As a provider of joint venture and general partner equity, real estate investment firm RanchHarbor has been seeing an influx lately of multifamily investment opportunities presented by sponsors as value-add. However, upon a closer look at the underwriting, these deals do not actually fit the typical value-add investment profile, says Adam Deermount, co-founder and managing director of the company. Instead, these opportunities end up being cap rate compression plays under the guise of value-add and are priced to perfection in today’s market. “Most of the return on investment is generated by rent inflation buoyed in the early years of the investment by positive debt service arbitrage due to interest only terms,” Deermount says.

Now here’s the rub: If a value-add opportunity requires market annual rent growth of 3% over annual expense growth of 2% to 3% over a five-year hold for the returns to work, it is not a really a value-add deal. ”True value-add plays have renovation or management or leasing risks so the increase in value from those activities should be enough to achieve returns in order to justify the risk on a shorter-term hold.”

This is particularly important in this current environment where net operating income growth in major urban markets is likely to see headwinds due to urban flight, a lack of affordability and a recessionary economy, Deermount says.

The bottom line, he says, is that market appreciation plays without rent growth is a rather dangerous way to play the market if cap rates do not contract and rental growth stagnates.

Six months ago in the pre-pandemic world, concerns about rental growth stagnation for the multifamily asset class would have been laughable. Even perhaps three or four months ago, in the beginning of the spread of COVID-19, multifamily properties were holding their own.

More recently, a slightly different picture has emerged. First, though, make no mistake: apartments as a long-term play are seen as a solid bet. But as the uncertainties and economic vulnerabilities introduced by the pandemic mount, cracks are beginning to emerge in what was once an almost unassailable asset class.

WEAKENING FUNDAMENTALS

Let’s start at the beginning. Renters are finding it increasingly difficult to pay their monthly obligations. The most recent data from the National Multifamily Housing Council, which measures the number of apartment households that make a full or partial rent payment, shows a drop of 2.4%—or 279,457 households—year-over-year, as well as a monthly decline. According to the NMHC Tracker, 86.2% of apartment households made a full or partial rent payment by September 13, compared to 86.9% that paid by August 13 of this year.

“While it remains clear that many apartment residents continue to prioritize their housing obligations and that apartment owners and operators remain committed to meeting them halfway with creative and nuanced approaches, the reality is that the second week of September figures shows ongoing deterioration of rent payment figures—representing hundreds of thousands of households who are increasingly at risk,” said NMHC president Doug Bibby.

Another report from Rentec Direct that evaluates the impact of COVID-19 on rent payments also gives further cause for concern. Its data has shown a consistent downward trend in the number of rent payments received nationwide by property managers and landlords, and the month of September has seen the biggest change with a 35% drop in total rent payments received.

Ultimately, the problem for multifamily is that its fundamentals are too strongly correlated to job losses for the sector to be completely resilient to the pandemic, according to comments John Pawlowski, senior analyst of residential at Green Street made during a webinar the company held earlier this year.

The magnitude and velocity of the recent job losses is nothing that institutional landlords have ever seen. Compared to previous downturns, “there are a lot more people exiting the labor force now.”

Another factor, which is not related to the pandemic but comes at a very inconvenient time, is shifting demographics. They are not as supportive of multifamily as they have been in other recessions, Pawlowski said. “This will be the first year of a net decline of 25-to-29-year-olds in the country and a broader deceleration of 25-to-35-year-olds”, a trend that will lead to a more gradual recovery for multifamily, he said.

Also the multifamily supply pipeline was very full as it entered this latest recession. “There is a good two years of supply that needs to be absorbed, which will lead to an evaporation of landlord pricing power,” Pawlowski said.

All told, Green Street is predicting a 6% decline in multifamily NOI for 2021, a deeper trough than earlier recessions, he added.

Other research highlights small but growing problems with the multifamily asset class.

Effective rents in the second quarter nationally declined by 0.4%, according to a report from Moody’s Analytics REIS subsidiary—the first decline since the multifamily sector started its recovery from the 2008 to 2009 recession. Further, according to REIS, 41 out of 82 major apartment markets recorded declines in effective rents, compared with just seven such markets for the first quarter of 2020 and zero a year ago.

And just as Green Street predicted, NOI is falling as well, according to the Freddie Mac Multifamily Apartment Investment Market Index. The index itself fell by 0.3% in the second quarter, while NOI dropped by 1.2%, marking the first time in index history where AIMI and NOI were negative together in the second quarter.

AIMI combines multifamily rental income growth, property price growth and mortgage rates to provide a single index that measures multifamily market investment conditions. “The second quarter is normally a strong quarter in terms of NOI growth,” the report noted. “The quarterly contraction reflects the impact of the COVID-19 pandemic.”

