Multifamily Growth Strategies Adjust To Economic Uncertainties

As the storm clouds of an economic downturn created gusting headwinds challenging all asset classes this year, CRE players expressed confidence that the high-flying multifamily sector—which has seen unprecedented rent growth during the past two years—is prepared to weather the storm.

“A pullback in the market will likely impact all property types as interest rates increase rapidly,” says Mike Wolfson, director of Capital Markets Research at Newmark.

“However, multifamily should remain a preferred investment destination in the near-term given its strong defensive characteristics, liquidity provided by government-sponsored enterprises and continued disruptions in other property types,” he said, a sentiment shared by many market analysts.

“Past pauses in the capital markets, such as those immediately following the 2016 election and COVID-19 lockdowns, have been very short-lived for multifamily in particular,” Wolfson added.

As the cost of debt rapidly increased in H1 2022, multifamily players were compelled to choose between closing deals quickly—before further rate hikes arrived—or heading to the sidelines and riding out the storm.

For some owners, these hold or fold choices had added urgency as the rising cost of debt pushed their assets into negative leverage territory while at the same time making refinancing an increasingly unpalatable option.

Forward-thinking players revised their acquisition strategies to lower risk and to get a piece of the action in an emerging multifamily growth sector, the conversion of under-used aging offices into apartments.

SOME RACE TO CUT DEALS, OTHERS SIT

As the economy began to sour in Q2 2022 and speculation over the scope of the downturn intensified, buyers and sellers in the multifamily sector migrated into two camps: those who feel compelled to close deals now before market fundamentals erode and the cost of debt keeps rising, and those who are deciding to pull back and wait for the next cycle.

At the end of the second quarter, signs of a cooldown increased, including in multifamily, an asset class that posted 15% YoY rent increases in Q1. Buyers were still out there, but the number of offers and property tours declined and many of the deals on the table didn’t hit their whisper prices.

No one suggested that the perfect storm of market conditions that has fueled an unprecedented boom in multifamily properties is going to disappear anytime soon.

The consensus projection was that tightness of supply in the housing market will continue, delays in new construction will persist and would-be first-time home buyers facing sticker shock from home prices averaging $450,000 still would need to find apartments to live in.

But the Fed’s rate increases and the rising cost of debt had a sobering effect on the CRE players who have been trading multifamily properties at a steady clip for the past two years. The music hadn’t stopped yet, but many of them decided to take their seats.

“We’re seeing owners fall into two clear camps,” Ryan Kidwell, senior VP and co-leader of the Seattle office of Mogharebi Group, says.

“One camp is moving quickly to market their properties before rates move up again along with debt costs, and the other believes they’ve missed the boat to some degree and have decided to hold until the next cycle,” according to Kidwell.

The same dynamic is playing out on the buyers’ side, he continues. “One camp is rushing to place its capital into deals before debt costs increase further, the other is hitting the pause button on acquisitions,” Kidwell said.

Mogharebi, a multifamily brokerage based in Costa Mesa, CA, saw trading activity begin to slow down, with a noticeable decline in offers.

“If we were averaging five plus offers on deals, now we’re seeing two,” Kidwell said, noting that a reduction in offers and property tours typically is followed by an adjustment in pricing.

“The question is how severe the correction will be and how long will it last? How buyers and sellers answer those questions will dictate their strategy for the next 12-14 months,” he adds.

The Mogharebi SVP said the rising cost of debt will increase negative leverage in the multifamily sector in the short term. Kidwell said the “time horizon for the return of capital” will be a deciding factor in determining whether owners—particularly those that may be facing negative leverage—choose to sell rather than refinance.

“Some investors will be willing to—or feel it necessary to—hold deals with negative leverage to stay competitive, especially if they view the interest rate spikes as relatively temporary,” Kidwell says.

Kidwell told us that most multifamily buyers still are pricing in rent growth, but many are being more conservative in their underwriting as the economic storm clouds gather. “Even if they continue to include healthy rent growth in their analysis, expenses have increased substantially, so we’re seeing lower NOI projections from some buyers,” he said.

Kidwell said cap rates, which move in correlation to the cost of debt, will expand in the multifamily sector, but not as severely as in other asset classes.

