Nothing normal about today’s market: Higher rates put brakes on multifamily finance requests

A normal market? Finance experts say that today’s multifamily market is far from one of those.

The reason is obvious: High interest rates have squelched the number of sales in the multifamily market. And as sales have slowed, so have the requests for multifamily finance.

We spoke to three multifamily finance experts serving the Midwest about today’s challenging market. How much of a dip has the number of apartment sales taken in the last six months? What will it take for buyers and sellers to begin transacting again? And are the fundamentals of the multifamily market still solid enough to keep this sector an attractive investment?

Here is some of what these finance pros had to say.

Let’s start with the obvious question: Have higher interest rates slowed the demand for multifamily financing?
Paul Smith: As rates have risen, developers, owners, operators and capital stacks have all gotten squeezed. Loan-to-value ratios have gone down. The senior debt has become tighter. This has made it more difficult for owners and developers to get stuff done. There has been an increase in mezzanine funding requests and construction loan requests. The interest rates have had a very difficult impact on people’s ability to get deals done.

What has to happen with interest rates, and the economy in general, to spur more multifamily deals?
Smith: For the big picture, we need to find a way to get inflation under control so that we can get some stability in the interest-rate market. The fundamentals of multifamily properties are still strong. The demand on the capital side is strong. Interest is strong everywhere. The issue is volatility. When rates are going up and down, it’s hard to find that baseline where people feel comfortable closing transactions. If we could get to a place where there is some stability with interest rates that would go a long way toward helping developers, sellers and buyers find a middle ground.

You mentioned that the fundamentals of the multifamily sector are still strong, even with the higher interest rates. Can you talk a bit about that?
Smith: We still have a housing shortage in this country. That has created strong occupancy levels and rent growth in multifamily during the last couple of years. We are starting to see rent growth slow. In some areas, we are starting to see rents fall. Couple that with what I think is going to be a wave of new supply over the next 12 to 18 months and I do expect there to be some softening in the demand for multifamily in the short term, the next 12- to 24-month window ahead of us. But once we get through that wave of supply, the multifamily sector will still look strong. That underlying demand in all markets for housing is not going away.

When people are looking for financing for multifamily deals, what type of apartment properties are they most interested in?
Smith: Interest is spread out across all the classes. Everyone has a lane. There is still demand up and down the spectrum. I do feel there is a slight lean toward suburban, well-located products. That doesn’t mean that downtown core product isn’t in demand. But suburban properties are a little more popular today. The demand is a little less for transitional assets, value-add properties. If you are trying to turn a class-C property into a Class-B or a Class-B into a Class-A building, those business plans are harder to execute today. The cost of capital is higher. Rent growth is not what it was. Construction costs are higher. Everything is more challenging. People today are interested in solid products with a stable cash flow.

What about in your home market of Columbus, Ohio? Is demand for multifamily product among renters and investors still strong?
Smith: We are in a good spot in Columbus. We haven’t had the huge spike in new development or demand like we’ve seen in some of our sister cities, the Raleighs and Nashvilles. That has served us well. We don’t have quite as much new supply coming online, so our fundamentals are still strong. The population in Columbus continues to go up. I feel good about where we are.

Even with the challenges we’re seeing in the national economy, is multifamily still considered a good investment?
Smith: Of all the food groups, multifamily is still the belle of the ball. Many of the other asset types are facing stronger headwinds. When we talk to investors and developers, multifamily is still the preferred asset class. It is still hard to build single-family homes in a lot of markets. The need and demand for multifamily is still there.

When you do receive a request from an investor or developer for multifamily financing, what do you consider when determining whether to take on that request?
Smith: It comes down to the basics of the deal: the location, the strength of the market and the business plan. The nuts and bolts of the deal are most important. In today’s market, capital wants to be selective. Having those basics down and having really strong fundamentals are what make deals go through. The fringier deals or the challenging deals are much harder to get done today than they were 12 months ago.

Have higher interest rates slowed the demand for commercial financing?
Henry Tomecki: The increase in rates has caused many investors to take a pause on new acquisitions. BankFinancial has seen new purchase opportunities slow as a result. Currently, there is plenty of liquidity in the marketplace as buyers are waiting for CAP rates to take effect and the lower valuation of CRE properties. Sellers, on the other hand, will need some time to adjust to lower valuations from record-low interest rates that drove CAP rates down and property values up.

What must happen with interest rates, and the economy in general, to spur more multifamily deals?
Tomecki: Many multifamily investors would prefer to see a return to pre-pandemic interest rates, which is unlikely to happen. A look at historical rates tells us that the comfort level many investors would like to see is between 5% and 6%. With inflationary pressure continuing to be a major concern, it will take some time before rates fall below 6%.

How strong are the fundamentals of the multifamily industry? Are vacancy rates and rent growth still solid?
Tomecki: The multifamily industry’s fundamentals continue to be strong with vacancy rates remaining relatively flat. However, we expect to see rent growth topping off sometime this year if it has not already done so. In many parts of the Midwest, we are seeing rent growth flatten out. With unemployment forecasted to trend up by the third quarter of this year, we forecast a slight increase in collections.

