Where’s the Inventory?
Investors face a clear choice: Sell now or wait for the uncertain winds of the next cycle
For the past six months, the Midwest has been slow to offer new multifamily product. Instead of selling, many investors have made the decision to refinance, especially given low interest rates and how attractive debt markets have been recently. However, the optimal point to refinance may be past us now, given the inevitability of interest rate hikes and the cycle’s late stage. With growing allocations from institutional groups interested in entering commercial real estate, we wonder why more investors aren’t choosing disposition.
In 2017, Fannie Mae’s Delegated Underwriting and Servicing platform hit a record $67 billion in financing — supporting over 750,000 rental units. For investors following the herd, this debt market strength can be comforting. However, savvy investors should heed the warning signs. In Fannie Mae’s 2018 Mortgage Lender Sentiment Survey, the highest percentage of lenders this cycle (48 percent) projected a negative outlook for profit margins. Plus, lender caution is on the rise: The Fannie Mae Chief Economist noted that easing credit standards declined for the first time in five quarters — to the lowest level in a year.
Other factors are looking less favorable for refinancing than they were a year ago. Interest rates are due for incremental upward movement for the foreseeable future. Despite the upward creep of interest rates, cap rates have so far remained at a steady 5.7 percent nationally from 2016 to 2017. This number has remained artificially unmoved due to institutions injecting significant capital into multifamily. However, this lag between cap rates and interest rates will not last forever, and smart owners should foresee an environment that will only grow less favorable to selling.
Equity sources remain very favorable to multifamily, and they have some of the largest allocations we have seen in this cycle. In fact, according to the 2017 Institutional Real Estate Allocations Monitor, 2018 marked the first year that the average target allocation for real estate investments surpassed 10 percent. In the Midwestern states where KIG CRE operates (Illinois, Ohio, Michigan, Wisconsin, Indiana, Kentucky and Iowa), we saw 144 institutional transactions in 2017, up from 31% from 110 in 2016. Sales volume in these states increased by 25%, from $5.65 billion in 2016 to $7.05 billion in 2017.
Additionally, transaction matrices continue to be aggressive, including price per unit, cap rate, closing time frames and hard money. According to Real Capital Analytics, Price Per Unit has increased for 9 straight quarters, and 14 of the last 16. With less inventory, capital has become more incentivized to be aggressive with deals that are out there.
It is true that the uptick in deliveries across major U.S. metros has led to a competitive rental market (particularly for Class A product), resulting in a plateauing of rents and occupancy from the historic acceleration earlier in this cycle. This has tempered yield expectations nationally, but this will do little to dampen the scale of institutional interest, who are acclimated to seeing even lower yields in other financial asset classes.
While major markets in Texas, the Southeast and the coasts have had a ton of opportunities, institutional money needs to blend allocations. Only so much can be allocated in each market. Many hot markets such as Austin, Denver, Nashville and Seattle currently have development pipelines representing over 10 percent of their total inventories. These metros will face some of the stiffest rent competition in the coming years; Austin already recorded a negative rent growth for 2017. Meanwhile, most Midwestern markets have shorter pipelines and will face relatively reduced rental competition as opposed to more saturated markets.
Given the rising tide of capital wanting to enter into the multifamily space and the late stage we’re at in the cycle, one would believe that groups wanting to execute in the next couple years would understand the time to sell is now.