BELOW REPLACEMENT COST STRATEGY LOWERS RISK

With rising construction costs, supply chain disruptions, labor shortages and a rising cost of debt for construction loans all expected to pose strong headwinds to new construction for the rest of 2022 and into 2023, a value-add strategy of buying older multifamily properties and renovating them is proving to be a lower-risk path to solid returns.

DB Capital Management, a Playa Vista, CA-based company with more than $500M in AUM, specializes in acquiring and operating multifamily properties in submarkets it has strategically targeted after closely analyzing market conditions.

In November, DB Capital put its bullseye over San Antonio, where it had projected steadily increasing demand—including a surge of in-migration—and limited supply of quality multifamily rental homes, which turned out to be an accurate description of the market in H1 2022.

DB Capital moved aggressively into the San Antonio market, acquiring 1,864 multifamily units in two acquisitions. In June, the company acquired ReNew TPC, a 408-unit garden apartment complex with 18 three-story buildings that opened in 2007 in a central neighborhood near some of the largest employers in San Antonio.

DB Capital’s strategy in San Antonio involves acquiring an asset in an exceptional location at a purchase price well below replacement cost and upgrading it with renovations to a quality level consistent with new developments, at a more competitive price point.

Before buying the property, the company closely examines the cost of new construction in the market and as well as future construction pipeline expectations.

“As value-add investors, one of our primary hedges to future supply is buying well below what a developer would be able to deliver a project at, because it means our rents are better, but not completely, insulated from softness or absorption issues related to significant changes in the delivery pipeline,” DB Capital CEO Brennen Degner says.

“We generally see relatively comparable underwritten returns for our value-add projects when compared to where ground-up developers are solving to. Maybe +/-200bps of projected return in favor of ground up projects,” he explains.

“We take the position that the return delta is not sufficient to mitigate the incredible difference in risk profile. From a risk-adjusted perspective, acquiring existing projects with a value-add component is a much better position to be in.”

DB Capital’s aggressive portfolio expansion in San Antonio has a two-year timetable, designed to rapidly build economies of scale.

“The advantages of building economies of scale in a market are extensive. It allows our construction and management arms to build a deeper, more reliable bench of labor and vendors, and it allows us to purchase and store materials in larger quantities, reducing overall costs,” Degner said.

Having scale in the market also allows DB Capital, which standardizes the materials it uses across its portfolio, to hedge the current supply chain issues by proactively buying in the largest quantities possible, he added.

We asked Degner if he is counting on rising construction costs, supply chain disruptions and labor shortages to hold down deliveries of new multifamily units while the company executes its rapid portfolio expansions.

“We see the rising construction costs and supply chain issues having a very significant impact in a market like San Antonio that still has on average a more affordable rent profile,” he said, adding that in markets with higher rents, like Austin, developers can cover their construction costs buy building higher-end units that command higher rents.

OBSOLETE OFFICES CONVERT TO MULTIFAMILY

Early optimism at the beginning of 2022 that as the pandemic waned workers eventually would return to offices soon gave way to the reality that a massive paradigm shift has taken hold in the labor-management relationship.

Millennials, who now make up more than two-thirds of the workforce, were already demanding a better work-life balance and shorter commutes to work before the pandemic. The pandemic, and the massive labor shortage that developed during it—a shortage that is likely to persist for years, if not decades—gave workers new leverage when they balked at return-to-work mandates.

The fact that millions of workers had proven during the pandemic that they could do their jobs remotely and maintain productivity sealed the deal: remote work now appears to be a permanent feature of the US workforce, pushing companies into a widespread embrace of hybrid work patterns.

By the middle of the year, the handwriting was on the wall: office occupancies in most major US markets have languished around 43%, and this is becoming the new normal.

A glut of half-empty offices and a nationwide housing shortage have created a perfect storm of opportunity for adaptive re-use projects converting aging office towers to apartments. The aging Class B office properties that make up about 60% of the US office market in cities like New York, Chicago and Washington DC are the prime targets for conversion to apartments.

Modern buildings that opened in the last 30 years generally are considered unsuitable for apartment conversions due to their larger floor plans and fewer windows. New buildings also are having a much easier time maintaining higher occupancy levels as tenants who are downsizing their office footprints are at the same time engaged in a “flight to quality.”

