How Can Multifamily Be In A Bubble Without Oversupply? We May Be About To Find Out

Unprecedented rent growth since the start of 2021 and historic levels of liquidity in the capital markets have pushed valuations in the multifamily market to dizzying — and to some, worrying — heights.

As both retail and office suffered the worst of the pandemic, investors of all stripes flooded into multifamily. The resultant increase in competition has led to some buildings selling for prices that leave veterans of the sector scratching their heads. With the Federal Reserve raising interest rates to combat inflation, market conditions have shifted enough for some to raise the alarm.

“We are in a bubble,” said Stroock partner Lorie Soares Lazarus, a commercial real estate attorney based in Los Angeles. “The numbers we’re seeing in multifamily, it’s hard to see how those can be sustained.”

Historically, bubbles in real estate are caused by oversupply or by some other force that causes the value of an asset to drop sharply. The degree to which demand has outstripped supply in both the rental and for-sale housing markets has been the main driver of rent growth and a key reason why most investors reject the notion that a bubble has formed. The U.S. housing supply currently has a shortfall of 6.8 million units, according to a National Association of Realtors report, which helped drive up rent 13.5% last year, per Yardi Matrix — more than double that of any previous year.

Multifamily investors and brokers who spoke to Bisnow for this article estimated rent growth anywhere from 3% to 10% annually over the next five years. CBRE projects a 6.4% rent increase nationwide for 2022, said Brian McAuliffe, president of CBRE’s multifamily investment sales business.

“We do not have a bubble [because] we do not have an oversupply problem,” The RADCO Cos. founder and CEO Norman Radow said. “We have a lack of supply problem, and it’ll take years to make up.”

Rising construction costs and difficulties getting entitlements look likely to keep preventing new supply from catching up with apartment demand, and they have also had the effect of keeping the market for construction financing relatively in check. Where the danger lies is in value-add investing, which is based on an assumption of rent growth to generate better returns than stabilized properties or new construction. 

“Some of the value-add buyers had money sitting on the sidelines, and now that needs to be placed, but I have been amazed and astonished at the prices some people are paying for these products,” Integral Group President of Real Estate Vicki Lundy Wilbon said. “At those prices, I don’t think they can withstand a lot of downward pressure in the market.”

Despite rents rising passively in markets across the country, value-add properties are the most sought-after deals on the market, and the competition for them threatens to erase the very value proposition on which such deals are based. Reports of value-add properties being sold above replacement cost in the hottest markets have grown commonplace.

“I think that the demand to put money out from some of the large investors and institutional groups has them making an excuse for why this property is special, or, ‘Oh, you can't build anything today,’” said Eddie Ring, founder of California-based investment and asset management firm New Standard Equities. 

The areas in which the housing market is especially overheated are in the Sun Belt, particularly Phoenix and cities in Texas and Florida, multiple experts told Bisnow. That is where population growth has been the steepest since the pandemic began, with rent prices following suit. 

Even though supply is trailing demand in the Sun Belt, construction prices are lower than in traditional gateway cities and the threat of political intervention like rent control is more distant, making the prospect of development ramping up to close the supply gap more realistic than some might expect, Ring said.

“On the West Coast, there's so little land and there's so little political will to allow developers to build more,” he said. “If developers are really looking at runaway rent growth in the Sun Belt, markets like that have very few restrictions in terms of what you can and can't build. And there's a lot more land to build on.”

But unbridled optimism about an asset’s future can be a danger in and of itself, and the suddenness of rent growth in the last year-plus has made it difficult to project the rate of growth going forward. 

In many Florida markets, Colliers projects rent to grow by as much as 20% over the next 12 months, though its valuation team has been underwriting for 10%-12% growth in its most recent deals, Colliers Executive Managing Director Casey Babb told Bisnow. In some cases, apartment buildings with more vacancy are trading at a premium because current leases are well below market no matter how recently they were signed.

“That's something that is breaking the model, frankly, for a lot of people in the industry,” Babb said. “But if you're not underwriting that sort of rent growth into your model, you will not win deals.”

When aggressive rent growth projections are required in order to finance an acquisition, those loans can quickly become a problem if market or economic conditions shift. The two most likely sources of negative pressure would be rent growth missing projections and the Fed raising interest rates faster and higher than expected, experts told Bisnow — and the latter looks more likely by the day. 

In its March meeting, the Fed’s board of directors cited additional inflationary pressure from Russia’s invasion of Ukraine as a reason why more aggressive policy is needed, CNN reports. A growing portion of the board, made up of the heads of local Federal Reserve banks, is calling for interest rate hikes of 50 basis points, with many board members reportedly regretting that the March interest rate hike was only 25 basis points. Support is also growing for an acceleration of rate hikes, CNN reports. 

Any multifamily investors with floating-rate loans on their properties “will have their cash flow hit hard” by the coming interest rate hikes, MJW Investments founder and President Mark Weinstein said. 

As a result, there may be a run on refinancing this year as borrowers attempt to switch from floating-rate to fixed-rate loans, McAuliffe said. The potential effects of such a run depend largely on lenders’ risk appetites, which could be on the wane given the Fed’s public stance.

“We’re seeing a bit of a pause from the standpoint that [lenders] are getting more cautious,” said Richard Rennell, managing director at national commercial real estate and multifamily lender Sabal Capital Partners. “They’re looking to see what [interest] rates are going to do.”

A crucial factor in the Sun Belt’s recent appeal is its lower cost of living than that of California and the Northeast, but that number traditionally corresponds with lower wages. That connection has been weakened, and in some cases broken, by the movement toward hybrid and remote work, but as long-term workplace strategy planning takes hold, it could very well return as companies with multiple offices take stock of their payrolls, Ring said. Even if it doesn’t, rent growth is already so far ahead of income growth that the ability of markets to absorb further increases is less than certain.

“There are certainly investors who are taking the approach that we made it through Covid, this is the current rent growth rate, and it will continue,” Soares Lazarus said. “That doesn’t consider how we got to where we are or whether or not incomes can continue to support that rapid rent growth.”

Within the flood of investors that have entered the multifamily market have been foreign investment banks and other forms of institutional capital — entities that are happy to accept returns lower than multifamily veterans expect because their other options for deploying capital have even less upside. Though such entities may not be taking on unacceptable risk themselves, they could be driving their competitors into dangerous territory. 

Equity and debt fund managers have mandates from their investors both to deploy a certain amount of capital within a given time frame and hit a promised level of return. In the current environment, debt service payments could easily eat up a property’s income if rent growth falls short or interest rates rise beyond a loan’s underwriting projection, Babb said.

“If they're not making the right assumptions — if they underestimate the taxes, insurance goes up beyond what they thought, if the rent growth slows down in any meaningful way, if interest rates go up to the mid-fours or higher, you are gonna see some people in a need-to-sell situation,” Babb said. “They're way out ahead of their skis.” 

CORRECTION, APRIL 11, 2 P.M. ET: A previous version of this article misstated the nature of Sabal Capital Partners' business. This article has been updated.

CORRECTION, APRIL 12, 3:55 P.M. ET: A previous version of this article misstated the nature of New Standard Equities' business. This article has been updated.