Recently, business-focused news outlets have been formulating warnings about the commercial real estate sector—using words like “tsunami” and “hydrogen bomb scenario” to describe what they view as impending peril in multifamily real estate.
We’ve been reading those articles, too, and we agree that several challenging economic factors are converging in the commercial real estate sector: lingering supply and workforce challenges from the tail of the COVID-19 pandemic; interest rate increases that are dampening high inflation but creating other ripple effects; a short run of bank failures that created jitters among lenders. All along, we’ve been writing about the impact of tightening credit, sharply rising interest rates, looming distress in multifamily, even issues specific to our target markets such as insurance rates and water regulations. In fact, we predicted negative rent growth while others were still positive that rents would simply cool down. (And we were right: Read our recent Rent Forecast Accuracy Report here.)
The multifamily firms referenced in some news articles bought assets at peak prices with floating rate debt when interest rates were near zero and rent growth was red-hot. And over the next few years, around $980 billion in multifamily real estate debt will be coming due—hence the hype. The Federal Reserve began steadily increasing interest rates starting in March 2022, and those firms are now finding that they can’t depend on either cheap debt or rising rents to keep their investments profitable.
Evolving Our Strategy Amid Market Shifts
We know that some of these firms will succumb to economic forces and have to hand the keys to many properties back to the banks. It’s a very real risk, and we don’t dismiss the seriousness of that situation. But unlike many of these firms, Origin Investments has not bought a single existing multifamily asset in more than three years. Instead, we shifted to preferred equity and ground-up development. Our preferred equity investments in multifamily developments are in protected positions of the capital stack. And in our common equity ground-up development deals, we build to gross margins of 30% to 50%.
As well, Origin Multilytics, our proprietary suite of machine-learning models that forecasts rent growth, has been telling us since March 2022 to expect negative year-over-year rent growth starting this year. So, our underwriting assumptions included lower to negative rent growth and recession scenarios. To further protect our investments, we conduct stress tests on the properties in our Funds to see if they can withstand higher development costs, lower rents and higher cap rates (read the stress tests for Origin’s QOZ II Fund, Growth Fund IV and the IncomePlus Fund).
Because investments are predominantly capitalized with a combination of debt and equity, commercial real estate is susceptible to risk as interest rates increase. To protect ourselves against the rising cost of debt, we have employed an interest rate hedging strategy. And over the past two years, as interest rates rose, this strategy helped us recognize a total of $43 million in gains, including unrealized swap, that we can deploy to protect our Funds from interest rate hikes. It makes sense for us to operate this way, but according to the Wall Street Journal, it was “virtually unheard of” for smaller, privately held firms to employ derivatives this way.
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Stay Alive Until ’25? We’re Fine, Thanks
Multilytics is predicting an upturn in rents starting next year. But in the meantime, the market is grappling with a confluence of challenges, including more than 500,000 units projected to come online this year, according to Berkadia. We believe that supply will retreat again starting in 2024, and rents will increase again. In our rent forecast earlier this year, Multilytics saw healthy five-year compound annual growth rates of 3% to 5% across our 15 target markets.
For those who read the headlines and decide that now is not the time to invest, we’d like to offer our viewpoint for consideration: We are skeptical of the doomsday scenario, and we aren’t waiting for the headlines to improve before we seize the opportunities that are coming. We have been saying for three years that the opportunities lie on the credit side of multifamily investment. Origin’s IncomePlus Fund comprises about 55% debt-like preferred equity investments. The Strategic Credit Fund, operated by our affiliate company, Origin Credit Advisers, targets loans originated with a 30% equity cushion from Freddie Mac and other lenders, and provides privately originated financing for multifamily projects.
We have been investing in multifamily real estate long enough to remember the economic fallout of the Great Recession. In fact, Origin Investments was founded around that time because we were in a position to purchase and turn around distressed properties during that difficult period.
Recently, some of our deal officers attended a multifamily real estate conference where the phrase being repeated was “stay alive until ’25.” Our attitude in this environment is not simply to survive. Our deals don’t represent the whole economy. They represent smart, actionable opportunities that not only will help us survive but set us up for longer-term rewards.
