Multifamily Expectations Gap Put a Tight Fist Around Activity

If the theme entering 2023 has been uncertainty with a heavy dose of unrealistic expectations, circumstances in the multifamily market has embraced it. Marcus & Millichap’s 2023 Multifamily National Investment Forecast makes it forcefully and mathematically clear.

There currently is tension between buyers and sellers giving rise to transaction gaps that go back to far before the opening of the pandemic, which only drove some trends much higher.

“Tight cap rates act as constraint on a resilient sector. The vital role that apartments play in the nation’s housing continuum has translated into substantial price appreciation over the past two decades,” the report read. “The resulting compression to cap rates placed yields in an unfavorable position as the Fed began to radically lift lending rates last year.”

As economic and business histories suggest, much of this is fallout from the national and global financial crisis of 2007 through 2008, and the following many years of results that occurred. As part of the response, the Federal Reserve injected liquidity and dropped interest rates for a long stretch, and then did more of each during the pandemic.

All that money needed to go somewhere, and much of it became investments in real estate as an alternative asset. The money bid up property prices, compressing cap rates in expectation of ongoing and outsized rent growth.

But the rent growth projections are slowing — and even receding in many markets — and that combined with the Fed’s rapid hikes in interest rates make more transactions difficult to financially justify.

“While elevated rent growth helped deals close last year, those projections are slowing now, and the expectations gap between buyers and sellers has widened to a point that many transactions have not been able to move forward,” the report said, also noting that the “complexities” that started late in 2022 aren’t likely to go away in 2023.

“Unless a buyer is pursuing a cash-only deal, the margin between implied returns and debt service costs has become unfavorable,” the firm said, with many multifamily investors taking a “defensive posture” this year. Market participants are waiting for the Fed to stop hiking rates so price discovery can kick in and both sides can move closer in their perceptions of reasonable valuations.

However, none of this means that the multifamily market is going nowhere. Marcus & Millichap points to three factors that investors should consider. One is that the euro has slid in value against the US dollar, which could mean more European investment here.

Second, investors can look at tertiary markets. “In 2022, about 39 percent of trades were in these smaller cities,” said the report. “The higher living costs and compressed cap rates of primary markets have spurred both renters and investors to target these smaller cities.”

Third, look for outlier scenarios. “Sales activity has improved across central business districts, returning to pre-pandemic levels last year. Amid tight financing margins and a softer overall outlook, investors are looking for dynamic options, such as those near stadium developments, neighborhood revitalizations, or new transit hubs that could spark strong localized rent growth.”