Cooldown Of DFW's Apartment Market Pits Well-Heeled Owners Against Rookie Investors

Short-term pain is on the horizon for DFW’s apartment industry as interest rates remain elevated and a supply glut takes hold.

Top developers, investors and lenders came together at the Bisnow Multifamily Annual Conference to discuss the state of DFW’s apartment market and whether reports of the sector’s fall from grace is enough to slow the breakneck pace of activity seen over the past few years. 

The short answer is yes: DFW is not immune to economic turmoil, and the next several months will bring a reckoning for some owners, panelists said.

But with the Metroplex poised to grow by 500,000 residents over the next five years, its long-term prospects are strong, panelists said. And those equipped to ride the wave could be rewarded down the road.

“It’s going to be harder to be bailed out by rent growth, and cap rates are not going to be on your side for a little while,” Mesa West Capital Director Brian Hirsh said at the Aug. 29 event held at the Hilton Anatole. “It’s really all about yield, and I think that’s where things have changed on our end — we are taking a much closer look at going-in cash flow.”

Negative leverage, or when the cost of a property’s mortgage cost is outpacing its rental income, has put a lot of owners underwater on their loans, Archway Capital Chief Operating Officer and Senior Vice President Tom Noble said. The firm has spent the last several months helping borrowers work through financing issues, in some cases recapitalizing with preferred equity to bridge the gap.

Developers have shied away from using preferred equity in the past, as it is typically more expensive than senior debt. But with financing options slim, the cost of mezzanine debt has decreased, prompting many to pair preferred equity with agency lending, DB Capital Management CEO Brennen Degner said. 

“There’s enough competition in the [preferred equity] space that the blended cost of capital is starting to come down,” he said. “Everyone in the middle-market equity space has decided they want to be that rescue capital, so there’s been a bit of a race to the bottom.”

Rising interest rates have sidelined many debt funds, but not all firms have abandoned private equity-backed capital.

Rise48 Equity continues to tap into debt funds for its bridge loans, co-founder and CEO Zach Haptonstall said. The firm hedges the risk by purchasing interest-rate caps that can cost anywhere from $1.5M to $3M but provide assurance that rates won’t exceed a certain threshold beyond the first three years.

“Obviously the debt fund pool is a lot thinner than it was the last few years, but we’ve still had anywhere from five to 10 serious term sheets for every deal that has gone out,” he said. “Debt funds, depending on the group, want to put out money — they’re just being more selective.” 

DFW had some of the tightest cap rates nationwide during the first half of this year, but that could change as price discovery unfolds, said Cole Kellogg, FCP vice president of multifamily acquisitions.

There are somewhere between 30 and 40 deals on the market in Dallas today, and many were priced when interest rates were lower, which means they could require more equity than originally anticipated when it comes time to close the loan.

“We are not particularly close to the whisper price on these deals, but at least preliminarily, most of these look like they’re going to miss values, and we could see a gapping up in cap rates in Dallas,” he said. “We are closely monitoring that right now and waiting for the opportunity to deploy more capital.” 

Some of those owners may be hurrying to put properties on the market before true distress sets in, Kellogg said. For many, the issue is not be that the property’s fundamentals are flawed, but rather that interest rates have risen to a point where the prospect of refinancing is too far out of reach.

“The deal itself may not be distressed — it’s a cash management issue,” Degner said. “We’re going to see a decent amount of that, where you have relatively good real estate with a financing problem that needs just a little bit of help.”

Projects that offer affordable rents are always financially pressed, but the last few months have made the jobs of people like JLL Senior Managing Director Angela Kelcher even more difficult. In some cases, developers of Low-Income Housing Tax Credit projects are deferring their fee and coming to the table with cash to make deals work, she said.

“Incrementally, around the edges, we have to cobble together solutions that make a difference,” she said. “You really have to think about where on the expense side you can have savings on the ongoing operations of the property.”

Affordable and workforce housing developer The Blvd Group is saving on utility expenses by beginning to implement renewable energy and water conservation strategies, Director of Development Nikhil Nardhani said. 

“Our mandate is to really focus on what things we can do to not only improve the community and improve the livability for residents, but how can we make it more sustainable by managing these costs through our construction and design?” he said.

Public Finance Corporations provide a tax break that has been critical in getting more affordable housing projects on the ground in Texas, but recent changes in legislation aimed at rooting out corruption could hinder progress, Kelcher said. 

The approval process is now more stringent, she said, which could pave the way for more resident opposition.

“It has the potential impact of making these deals not feasible, as the affordability requirements have increased pretty significantly,” she said. “The NIMBYism is real, and so having just another hurdle introduced makes it a little bit harder, even though there do need to be guardrails around the program.”

Government sponsored enterprises, including Fannie Mae and Freddie Mac, are now financing around 75% of an asset’s value as banks and other lenders spooked by economic uncertainty pull back, said Ryan Everett, vice president of acquisitions for S2 Capital.

Much of the uptick in agency activity is motivated by the Federal Housing Finance Agency’s mission of increasing access to mortgage credit for affordable homeownership, he said.

“They’ve really stepped in as rates have [gone up] to be able to provide that financing for borrowers that need to be providing housing for their residents within their different jurisdictions,” Everett said.

Several emerging trends could prove beneficial for multifamily. For one, the prospect of owning a home continues to fade for many tenants as mortgage rates remain elevated, which should drive demand for apartments. A narrowing bid-ask spread, which many said has already begun to materialize, could also get things moving again.

“Some sellers have capitulated on pricing, which has made the negative leverage issue less of an issue,” Noble said. “Inflation is cooling and [interest] rates might moderate a little further from here, which we think is a tailwind in the next 12 months.”

About 950,000 new units were under construction in the U.S. as of June, per The Wall Street Journal, and metro areas in the Sun Belt are disproportionately exposed to the acceleration of supply. 

But rising costs continue to impede new construction, which over the next few years should give demand time to catch up with supply, Haptonstall said.

“A lot of the new supply pipeline has slowed down over the last 12 months and probably for the next 24 months,” he said. “The residual effect will be in three to five years, there will probably be a shortage.”