World Events
A few key events always become defining moments in any given year. In 2023, we saw some real defining moments.
For the first time in almost 70 years, there was a coronation in England, spy balloons were shot down over the U.S., devastating earthquakes hit Turkey, and conflicts in the Ukraine and Israel were just a few of the notable events.
Some of the biggest news from financial markets centered around the explosive growth of AI, the trial of Sam bankman-Fried, a banking crisis, and the resilience of the U.S. economy (more on the last two later).
Within real estate, the news focused on a lack of affordability, decades-high interest rates, and declining sales volume. By the third quarter of 2023, multifamily sales volume was just under $90B – far below the $251.9B mark from the same quarter in 2022.
As we close out the year, Lennar (LEN), the second largest home builder in the U.S., is considering a sale of more than 11,000 apartment units that could fetch the company $4.5B.
The apartments are operated by Lennar’s luxury multifamily development subsidiary, Quarterra, which reported a $12MM operating loss for 2023.
Quarterra is far from the only company that has faced headwinds in the multifamily space over the last year. Through Q3 of 2023, nationwide multifamily sales declined by 61.9%, and per-unit pricing has dropped 7.8% over the course of the year.
High-end apartments face some of the greatest challenges with rising operating costs and softening rents. Oversupply is a significant concern, with 70% of the estimated one million apartment units under construction classified as high-end.
Lennar’s actions are representative of market sentiment, but without turning this into a case study in the academic sense, let’s take a moment to review 2023 and get a glimpse of where things could be headed in 2024.
The Market in 2023
It is no secret that 2023 was far from a banner year for the multifamily sector or any other commercial real estate sector. The year started with predictions of a looming recession, continued economic uncertainty, and the Federal Reserve executing an aggressive monetary tightening policy.
The banking crisis started with Silicon Valley Bank on March 10, 2023, and 48 hours later, Silvergate collapsed. On May 1, California banking officials took over and closed First Republic Bank. The rapid collapse of the three banks triggered a decline in global bank stock values and created fear of a pending banking collapse. The Federal Reserve and a consortium of financial institutions stepped in to shore up consumer confidence.
Even with the banking system’s stability in question, the Federal Reserve continued its tightening policy. By the time the Fed hit the pause button, the Federal Funds Rate was 5.25% to 5.5%, which has remained since July 2023.
Banks that had already started pulling back on lending contracted even more. As liquidity came out of the system, the already slowing multifamily market slammed on the brakes. After the buying frenzy of previous years, markets came to a virtual stop.
The banking industry alone was not responsible for the slowdown. An inverted yield curve, higher borrowing costs, and a seller-buyer pricing divide were other significant factors impacting transaction rates.
CoStar’s Commercial Repeat-Sale Indices measure market liquidity through several data points. The most recent report (November 2023) showed that the sale-price-asking-price ratio widened to 93.2% in October, and withdrawn listings jumped 1.9% to 25.8%. For context, a sale-price-to-asking-price ratio of less than 100% indicates that properties are selling below the asking price – in this case, almost 7% below the asking price.
Ownership and Developer Challenges
There has been a lot of talk about a pending “wave” of forced sales and foreclosures in commercial real estate. While the “wave” hasn’t materialized, owners face many challenges.
Inflation, a strong jobs market, and the lingering effects of the pandemic have pushed up labor and material costs. The price for construction materials spiked during the pandemic, pushing up 19% on average, and, according to Gordian, those prices have remained elevated.
While operating costs have gone up, rental rates have softened, and vacancies have trended up. In November of this year, rents increased 3.3% year-over-year compared to the 8.4% growth in November of 2022, well down from the peak growth rate of 16.2% in February of 2022. As for vacancies, from a low of 4.71% in 2021, they have now worked back up to 7%.
Workforce units have fared better than luxury as more and more buyers are forced out of the housing market. The 30-year mortgage rate peaked in October at 7.79%, and the median sales price increased to $365K. With the cost of homeownership out of reach for many Americans, they were kept in the rental market. This kept occupancy and rent growth stronger in Class B and C segment of the market.
Not All New is Bad
Rent growth, which has been steadily declining since Q2 of 2022, has begun to stabilize. Growth is still well under 2% nationwide, but Q3 of 2023 marked the first positive change in over a year.
Vacancy rates, which have been climbing since Q3 of 2021, have stabilized over the last two quarters and are now holding around 7% nationally.
Across the industry, mortgage rates have begun trending down. Freddie Mac’s commercial rates have dropped several times over the closing months of 2023, and barring a black swan event, rates are expected to continue their downward trajectory.
Lending standards are still stringent, with many lenders requiring either an existing relationship or significant cash deposits to consider originating new commercial loans.
What to Expect in 2024
The big news for 2024 is the expected rate cuts. Some Wall Street experts expect the Federal Reserve to cut rates up to six times in 2024. Since the Fed typically moves the overnight rate 25-basis points at a time, that would mean a drop of 1.5% in 2024. The last time the Fed cut rates that quickly was in 2020 by dropping the rate from 1.75% to 0.25% (effectively 0%).
While that may seem like a bold prediction given the last two years of economic news, it is not without precedent. A 4.0% rate would be welcome news for the borrowers since the Federal Funds rate is a benchmark for many commercial lenders.
Assuming the cost of borrowing will decline over the year, we will likely see transaction volume start to inch its way back up. There is no reason to expect the same frenzied buying seen at the decade’s start, but slow growth is likely.
As lenders grow more comfortable with market conditions, they will begin to relax lending standards, and the market will start to move again. Inventory and pricing will likely remain unchanged throughout 2024.
Investors will remain cautious in their underwriting, and sellers will likely try to hold out for higher prices to come back. This will keep the buyer-seller price divide a factor in 2024 and cap market activity.
We Want to Hear from You
When markets are in transition, it is essential to have expert help on your side. With decades of lending commercial mortgage experience, Sweetwater Capital can find you the right loan product for your purchase or refinance. Our Investment Sales team has continued to close deals even as the market has slowed. Sweetwater Property Management has kept revenues up and operating costs down for our clients. Reach out to any of our skilled brokers to see how we can help with your commercial real estate needs.
Writen by Don-Carlos Moniz, Investment Sales Broker with Sweetwater Capital
