Multifamily Trends in the Southeast Differ from the Broader CRE Market

The broader U.S. real estate market is at a turning point after more than 12 months of rate increases from the Federal Reserve. According to research from Morgan Stanley Wealth Management, more than half of $2.9 trillion in commercial mortgages will need to be renegotiated in the next 24 months when new lending rates are likely to be up by 350 to 450 basis points.

This means that debt used to finance new acquisitions, or refinance existing loans, will be done with a materially different base-rate, funding-spread, and credit-terms environment than we’ve seen for the last 15 years. We are already seeing large institutional real estate investors, like Brookfield, making the decision to hand back the keys on portfolios of office buildings to their lenders, rather than try to refinance or even restructure their debt.

With this uncertain backdrop for the commercial real estate sector, we wanted to provide some context around what we are seeing, specifically in the multifamily space in the Southeast.

To date, the Ballast Rock originations team has seen limited price movement from sellers, let alone significant signs of distress. In our markets, as you can see below, the past 12 months have seen distressed sales in multifamily drop by half compared to the year prior. Office, on the other hand, has seen a spike in distressed sales and foreclosures.

One significant factor driving this divergence in performance is the debt profile for each market. Whereas lending in commercial real estate is primarily driven by banks, and in particular the regional banks, a significant portion of multifamily is financed by Government Sponsored Enterprises (“GSEs”), namely the Federal National Mortgage Association (“Fannie Mae”), the Federal Home Loan Mortgage Corporation (“Freddie Mac”), and the Federal Housing Administration (“FHA”). Furthermore, only a small portion of these GSE loans is set to mature in 2023, with more than half not maturing for at least five years or more.

That is not to say that we don’t expect to see defaults in the multifamily space. In fact, we have already seen some notable failures. Indeed, a value-add operator in Houston, Texas, defaulted on 3,200 units in April, blaming, amongst other things, an increase in its cost of debt from 3.4% to around 8%. We expect this trend to continue for the next 12 to 24 months, as we see professional value-add sponsors who bought at peak prices over the last few years with short-term floating-rate debt, needing to refinance in 2023 and 2024 and facing much higher debt costs that could exceed revenues if they haven’t.

To date, we have seen limited evidence of weakness in the Southeast, but we are actively trying to identify potential distressed assets in our target markets. We’ve also had conversations with investment advisors focused on investing in private credit “rescue capital” funds targeting the multifamily sector, but without significant market distress (which we don’t see happening given debt profiles and dry powder looking to be deployed) we don’t believe there will be adequate opportunities to fill the demand, thus driving down the payout and deal quality for these funds.

While we expect we may see more opportunities in the second half of 2023 and into 2024, any individual distressed assets should not be mistaken for a sector-wide multifamily crash. Certainly, so far, we’re still not seeing the bargain shopping that many (including myself) had hoped to see.

Regardless, we continue to believe that a core strategy of investing in value-add multifamily assets in fast-growing Southeastern markets, but with the potential for opportunistic one-off distressed acquisitions, will create the right balance of stable income and capital appreciation potential.