The Monthly Multiple—July

Taking on Current (Potential) CRE Myths

These are uncertain times — we get it. A period of steadily rising interest rates has left many investors leery of CRE. That said, a few major (more negative) narratives in the space do not really hold water. This is good news for you, discerning investor. It may mean other investors are unduly fearful, and this could bring unique opportunities your way.

Let’s dive in.

Office Is an Existential Threat…to More Than Just Office

Is distress in the office sector a threat to CRE in general, and potentially to the entire financial system? We’ve received this question more than once from anxious investors, and no one can blame them for asking.

The raft of gruesome headlines from, say, late 2022 to early 2024 seemed to indicate two things about how the press understands and talks about commercial real estate. Number one: it bleeds, it reads (same as it’s ever been). Number two: the papers seem to think CRE = office; or at least think that people think CRE = office. Green Street data shows that office is now just 7.1% of CRE holdings in the U.S. It accounts for just 3% of the market cap of listed REITs. And a Morgan Stanley analysis of 30 banks of various sizes indicated average office exposure, as a percentage of total assets, at just 2.7%.

Small and regional banks are also quick to point out that their typical loan is on a mid-sized building (the grocery-anchored retail centers, small office buildings, dentists offices, and so forth that make up the backbone of a community). Banks with under $15 billion in assets, of which there are many, are not the lenders messing with the huge, half-vacant office buildings that capture headlines.

Multifamily Is the Next Domino to Fall!

In parts of the country, rents are indeed starting to fall. There’s now fear among some industry watchers that multifamily is overbuilt, and that the music is slowing for this key sector. With elevated interest rates, some worry that challenges to rent rolls plus growing debt service cost will create alarming distress for lenders with a high degree of multifamily loans on their books.

Let’s take a look at both factors.

Is Multifamily Overbuilt?

Short answer: no. America is still short 7–10 million market-rate dwelling units. The multifamily pipeline is dwindling. Writ large, residential in the U.S. is still vastly underbuilt. With homeownership historically expensive, this creates broad and durable upward demand pressure for multifamily.

Yes, luxury apartment buildings are overbuilt in many markets. Certain Sunbelt markets that caught fire during the pandemic and generally have loose building regulations may be overbuilt. But, to borrow from Tolstoy, all multifamily markets in supply/demand equilibrium are in equilibrium in the same way; all multifamily markets that are out of equilibrium are out of equilibrium in their own unique way, creating idiosyncratic opportunities for investors. Everyone needs a place to live, and this is a big country, full of metro areas with their own unique demographic trends and housing supply challenges.

You can read more about the mechanics of specific multifamily markets, and where we see opportunity, in our recent Second Half ’24 Whitepaper.

Is Multifamily a More General Concern for Lenders, and Hence for the Broader System?

For the reasons explored above, probably not. Some lenders who were loose on their underwriting and overexposed in very specific markets could be justifiably concerned about multifamily, but the case for multifamily remains generally strong, and rent levels are unlikely to decline relative to debt service costs for long.

That said, higher interest rates do challenge multifamily lenders, including small and regional banks, who may be tightening lending standards amid greater scrutiny (see above). Who stands to gain? Probably not Fannie and Freddie, as the article implies.

“If regional banks and large investment banks decide they’re not going to be making multifamily loans, then Fannie and Freddie will simply get more of the business,” said Lonnie Hendry, the chief product officer for Trepp, a commercial real estate data firm. “It’s a fail-safe that the other asset classes simply do not have.” This is not quite right. Fannie and Freddie do not issue loans; they buy and securitize existing loans. This may include HUD or FHA loans that are guaranteed by the federal government. Could Fannie and Freddie provide a lifeline to certain lenders and multifamily asset operators (borrowers) who otherwise may be facing distress? Sure, but the charters of these organizations preclude activity on loans over a certain dollar amount. In other words, in a credit crunch and amid dwindling DSCR figures, Fannie and Freddie aren’t going to do very much for the world of multifamily finance.

So, who could get more of the business? Private lenders. Alternative sources of capital, such as EquityMultiple’s Ascent Income Fund, may be critical for operators, both for refinancing and completing the capital stack for new projects.

Remember: Real Assets for Shaky Times

These days, predicting any kind of downturn would be a “cry wolf” move. The U.S. economy bucked fears of a recession throughout 2023 and well into 2024. The latest quarterly macro figures just came in higher than expected. The stock market remains at or near historic highs. Hopefully things will look more or less the same for the time being — we naturally approach the long-term 2% inflation target, and the Fed accordingly eases down rates.

But it’s worth considering whether those are, in fact, storm clouds on the horizon. While inflation has come down, it remains “sticky.” The IMF has forecasted down GDP growth in the U.S. as labor markets and consumer spending cool. Meanwhile, the stock market is tranquil on the surface, but elevated P/E ratios, an uncertain policy environment in the U.S., and geopolitical tension all could spell volatility for public equities.

It isn’t easy to shake up an asset allocation strategy, much less explore a new asset class, in uncertain times. Still, there are a couple of persistent reasons why private-market real estate can be worth considering at such a moment.

Real Estate Tends to Outperform During Inflationary Periods

This is part and parcel of the underlying appeal of real estate. It behaves differently from other asset classes, in that returns are driven by demand in the real economy. Factors such as a supply/demand imbalance in the housing market, as noted above. This means real estate, of the right type and in the right places, can potentially be a source of income and total return even as other asset classes and economic indicators show poor performance.

An Alliance Bernstein analysis for the years 1970–1991 had U.S. real estate as the strongest risk-adjusted return driver during stagflationary periods.

A KKR study during inflationary periods showed private real estate, along with infrastructure, far outperforming U.S. public equities.

Give Yourself a Few More Bites at the Apple by Diversifying

As with multifamily markets, each combo of CRE sector and metro area in the U.S. brings different dynamics and a different opportunity set. The stock market may or may not continue on its current trajectory through this year’s election cycle and into 2025. But you can be sure that the majority of individual investors will be betting on it, and mostly, therefore, on a handful of tech stocks. Private-market real estate, across a wide range of sectors and markets, offers opportunity for idiosyncratic return potential.

As always, don’t hesitate to give us a shout at ir@equitymultiple.com.