Flood Of Capital To Red-Hot Multifamily Pushing Down Returns, Even As Rents Spike

Investors have been pouring billions into the U.S. multifamily market this year, creating an environment of unprecedented competition for buyers and lenders hoping to cash in on the sector's combination of reliable cash flow and skyrocketing rents.

The dynamic has compressed capitalization rates on multifamily acquisitions, forcing investors to pay more for properties and accept lower return expectations, industry executives said last week at Bisnow’s Multifamily Annual Conference East in Washington, D.C. But they said surging rents in markets across the country are helping offset the higher prices they have to pay for acquisitions. 

“It’s amazing to watch how much money is being raised by Starwood and Blackstone,” Jefferson Apartment Group CEO Jim Butz said. “The talk is that they have to buy one out of six apartment deals for sale in the United States every week. I mean, you wonder why there’s cap rate compression, there is so much money out there.” 

U.S. multifamily investment volume totaled $78.7B in Q3, according to CBRE, a 31% increase from the prior quarter. Through the first nine months of the year, multifamily investment volume totaled $179B, putting this year on track to crush 2019’s record of $193B.  

A significant portion of this investment has come from nontraded REITs, which are on track to raise $35B this year. These funds, managed by investment giants like Blackstone Group, Starwood Capital, Nuveen and Hines, have largely deployed money into the multifamily and industrial sectors.  

On the lending side, increased competition from debt funds is leading to higher leverage on multifamily deals, and borrowers are shying away from less aggressive agency lenders Fannie Mae and Freddie Mac, executives said.  

For new development deals, rising construction costs are making the financing math more difficult to pencil, especially for developers trying to build affordable housing.  

Prior to this year, TruAmerica Multifamily co-Chief Investment Officer Matt Ferrari said he was underwriting acquisition deals with returns between 15% and 20%. But the increased competition and compressing cap rates throughout the course of 2021 have brought return expectations down, and his team is now underwriting deals closer to 10%. 

Ferrari, who said his firm has acquired $4.8B of apartments over the last two years, said that cap rates have compressed from the 4% range to the 3% range over the course of this year. While those tighter cap rates are reducing the expected returns on the deals, he said they may end up beating those expectations because of strong rent growth. 

In some markets in the Sun Belt region, his firm is seeing new lease tradeouts — the rent growth that occurs when a tenant vacates a unit and is replaced — between 20% and 40%.

"Return expectations have certainly shrunk from the beginning of the year to end of the year, but the big reason why you’re still able to make what was once a 4[%] cap [rate] and now a 3 cap work is because of that tradeout combined with still relatively inexpensive debt," Ferrari said. 

Data from RealPage confirms Ferrari's observations about new lease tradeout rates. In an Oct. 18 report, the firm found that new lease tradeouts in September averaged 18.3% nationwide, the highest growth since it started tracking the metric, and several markets in Florida, California, Nevada and Arizona had new lease tradeout rates ranging from 25% to 39%. 

CBRE Vice Chairman David Webb, a D.C.-based capital markets broker who moderated Ferrari's panel at BMAC, responded with surprise to Ferrari's new lease tradeout numbers and said developers in the D.C. area are happy with a 10% to 20% rate of growth. 

"We scoff at that in the Sun Belt," Ferrari responded.  

Artemis Real Estate Partners principal Michael Vu said he is also seeing strong rent growth, and that makes investors want to see higher returns. But the competition in the market is making that difficult. 

"There is that tension of trying to get higher returns in a more competitive environment where theoretically investment returns should come down," Vu said. "We constantly have that struggle. We are forced to take some different bets, so we’ve gone more into ground-up development in hopes of achieving higher returns, and we’re pursuing some investments in smaller markets that we weren't paying attention to as much."

Nuveen Managing Director Nikita Rao said there is a debate about return expectations between her team, which promises certain levels of returns to investors, and the acquisitions team, which is forced to find deals in a competitive market. She said some funds have been able to maintain their return targets while others have reduced them. 

"Our value-add fund, which is in the market currently, has reduced their return targets from their prior funds, so we're seeing overall a decrease in total returns," Rao said. "From my perspective on the core side, we’ve been able to maintain our target returns and look for creative ways with alternative housing like single-family rentals to build additional return."

