A couple of weeks ago, we wrote about how we were addressing potential impacts on our Funds from recent bank failures and ongoing uncertainty in the financial sector. Two weeks after the failure of two major U.S. banks, regional bank stocks have rallied, and steps are being taken to further stabilize the situation. We wanted to build on comments that we made during our recent webinar with Sheila Bair, former head of the FDIC, to address how we believe the next few months could unfold. We’ll consider the multifamily real estate market more broadly and Origin specifically, including potential scenarios and investment opportunities as well.
Lower Levels of Multifamily Housing Supply to Meet Demand
We cite the fundamentals of multifamily real estate often as a primary reason for our investment focus on this sector: Housing needs weren’t being met before the economy encountered higher inflation and rising interest rates over the past year. And year-over-year rent declines, rising interest rates and a 40-year record of supply coming into the market are dampening nearly two years of rent increases. Indeed, our own MultilyticsSM Rent Forecast shows rents encountering negative growth over the coming year. But that’s only half the story. In our investment markets, we expect rent growth to return to positive territory in 2024 and beyond, and even to top average 3% year-over-year growth. It’s why we focus on areas where the population and jobs are growing.
Overall, we believe there will be less lending in multifamily just as there will be less lending for home, car and credit card loans. Before the recent failures of Silicon Valley Bank and Signature Bank, there was lower loan availability for commercial real estate. And now, banks will likely be less eager to extend credit because they’re trying to shore up their own short-term balance sheets. With less available capital, fewer new housing developments can be financed and built. The longer that housing shortage persists, the stronger the long-term fundamentals of multifamily as an investment opportunity remain.
Less Money Available to Refinance
When less money is available and interest rates are rising, and you’re the owner of an industrial, office or retail asset who needs financing, there is no lender of last resort. As an asset class, multifamily is unique because of the dedicated lenders available to it such as Freddie Mac, HUD and Fannie Mae. It’s another reason we focus on this asset class.
Last week, the Federal Reserve approved its ninth consecutive interest rate increase. But the quarter-percentage-point hike, and comments by Fed Chairman Jerome Powell, appear to take recent bank turmoil into account. With money to refinance debt getting more expensive, we believe real estate asset valuations will probably go somewhat lower. The good news, though, is that these types of moves can be deflationary. With banks pulling money out of the economy themselves, perhaps the Fed won’t continue to raise interest rates as frequently or as substantially as they have in the past year.
New Opportunities Through Recapitalization
With this potential for dislocation, we believe an early consequence will be recapitalization. Multifamily developers and debt holders need new equity when they refinance, and tighter lending protocols may mean they don’t get as much as they need. That’s the type of capital and the deals we’re seeing now. If recapitalizations don’t produce enough liquidity for owners, assets could be lost to their senior lenders.
Origin is positioned to take advantage of this market in the preferred equity space through the IncomePlus Fund, which can purchase distressed properties and recapitalizations in preferred equity. We are seeing preferred equity being issued at 14%-15% today in protected positions even through stringent underwriting. As evaluations start to change, this long-dated Fund, which is designed to be tax-efficient, also can change its investment thesis. That means we can move more towards common equity positions. Also, we soon will introduce the new Strategic Credit Fund, which among other investment options can purchase distressed debt collateralized by multifamily and provide preferred equity.
Potential Opportunities in Distressed Assets and Loans
Origin has not purchased a stabilized cash-flowing building in more than three years because we believed assets have been overvalued, so we directed our investments elsewhere, including into ground-up development. But if recapitalizations put asset owners in a position where preferred or mezzanine refinancing is not available, then the lenders take over the assets. Lenders don’t want to be in the business of multifamily real estate ownership. They want to sell the loans or the buildings.
Either way, Origin is positioned and prepared to be a buyer, for three reasons: One, we are tracking potentially problematic loans to determine if they fit our investment criteria and could be opportunities. Two, we have relationships with the banks and brokers that we’d deal with for these opportunities because we have been so active as investors and borrowers in our target markets. And third, our capital is ready to deploy when it makes more sense to buy direct assets relative to other investment opportunities. One scenario is the ability to purchase a building below replacement costs.
Origin’s expertise in restructurings, foreclosures, short sales, bankruptcies and gap capital during the Global Financial Crisis helped our Growth Fund I achieve a nearly 28% net internal rate of return from February 2011 to July 2017. Currently, we don’t see distress yet, but we believe there will be dislocation by the end of the year, with potential opportunities to leverage.
Other Economic Factors: Is a Recession Coming?
The longer banking dislocation happens, the greater the ripple effect on lending and other economic factors. We believe that many people underestimate the personal effect, as well: If you’re paying attention to what’s going on, it’s also potentially an effect on your own demand. If you’re more nervous, you’re less likely to make a big purchase or go on a big vacation, and that erosion of consumer confidence has a marked effect because we operate in a consumption-based economy.
While we can’t predict what will happen over the next 12 months, economic signs such as the yield curve, a reliable predictor of recession, point to the likelihood of such an event (Multilytics is predicting a recession beginning in October). We are being vigilant in our risk management strategies to manage our investors’ funds during this volatile period, even as we remain alert to the opportunities.