Is multifamily still one of the more desirable investments today?
Tomecki: The retail sector is still stabilizing from the Amazon effect and the office sector continues to struggle. Yet multifamily is holding its own and its fundamentals overall are still favorable and the least risky of all the options. 

When investors are making multifamily deals, what type of properties are they looking at? Are they still primarily interested in Class-A buildings, or are they also considering Class-B apartments?
Tomecki: In today’s environment of rising rates, BankFinancial has had many investors looking at Class-B apartment buildings. Many of those properties still have an upward opportunity to increase rents and decrease some costs. Class-A properties are currently showing the highest vacancy and collection at this point. They are dropping rents, and concessions are increasing.

What do you consider when deciding whether a financing request is a solid one?
Tomecki: CRE Lending is an important line of business for banks, and we rely on its revenue. As such, most banks are cash-flow lenders. Therefore, the primary items that we consider for viable financial requests are Debt Service Coverage Ratio, Loan-to-Value, strength of the borrower or guarantor and the liquidity reserves.

I’ll ask the same question I’ve asked the other sources in this story: How big of an impact have higher interest rates had on the multifamily finance business?
Kevin Kovachevich: The rising interest rates have significantly impacted the flow of money. Unless you absolutely have to, you don’t want to borrow right now. The rates took such a significant move upward that the cost of borrowing has exponentially gone up. The monthly rents have not followed. Those prices remain the same. You have a situation where the rates rose so quickly that sellers haven’t had time to adjust. Sellers still want prices from 2022. Buyers are saying that the cost of their capital has gone through the roof and that sellers need to adjust.

There’s a serious disconnect between buyers and sellers?
Kovachevich: Because of this disconnect, we are seeing very few transactions. The number of transactions on the sales side nationally has fallen off a cliff. Having such a steep rise in interest rates in such a short time has crippled the sales market and has slowed the financing market.

Do you think the Fed increased rates too quickly?
Kovachevich: They did move quickly. Real estate is a slow-moving market. It doesn’t react quickly to overnight moves or sudden moves. Historically, if the Treasury goes up, we see some spread decreases. The spreads tighten up to make up for some of that increase. In this case, spreads have widened over the last 12 months. You have a double whammy. Spreads are widening and your borrowing rate goes from 3% to 6%. It’s a shock to the system. The multifamily sales market is cripped for the time being.

Everyone is looking for the second half of this year for activity to pick up again. The most recent Fed announcements, though, made it painfully obvious that they are not slowing the rate hikes. They made it painfully clear that rates aren’t coming down anytime soon. People are buying 10-year Treasuries to be safe. Those are risk-free.

What will buyers and sellers need to see before multifamily transaction activity rises again?
Kovachevich: When the long end of the curve starts to go back down and spreads tighten, that is an indicator that sales will start happening again. The steep increase in rates halted everything. The only sales we are seeing now are forced sales, an action that has to take place. If you are a holder of multifamily product, you are not running out to sell right now.

Are there any other challenges in the multifamily market today?
Kovachevich: Multifamily rent growth has slowed. In 2021, you were hearing about 15% to 25% lease trade-ups. People who had been renting for $900 a month went up to $1,500 a month overnight when they signed their leases. That was the new market rent. People were underwriting these large rental increases like they were going to continue forever. That was a major factor in those record-breaking sales prices and volumes that brokers recorded in 2021 and 2022. That has slowed down. Rents are still going up, but we are seeing more realistic increases. You can still push rents, but we saw such a hard, aggressive approach to rent increases in the last 24 months. They had to come down. You can’t continue to push rents at the pace we were pushing them during the last two years.

Even with all that is happening in the economy, is multifamily still an attractive investment?
Kovachevich: Yes. Multifamily is one of the darlings of the commercial real estate world and has been for a while. The two best product types in the market are multifamily and industrial. The industry fundamentals are still good. We still have a housing crisis. There are not enough housing units for people. Homebuyers face pressure from rising interest rates. Say you are getting ready to buy a house. You’ve saved money. You were looking at 3% interest rates. Suddenly, those rates are at 7%. That might delay your decision to buy a home. You are back in the renter pool for the next few years until interest rates come down. The fundamentals of multifamily are phenomenal.

Deals will still get done. But it will take time for buyers and sellers to meet up.

When you do get a request for multifamily financing, what do you consider when deciding whether the request is a sound one?
Kovachevich: The fundamentals of the deal are always the top priority. How strong is the local market? How strong is the operator? Those factors are always in play.

What types of deals are getting done today?
Kovachevich: We are seeing some deals in the Class-B space and in tertiary markets. Those types of investments make more sense today. Those deals are more attractive because of the yield that they present to investors. Multifamily investors are antsy people. They must continually transact to keep themselves and their employees busy. They are deal junkies by nature. Sitting back idly is not in their DNA. This presents a challenge. Eventually, their patience will run out. People will start to buy things. And hopefully by then, the interest rates will start to settle and we’ll see more of a normal market. There is nothing normal about what is happening today.