As I write this, I’m sitting in my home office, working at full capacity. The S&P 500 is back near all-time highs and asset prices have remained high, driven by the reduction of interest rates to near zero and the liquidity that has flooded the markets. Things almost feel good.

What’s happening in the economy, however, is a stark contrast. In Q2 we experienced the greatest setback in history (based on GDP decline), COVID-19 isn’t anywhere close to being under control, and a second spike is looming, complicating efforts to re-open the economy.

In May, I wrote about the widely-held belief in a V-shaped recovery and that many people think everything will get back to normal quickly. We now know that’s not reality. The economy re-opened too early and we got the worst of both worlds; a sharp recession and continued infections.

The effects of the pandemic are also highly uneven. People of color and low-income individuals are affected disproportionately. They are more likely to be infected, loose their job, and not benefit from asset appreciation.

So what does all this mean for multifamily?

First, many of these individuals who have been disproportionately affected are renters, skewing toward more affordable properties. With the extra unemployment benefits recently expiring, permanent job loss in many sectors, and minimal savings, many renters won’t be able to pay rent come September. Couple that with the moratorium on evictions being lifted, and it’s hard not to envision a scenario where delinquency and vacancy doesn’t spike and rents decline at the Class B and C communities.

With interest rates near zero and no shortage of dry powder on the sidelines, cap rates will remain compressed. However, if cash flow is down and cap rates are flat, then values should decline. Using the apartment REIT sector as a proxy, values in the private market should be down 15-25%. That’s not the case.

Trades are down, but values have more or less held firm. According to Costar, apartment sales have fallen off 50% compared to last year.

“Roughly $15 billion in multifamily assets traded in the second quarter of 2020, a fraction of the record $51 billion that traded” in the second quarter last year, according to the latest CoStar national apartment market report. “This dollar amount is less than half of the trailing five-year second-quarter average of $37 billion.”

The deals that have transacted, have been sold based on cash flow streams buffered by Federal stimulus and that have been acquired primarily by regional buyers with long-term hold perspectives. The impact of a pandemic which has led to 30M unemployed and a 12% decline in GDP, has had almost no impact on values up to this point which is hard to believe.

So why and when will values drop? Here are a few thoughts:

  • Pain needs to be felt at the property-level. A spike in vacancy and delinquency coupled with declining rents and increased concessions. Supply up and demand down = declining performance. This is econ 101.
  • We need forced sellers. Once pain is felt at the property-level, we’ll begin to see forced selling. Owners may not be able to refi at debt maturity, new lease-ups will under-perform, and over-levered borrowers will run out of cash etc. These assets should sell at some discount to previous market-values. Keep in mind, lenders may kick the can down the road, but eventually some form of distress will make its way through the system.
  • Pessimism needs to creep in. With significant capital on the sidelines and optimism around the fundamentals of multifamily as asset class, prices are likely to remain high (i.e. cap rates low). However, as deals under-perform and values drop, pessimism will begin to creep in, causing a pullback in investment. If liquidity dries up, cap rates could expand.    

As we look ahead, it’s becoming clearer that it’s going to be a slow and uneven recovery which will undoubtedly impact the multifamily sector:

  • Many industries, such as travel, entertainment, and hospitality may take many years to fully recover.
  • Many new businesses will need to be born in order to have material job growth. This takes time.
  • The class of 2020 graduates are largely jobless and hopeless. These would-be apartment renters are moving back home instead.
  • There’s a massively increased role of government at the same time there’s political uncertainty.
  • COVID still exists and is getting worse. Treatment and vaccines will take time.

It’s going to take time to recover and the apartment industry is not immune to the pain. When the pain is felt and how severely it’s felt, is impossible to predict. But what’s the point of having a blog if you can’t make predictions you have no business making?

I expect to see apartment prices decline 10 – 20% in the private sector on average and more severe distress in select segments of the business such as Class C deals or new lease-ups in already over-supplied markets.

What do you think?