Origin Investments: Time is Right to Go on the Offensive

Pace of Development and Secular Fundamentals Paint Positive LT Outlook for Multifamily Investing

CHICAGO (June 12, 2024)—The impact of stubborn inflation, the lack of anticipated downward movement in lending rates, and the looming probability of distress later in 2024 makes David Scherer, co-CEO of leading multifamily fund manager Origin Investments, believe that now is the time for investors to go on the offensive, including reallocating to multifamily investments.

Scherer points to the secular nature of housing market fundamentals as the rationale for investors that are now in a position to recalibrate investment portfolios, just as investment fund managers have done historically as market dynamics shift.

“Pension and endowment funds are rebalancing investment allocations right now,” Scherer said. “It’s what they do, selling NASDAQ positions because it had a huge run, and allocating to other areas, like multifamily real estate, where steep value declines have occurred. Multifamily investments will do well and, as the level of dry powder and pent-up acquisition demand would indicate, it’s a great time to start scaling up.”

Scherer presented perspectives on a variety of multifamily real estate issues in a mid-year predictions check-in webinar. As a follow-up to his predictions for multifamily real estate in 2024, Scherer highlighted:

• Asset valuations likely will still decline, which makes calling the bottom of the market difficult. 
• A period of distress looms, although the window of opportunity likely will be shorter than previously anticipated.
• Multifamily fundamentals will only get stronger and underscore the sector’s secular benefits.
• The big caveat is interest rates, whose movements have been front and center for some time.

Asset valuations will still decline.

Multifamily investment value declines ranged from 15% to 30% through the end of 2023, according to Origin’s December predictions report. At the time, Scherer predicted that while valuations had mostly corrected, they could fall by as much as another 10%.

“In the past six months, valuations have fallen by another approximately 5% and the trajectory has slowed,” Scherer said. “I am not going to call a bottom. But I think it is more likely that we have upside potential, meaning it is much more probable that values will go up rather than down.”

A period of distress looms ahead.

Falling valuations, relatively high interest rates and an avalanche of variable-rate bridge loans coming due have peaked anticipation of a bursting dam of distressed multifamily assets. Distress remains a concern. Scherer predicts distress in the sector will become more prevalent in the third quarter and may only last for a year.

“We’ll continue to see generational investment opportunities in the sector, and there is an abundance of dry powder on the sideline waiting to chase those opportunities,” Scherer said. “However, what we’re seeing today—Distress 2.0—is very different than the Distress 1.0 that occurred in 2008-09 when we had a distressed economy.”

Scherer defined Distress 2.0 with the example of the developer of a Class A asset in a good submarket within a Tier 1 western city. This high-quality asset, which has been de-risked, is currently in lease-up. The mezzanine lender is willing to take a 100% equity haircut to relinquish their position. The investor will receive development-like returns without taking development risk.

“This is representative of Distress 2.0,” Scherer said. “With Distress 1.0, in 2009, we were buying notes from banks. In certain instances, those banks were failing. It wasn’t a distressed real estate situation. It was a distressed economy scenario. Banks were fighting for their lives and unemployment was huge. That’s not the market we’re in; it’s not the distress that’s likely to happen.”

Multifamily fundamentals will only get stronger.

The multifamily market is experiencing the greatest disparity between construction starts and the delivery of units since 1975 as the disparity in interest rates from 2020 to mid-2023 become increasingly more obvious. According to the U.S. Census Bureau, 644,000 units were delivered in February 2024, the highest level since 1974. At the same time, however, year-over-year starts, from March 2024 to March 2023, dropped dramatically by 43.7%.

With sources estimating the U.S. housing shortage ranges from 2 million to 3.8 million units, imbalance is here for the foreseeable future. Additionally, as higher interest rates continue to choke off new construction and home purchases, the discrepancy between buying a home versus renting is growing. According to Bankrate and Realtor.com, homeownership is 50% or 60.1%, respectively, more expensive than renting.

That imbalance, among other factors, is bringing rental rate growth back to historic levels, as Origin’s Multilytics℠ forecasted in November, and is improving national occupancy rates.

“Looking forward, I believe multifamily fundamentals are incredibly strong,” Scherer said. “As an investor, instead of focusing only on today’s reality, you need to look at what next year will look like, and the next year and the next year.”

Interest rates are the big caveat.

As interest rates go, so goes multifamily. Almost every element of the multifamily investment cycle has a link back to rising, falling or flat interest rates, and the uncertainty of what will happen next.

“The big caveat is interest rates,” Scherer said. “If the risk-free rate goes higher, then borrowing costs go higher, and cap rates tend to follow. If that occurs, everything is impacted: construction activity, capital costs, valuations, and net operating income, as well as the optimism we feel for 2025 and beyond, would need to be adjusted.”

Scherer remains firm in his belief that interest rates will remain elevated, but not go higher, because the 10-year Treasury yield, which heavily influences interest rate movement, will stay between 3.50% and 4.50%. There is no expectation for a substantial drop in 2024 until inflation is slowed further, and to date that hasn’t materialized. As a result, long-term interest rates will remain higher than investors like or expect, but Scherer still sees opportunities.