Bainbridge Cos. President of Capital Markets Jake Wright said his firm, one of the largest multifamily developers in the nation, has a perspective from the seller's side on how competitive the market to buy apartments has become. 

"In April and May we put deals under contract that, by [the] time they closed, we were thinking, ‘Oh my gosh, we could have gotten $50K/unit higher for this project,’" Wright said.

He said price growth has been especially strong in southeastern U.S. markets like Charlotte, Raleigh, Tampa, Orlando and Jacksonville.

"It feels like every deal we sell is another record," Wright said. "And that’s not to pat ourselves on the back, it's the market. It’s a combination of rents going up and cap rates going down."

Hines Managing Director Andrew McGeorge, asked about the most surprising trend he has seen this year, said it has been the cap rate compression in the multifamily market. 

"We assumed there would be snapback in lease-up, and there was, but the actual cap rate compression has just been astronomical," McGeorge said. 

The competition to deploy money into the multifamily sector has also been seen on the debt side. Debt funds have been the most active lenders this year, executives said, and they have become increasingly aggressive in their underwriting. 

Ferrari said he has seen debt funds finance multifamily acquisitions with loan-to-cost ratios in the 70% to 80% range, meaning buyers have more leverage on a property, though he said TruAmerica typically doesn't do deals in that range.  

Jason Gerstein, the founder of finance brokerage firm LGA Capital. said he is also seeing debt funds become more aggressive on their leverage ratios as they compete to finance deals. 

"There’s a little bit of concern with how aggressive some of the debt funds are getting, so we’re starting to explore alternative options to try and keep our leverage points down on the deals we’re working on around the country," Gerstein said. 

The competitive rates that debt funds and banks are offering have pushed borrowers away from Freddie Mae and Fannie Mac, Gerstein and Ferrari both said. 

"Historically we’ve often borrowed from the agencies, that really changed in 2021," Ferrari said. "[This year] 95% of our debt is going to end up coming from banks, life companies or debt funds."

The Federal Housing Finance Agency, which sets the multifamily loan purchase caps for Fannie and Freddie, in October announced it would raise those ceilings from $70B for each agency this year to $78B next year.

FHFA Associate Director Siobhan Kelly, during a keynote at BMAC, said the dynamics of the multifamily lending market have changed over the last year as private lenders have become more active. 

"One of the things we saw last year during the pandemic was other sources start to pull out, so the enterprises were able to play their countercyclical role," Kelly said. "What we're seeing now is a lot of sources back in, and multifamily is still a very attractive asset class ... so we’ve seen competition coming back in, and all forecasts are showing the multifamily market is going to be bigger next year."

While the market for buying and financing apartments is flush with money competing for deals, there isn't as much capital available for developers looking to build, especially affordable units. Affordable housing developers say they are struggling with uncertainty around their financing sources combined with rising construction costs. 

McCormack Baron Salazar Senior Vice President Pam Askew is working on a financing deal for an affordable housing project in Maryland, and she said construction costs are complicating an already difficult financing process.

She said Maryland's government doesn't provide the same level of affordable housing funding as D.C. does through its Housing Production Trust Fund, so she is trying to secure federal dollars through the American Rescue Plan Act, which can be used for affordable housing projects. But she isn't sure if that path will succeed.

"On the development side, I have construction costs, I cannot cover the gap, and I don’t have an answer," Askew said. "Prices are going up. I’m on hold on closing to fill that gap ... We’re at a pause, so we’re seeking ARPA funds as a reach. It may not be successful in securing those funds, but I’m not sure how it’s going to work out."

National Housing Trust President Priya Jayachandran said she is also facing these issues, especially when trying to finance deeply affordable housing projects. She said the only way to make those deals work is with "soft money," such as from D.C.'s housing fund or from organizations like Amazon, which is providing below-marktet loans through its $2B Housing Equity Fund. 

“We all want to do it, but to Pam’s point, the construction costs are the construction costs, and the only way to pay for those deeply subsidized units is with soft money,” she said. “We’re lucky D.C. has the Housing Production Trust Fund, and we’ve got Amazon that has committed a lot of money here. So all of us are tapping into those resources, but you don’t know until you’re finally awarded, and then it’s a numbers game."