AGING NYC OFFICE TOWER CONVERTS TO APARTMENTS

The largest office-to-apartment project in NYC was announced in June: a joint venture of Silverstein Properties and Metro Loft purchased 55 Broad Street, a venerable 30-story office tower that opened in 1967 in New York’s Financial District, for conversion into a residential building with 571 multifamily units.

JLL arranged the financing for the 55 Broad Street acquisition.

Alex Staikos, a director in the New York office of JLL Capital Markets focused on commercial real estate debt and structured finance transactions, explains that the combination of tight housing supply and weak office occupancy has created a perfect storm of conditions for adaptive re-use of office-to-apartment conversions.

“Converting underperforming office buildings into multifamily can reinvigorate downtowns,” Staikos said. “When thousands of new residents move into a particular area, you see new restaurants, shops, and entertainment venues pop up. Suddenly an underutilized pocket of the city becomes a vibrant mixed-use live/work/play community.”

“NYC and many CBD’s went through a building boom in the late 60s and 70s and those buildings are now at the end of their lives. The pandemic has accelerated a flight to quality in the office sector and demand is towards newer Class A product.”

Developers acquiring office properties for multifamily conversions have some competitive advantages over those who plan to build new residential buildings as well as investors who are buying office buildings and plan to continue office use, Staikos says.

“A conversion is generally cheaper than building ground-up and quicker, since it’s retrofitting an existing structure,” he said. “While a new building may take 3-4 years to build, a conversion can be completed and ready to be leased sometimes in under one year.”

Staikos told us that a developer with a viable multifamily conversion plan can generally pay more for an obsolete office building than an investor that will keep it as office because of the capital intensity of improving and leasing that office space, including renovations, tenant fit-outs and leasing commissions, relative to rents.

Some CRE analysts have suggested that the recent expiration in New York City of 421-g tax abatements that encourage office-to-apartment conversions in Lower Manhattan—including residential development after 9/11—may slow down the current push for adaptive-reuse as an answer to the housing shortage.

“The 421-g program made early conversions in the wake of 9/11 more financially feasible, but apartment demand in Lower Manhattan was at a record low following the terrorist attacks. The achievable residential rents were depressed, and the abatement was necessary to make the investment make sense,” Staikos said.

“Today, demand for apartments has never been greater, so we don’t see this same sort of dynamic.”

However, Staikos noted that current zoning laws in NYC only allow conversions of buildings that were occupied as offices prior to 1977.

HINES JOINS THE ADAPTIVE REUSE PARTY

The growing wave of office-to-apartment conversions has reached Salt Lake City, and it’s pulling in new players.

Hines is undertaking its first office-to-apartment conversion with its acquisition of the 24-story South Temple Tower in Salt Lake City, which the Houston-based global real estate firm plans to transform into a 255-unit luxury multifamily.

Although the South Temple Tower is considered a local landmark, with spectacular unobstructed views of the city skyline, the state capitol and the Wasatch Mountains, Hines determined that the tower has no future as an office building.

“The building was failing as an office building. The previous owner invested significant capital before the pandemic and still struggled to lease it. The pandemic made it clear it would never recover,” Dusty Harris, senior managing director at Hines, says.

Hines will strip the building to its core and shell, remove all of the existing offices and restructure the building to create an efficient residential floor plan.

Hines said it conducted an extensive analysis of the South Temple Tower before the acquisition to ensure the building was suitable for conversion, evaluating the building’s walkability, natural light, the shape of the building and the number of potential apartment units.

“We knew the floor plates were challenging for an office and there wasn’t enough parking. Those weaknesses actually became strengths for a residential building,” Harris said.

Harris believes there will be a large market of office-to-apartment adaptive reuse projects, but he cautions that many existing office buildings have floor plates that may be too large for residential conversion, as well as prohibitive zoning.

“There also are existing tenancy challenges that could make re-use changes difficult,” he added.

According to JLL’s Staikos, the factors that should be considered when evaluating whether a building is a suitable candidate for conversion to multifamily include “site context”—walkability, access to transit, natural light and views—and the shape and the size of the building’s floor plates and how easy it is to plan efficient units.

“Adaptive reuse is far more sustainable than building ground-up,” he said. “There is less waste put into landfills and there’s less carbon associated with new materials.”