Q4 2022: Macro Investor Trends: "Staying the Course" with Co-founder and Principal, Sean Mabarak
Macro Investor Trends: "Staying the Course"
Written by Sean Mabarak
Q4 2022 Newsletter
Despite financial conditions becoming tighter and tighter this year, we’ve grown more confident in our investment strategy and are starting to see significant opportunity form in the face of rising lending and cap rates combined with the materially higher post-COVID reset in rental rates.
Over the last 4-5 years, SPI’s strategy has been to focus on Class A multifamily due to the risk premium for lesser quality assets declining precipitously during the prolonged period that followed the Great Financial Crisis of higher liquidity and lower interest rates. Even today, albeit with far fewer sales in 2022, the risk premium assigned to Class C vs. Class A multifamily is still far too low, especially in the face of a Fed-engineered recession.
At the onset of 2023, my strong recommendation is to "stay the course" and continue to purchase institutional-grade assets in primary markets while price discovery works its way through the workforce housing and value-add multifamily markets. This recommendation is supported by three primary trends: (1) price discovery materializes much faster at the institutional level, (2) this rapid repricing makes it incrementally more difficult for developers and their lenders to make sense of new projects, and (3) while prices have reset lower, rental rates have reset significantly higher.
For simplicity, the analysis below will reference only data on Class A, recently built, suburban Austin/DFW multifamily.
Prices for Class A multifamily have deteriorated from their obscene highs observed at the beginning of this year. In the second half of 2021 going into Q1 of 2022, it was commonplace for brand new construction deals to sell pre-stabilized (at the certificate of occupancy) for fully-stabilized year 1 buyer proforma cap rates of 3.75-4%. This resulted in the developer selling for materially higher pricing than originally modeled, and in a much shorter time horizon. Simply put, there were many developers who made generational wealth over the recent term. Today, we’re seeing buyers require a 4.75-5% cap rate on in-place numbers in order to clear a deal.
So, as we close out 2022, repricing is developing much faster in new construction properties in comparison to the workforce housing space because these assets are primarily owned by institutions that must make their decisions quickly in order to guarantee solvency and profitability in the future. In addition, these developers are seeing even their bear-case scenarios begin to be challenged by rapidly increasing interest rates. Since many of the developers’ debt is tied to completion and personal guarantees, when they face a scenario in which the cost of new construction starts to approach recent sales comps, their only viable options are either to recapitalize with long-term equity (which is currently largely unavailable) or, to sell. In these types of decisions, there’s far less emotion involved than with individual owners and family offices; these developers’ primary goal is to deliver whatever returns they can, as fast as they can, so that they can continue to build and be solvent in the future.
Furthermore, construction lenders are currently beyond their capacity to lend on any additional, new development projects until they’ve paid off a substantial number of existing loans. We foresee this will put significant pressure on developers’ ability to fund and build new projects, many of which were scheduled to break ground soon. Our theory that many previously permitted projects will result in delays or be canceled altogether in the next year or two is yet to be substantiated, but as the macroeconomic headwinds continue to pile up, it’s only a matter of time.
The cap rates and unleveraged yields we are seeing today mimic what we saw in 2019, pre-pandemic. However, since then, rental rates have skyrocketed 30-40% as migration to Texas accelerated faster than our ability to build housing. This presents an opportunity to buy newly-constructed assets at 2019 unlevered yields or better with forward supply likely to pull back dramatically. Seems like a no-brainer, right? Well, when you put this all in a five-year model at today’s rates of 5.75-6.25%, the returns look . . . not great. That’s because the market cap rate of 4.75-5% is still inside the borrowing rate (negative leverage), which erodes cash flow more rapidly the more leverage you take on.
When negative leverage occurs, any textbook on real estate investing will advise that you stay on the sidelines until cap rates normalize. The problem with this strategy is twofold:
- Just because rental rates increased 30-40% over the last two years doesn’t imply that effective income increased comparably. It takes time to normalize rents across the rent roll to reach this new level, and the delta is called loss to lease ("LTL") re-pandemic LTL averaged in the 2-5% range. Current LTL, on average, is 10-20% depending on if the current owner or developer was slow to respond to rapidly increasing rental rates. This discrepancy creates a clear path to going from a 5% cap rate to a 6-7% cap rate over a short period of time, even if you factor in flat to falling market rent growth in a recessionary environment.
- We can’t justifiably model a reversion cap rate (the assumed cap rate upon resale) that's lower than the current borrowing rate. But, we also cannot reasonably explain why or how borrowing rates will remain this elevated over the next 5 years when the current economy is revealing progressively more and more cracks with each additional rate hike…Lower rates seem inevitable over a 2+ year time horizon, but we simply can’t model that. We can, however, run scenarios depicting what would happen if multifamily loan rates did fall back to 5% or 4%, or 3%, and, as you can imagine, those scenarios look VERY attractive.
In addition to the two main points above, if borrowing rates are higher than cap rates, but the equivalent risk-free rate over your investment horizon is notably lower than cap rates, it still seems sensible to buy the property all cash, or with minimal leverage and lever up in a more favorable capital market environment. For example, if the 5-year Treasury is 3.65% and your cap rate is 5% for a low-risk, high-quality multifamily asset, it probably makes the most sense to invest. If you take it a step further and have a clear path to a 7% cap rate over that 5-year period with substantial tax benefits, you’ll be decidedly better off buying the property and yielding substantially higher than the market’s current expectation for risk-free rates over the next 5 years. You’re also better off when it comes time to sell the property and generate a substantial capital gain based on higher income. Throw in the potential for rates to fall in the next few years, and you create the opportunity to apply positive leverage to amplify returns and have a compounding effect on the resell values, further increasing ROI.
Taking all of this into account, one likely strategy for SPI in 2023 is to target purchasing high-quality assets with low to modest leverage, while the number of developers needing to sell outpaces buyer demand. We feel this opportunity will be most pronounced at the onset of the year and will dwindle as we approach 2024, so we intend to execute this strategy in early 2023. We plan to structure these purchases in a way that can weather a prolonged high interest rate environment but will also result in outsized benefits in the event that rates fall. Using low leverage will allow us to then increase leverage in the future and allocate that equity to higher-yielding projects when workforce housing and value-add multifamily start to trade at an appropriate risk premium.
Mike discusses that opportunity in more detail in his "Opportunity Ahead" article from this newsletter. We’re certainly not to that point yet, but I firmly believe that it’s where we’re headed, and it will happen concurrently with a flight to quality that will reinforce the values of the Class A deals we purchase in the interim.
Cheers,
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