Overbuilding and Overpaying Plague Multifamily Sector Article originally posted on Globe St. on December 2, 2024 After so long considering the troubles facing office — and many tiring of hearing it repeatedly — there’s a new problem being brought up: multifamily. But things are more complicated than office. Some of the problems in multifamily were visible by the summer. Distress rates had begun to climb, and the volume has been disturbing. Short-seller Carson Block said multifamily in the Sun Belt was next to have major CRE problems after office. “A lot of multi-unit residential in the US — particularly in the Sun Belt — is in trouble,” Block told Bloomberg in an interview. “That’s the shoe that hasn’t really dropped yet, but that we think will.” Since a year ago, Carson has been publicly arguing — and investing — that the multifamily market has some fundamental weaknesses. He announced then that he was shorting Blackstone Mortgage Trust, which lends money against commercial real estate collateral. And it hasn’t been all office towers as far as the eye could see, although those were earlier warning signs. Many in multifamily see issues and yet disagree with a completely dire outlook. “Today’s challenges in the Apartment market are not the same as those in the Office market,” Lynn McKee, director of the Master of Science in Commercial Real Estate Program at Georgia State University’s Robinson College of Business, tells GlobeSt.com. “The current correction in values and potential loan defaults in both property classes, stem from very different dynamics.” One was a “city-specific case of over-building.” “Many, if not all of the popular areas — both fast-growing tertiary markets and the major core markets in the Southeast and Sunbelt — are feeling the pain from over-supply or overbuilding at the moment,” adds Jeff Klotz, managing partner of the Klotz Group of Companies. “Now this is an interesting phenomenon because the demand is there and the supply versus demand metrics are positive but there was just too much built at once or all at the same time, and everyone has been competing for lease-up absorption.” The other headwind was “‘dumb investments’ made in value-add apartment deals at the top of the market bubble in 2021-22,” McKee says. “Investors overpaid and overleveraged these deals based on unsustainable low interest rates and rosy rent growth projections.” Much of this action was the result of macroeconomic forces. A long stretch of low interest rates, capped by pandemic-era zero interest rate policy, gutted fixed-income investment. With a flood of liquidity from fiscal and monetary policies between Congress and the Fed, many investors pushed into CRE, with multifamily as one of the favorite resting places. That drove up prices, pushed down cap rates, and required the rent growth projections to pencil deals. That created “the matter of short-term loans maturing now that require refinancing,” Tim Donovan, managing director of Midloch Investment Partners, tells GlobeSt.com. “There’s trouble on this front for sponsors who are over-leveraged with projects that are underperforming. These loans will have to be worked out. There will have to be some capital calls.” The biggest difference between multifamily and office classes is the ongoing need for space. Work-from-home and hybrid work patterns shook businesses from their traditional connections to real estate. Companies could reconsider the space needed and whether they’d rather move up to Class-A properties from B or C. People renting apartments don’t have the option to leave and stay in an office instead. Obsolescence isn’t so much a factor. “There has been an extreme slowdown in new construction starts which should solve the oversupply issue, but it hasn’t yet,” says Klotz. And there are concerns about the Trump administration’s plans for deportations. “Undocumented immigrants rent in mass,” says Jeff Lichtenstein, owner and broker at Echo Commercial Properties. “The vacancies that will go into effect because of much more supply hitting the market is a genuine concern I’m hearing from clients.” “Looking forward, prudent developers and investors should proceed carefully and, in most cases, secure fixed interest rates for new projects or refis,” Donovan says. “If new projects don’t pencil using debt at current market pricing, I’m skeptical they should be undertaken. I wouldn’t bet on the future of interest rates.” “Investor interest in affordable, workforce, and market-rate properties remains strong, and they have ample dry powder waiting on the sidelines to deploy into the multifamily sector once the debt markets stabilize,” says Laura Khouri, president and chief operating officer of Western National Property Management. “As construction deliveries attempt to rebound and values rise, the demand for affordable housing will surge. States such as California and Nevada will see a growing demand for budget-friendly housing in markets with low affordability.”