector is grappling with financial difficulties akin to those faced by office, retail, and hotel-hospitality asset classes.