From time to time, I have the opportunity to meet with our investors. Sometimes we connect for a one-on-one lunch or coffee, and other times our investor relations team will host a larger event. In any case, I truly enjoy learning about who they are, why they chose to invest in Origin, and, most importantly, talking about investing. Investors always have thought-provoking questions, with the most recent themes centering around market risks. My initial response is a direct quote from Origin Investments Co-Founder and Co-CEO Michael Episcope: “You are thinking about the right hook when you get punched with the left jab.”
Said differently, it’s hard to know where the true market risks lie or the source of the next economic headwind. But here are three places I see risk today.
What Goes Up Must Come Down
Multifamily asset prices skyrocketed more than 20% for four quarters, from the summer of 2021 through early 2022. These increases were the result of massive tailwinds: Rapidly increasing rents and cheap debt pushed cap rates to historic lows and the cost to buy multifamily communities to all-time highs.
Freddie Mac Multifamily Apartment Investment Market Index, 2017-23
Source: Freddie Mac
Since values peaked in 2Q 2022, values have eroded substantially, with multifamily asset prices down 10% through Q1 2023. During this period, insurance costs have escalated quickly and rent growth has decelerated, or even turned negative—read more about that in Origin’s new rent forecast accuracy report—resulting in muted growth in property-level net operating income (NOI). Pair flat NOI growth with higher cap rates, and values had nowhere to go but down. This is already presenting some market risks and challenges to some owners, with many more likely to come.
Higher for Longer, and Less of it
Everyone not currently living under a rock knows interest rates have increased rapidly since April 2022. As of Aug. 21, 2023, the interest rate on a Freddie Mac 10-year fixed rate loan for an apartment community was roughly 6.25% at a 55% loan to value (LTV) ratio. In August 2022, that same loan cost only 4.5%, and borrowers were borrowing 65% or even 70% LTV. Proceeds, or leverage levels, have been reduced by upwards of 20%, and rates have increased nearly 40% in 12 months.
Hundreds of billions of dollars of multifamily real estate traded hands during the period of elevated pricing noted above. Some buyers were highly levered and are beginning to fall behind on required interest payments on their loans. However, if rates remain elevated and values continue to decline, even more moderately levered buyers may begin to feel the market risks and strain to make their monthly payments. Additionally, if lenders continue to limit leverage levels and borrowers can’t support a cash-in refinance, some may have no option but to lose their assets to foreclosure or bankruptcy.
Flatlining in China
While many people don’t have full transparency into the inner workings of the Chinese economy, most would agree it’s one worth watching closely. With a 2022 gross domestic product of nearly $18 trillion, China’s economy is second only to the U.S., and more than four times larger than number three Japan. Much like the moon, there’s enough gravity in the Chinese economy to move the tide, and there are cracks in their structure that may exacerbate market risks and impact the world economy.
Top Global Economies by Gross Domestic Product
Source: World Bank
Since December 2021, the People’s Bank of China has cut interest rates five times, most recently on Aug. 21. In the U.S., Jerome Powell and the Federal Reserve are tightening the monetary environment by rapidly increasing interest rates. Why is China moving in the opposite direction? It becomes clear with a deeper dive into some of the country’s headline struggles. First, Evergrande Group, the country’s second-largest developer by sales, warned of massive balance sheet liabilities of nearly $300 billion and ultimately filed for bankruptcy earlier this month. Soon after, Country Garden Group, a $29 billion property developer based in Shunde, China, failed to repay two bonds totaling roughly $22.5 million, potentially a trigger for default. Much like the regional bank collapse in the U.S. in March, market participants are wondering who’s next in the country’s wave of real estate distress.
China’s enormous, fast-growing and opaque economy makes forecasting probable event-centric outcomes very difficult. But we can see the effects, such as the recent selloff in blue chip stocks. And while it’s possible it will continue to grow at an annualized rate of 4% to 6%, any material slowdown will have global ripple effects.
So, where are the biggest investments risks today? I’m not entirely certain, but I do know that staying vigilant in seeking the best risk-adjusted returns and being agile enough to avoid being sucker-punched will help to mitigate those risks over the long term.