EVICTION MORATORIUM

As fundamentals weaken, apartment owners must also deal with a novel approach taken by the US Centers for Disease Control and Prevention—its national eviction moratorium that it ordered in September and that is set to last until the end of the year.

The National Apartment Association and the New Civil Liberties Alliance are challenging the order in court and are seeking a stay until arguments can be heard. But given the constitutional powers at stake in this case, one can assume any court case is facing a long slog through the legal system.

The apartment industry is already hurting from the crisis, NAA President and CEO Bob Pinnegar says.

Small mom-and-pop landlords have reported lower rent collections this year, with 25% of them borrowing money to cover operating costs, according to a survey by The National Association of Hispanic Real Estate Professionals and UC Berkeley’s Terner Center for Housing Innovation.

Landlords of affordable housing—a category that is supposed to be recession resistant—are also reporting lower rent collections and Pinnegar says there is a real risk that this housing stock could be significantly reduced by the time the pandemic has passed. If apartments that have been financed with tax credits go into foreclosure, the bank is the entity that will decide if it keeps the affordable housing mandate, Pinnegar says. Even market rate properties have a similar risk, he adds. “If a property goes into foreclosure, the resident will still be there and who will want to buy that? There could be a severe loss of units.”

Institutional landlords also have their problems although they have not been as badly affected as they tend to own class A and class B properties, which have generally been unscathed from the economic dislocation resulting from the pandemic. Yet there has been a steady decline of people paying their rent at the first of the month, Pinnegar notes, and the institutional investors are starting to see some fraying in their portfolios as well. “Based on the conversations that I have been having with them, they have people with financial hardship but it is not as widespread.”

But there is starting to be more movement in rent trackers showing fewer and later payments from class A and class B tenants. Many of these individuals are accumulating mounting rent debt, which is significant, Pinnegar says, and it is unclear whether these tenants will be able to repay. “Either the landlord gets a judgment against the individual and likely won’t be able to collect or the tenant will declare bankruptcy.”

A CASE FOR HOPE

Despite all this, multifamily is still considered to be, along with industrial, a top performer for commercial real estate and there are several reasons why it is expected to prevail over its growing pressures.

For instance, Deermount notes that private-market multifamily asset values have held up remarkably well thus far through the pandemic, despite rent collection and concession issues in some markets. ”When coupled with low interest rates, relatively aggressive leverage and interest only terms available from the GSEs, this has allowed sponsors and investors to continue to underwrite prospective acquisitions very aggressively.”

Jared Wolff, president and CEO of Banc of California, echoes similar sentiments.

“In Southern California, multifamily is holding up remarkably well notwithstanding the economic and political headwinds,” he says. “It is still viewed as a safe-haven for investors desiring yield, given demographics and supply, and there is a tremendous amount of liquidity looking to be invested.”

Wolff does point out that the West Coast has suffered a bit more in terms of collections than other parts of the country due to both legislative efforts and the fact that rents are higher, in actual dollars and as a percentage of income.

Still, the perception that the pandemic will subside has not caused cap rates to rise much, and historically low interest rates continue to drive interest in the asset class, he continues. “Refinancing volume has slowed somewhat as rent predictability has made it challenging for lenders to properly size loans, but stronger operators are still getting refinancings done. We are also seeing stronger operators take advantage of the dislocation by seeking to buy properties from less seasoned operators who don’t have the financial resources or operational capability to carry properties that are underperforming.”

Indeed, it is easy to see there is a healthy flow of capital in the market. To cite just one example, Blackfin Real Estate Investors and their equity partner, GMF Capital recently secured a $57.6 million refi of Coastline Apartments, a 600-unit multifamily community in Virginia Beach, VA. NKF Multifamily Capital Markets managing director George Wisecarver and vice chairman Steven Leitch arranged the Freddie Mac financing.

Blackfin purchased the property in February 2019, and made significant property upgrades, after which they were able to increase occupancy and rents. “This was a tremendous value-add over a very short period,” said Wisecarver.

A quick perusal of NKF Research shows that in Q2 the multifamily sector was, despite the drop, a top-performing property type for rent collection since the onset of COVID-19 and the only property type to exceed 90% rent collections each month since April. It also noted that the sector’s total debt originations by Fannie Mae and Freddie Mac rose to $39.8 billion as the market stabilized in part due to Federal Reserve policy.

Ultimately, multifamily will emerge from the slowdown with a reputation relatively intact among investors, Green Street’s Pawlowski said. “When dust settles on this downturn investors will still be able to use the resilient label for apartments versus other big property types.”