Another Part of Commercial Real Estate Is in For a Reckoning

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1:27Hello and welcome to another episode of the Odd Lots podcast. I'm Joe Weisendorf. And I'm Tracy Alloway. Tracy, when it comes to real estate troubles, you know, one surprising thing is, I guess, how strong the housing market has remained this year despite the rate increases. When people talk about troubles in the real estate industry, though, it's mostly the conversation has been on commercial real estate. Yes. And actually a specific segment of commercial real estate. So for obvious reasons, everyone has been very focused on what's happening to office properties. You know, the whole work from home trend means there's less demand for offices, ostensibly.

2:09Meanwhile, higher interest rates are increasing expenses. And so that has been the predominant area of attention. But of course, there's also the forgotten, I call it the forgotten commercial real estate, which is actually multifamily residential, which counts as commercial real estate technically. Right. Totally. And we talk about residential and we often talk about it in terms of just single family homes and what's happening to home prices specifically. And of course, that's a huge part of the real estate industry and where people live. And we talked about this in September, I think it was, with Julia Coronado.

2:46One other big thing that's happened over the last several years is just this incredible boom in apartment buildings, multifamily dwellings, particularly across the Sunbelt. Yes. So I remember this sort of 2020, 2021. There's just staggering amounts of construction of multifamily properties that were intended, I think, primarily to be rented out in super popular areas of the country like Texas or Arizona, places like that. And of course, since then, my understanding is that we've obviously seen an increase in interest rates. We've also seen or started to see a decline in rents. And so your cost of financing is going up while your income from rentals is actually going down.

3:35That seems like a bad combination. Right. So a big question is like, who are, I guess, the bag holders? Or maybe that's a question. Or maybe that's when or how heavy is that bag? because presumably, no one anticipated this surge in financing costs. No one really anticipated the surge in inflation, construction costs. And rent growth had been one of those things that just went up and up. It went wild during 2020, 2021, 2022, one of the most dominant drivers of inflation overall. But supply and demand seems to be a real thing. And it seems as though with this incredible boom in supply that we actually have seen some softening in rents.

4:20Here's hoping. This is where we have to caveat that we never actually see the softening in rents. None of us will ever have rents cut. It's like a mythical unicorn. I have heard that rents go down. I have yet to experience it. Actually, I just got my new lease agreement offer. How much? I'll just say it's gone up, Joe. Okay. Let's put it this way. charts exist on the internet that show the line going down the other direction whether those charts are actually reflective of anyone's reality that's a separate question but i have seen charts that at least in some cities again probably more sunbelt boom cities austin nashville atlanta that rent prices have gone down okay i've seen the charts okay i i too have seen charts okay let's uh Let's keep going.

5:12Well, so then the question is, what is really happening in reality? And we sort of got to get a temperature check on, okay, if rents are going down unexpectedly, supposedly, if all these things have caught the industry by surprise, how big is that bag? Who's holding it? And how much trouble could it be in? And I think we have to have this conversation because, again, so much of the convo and the discourse has been about office. It's all offices, all the time. So now we turn to the, again, the forgotten corner of commercial real estate. Well, I'm very excited. We have the perfect guest to discuss it, someone with a lot of experience in the multifamily world.

5:50We are going to be speaking to Lee Everett, head of research and strategy at Waterton. It's a multifamily investment manager. It's been around since 1996. So Lee, thank you so much for coming into the studio and coming on OddLots. Thank you very much. It's a pleasure to be here. Who are you and what is Waterton? And I just asked at the beginning because I figure listeners might want to know why we're talking to you. My name's Lee Everett. As you stated, I've been in the industry now for roughly 20 years, the entire time focused on the residential sector. And I've touched everything from senior living to multi to single family.

6:25And primarily, I've spent that time advising internally or externally as a consultant, C-level executives on the multifamily sector. Today, I head up research at Waterton. That's a multifamily investment advisor with about 15 billion AUM today. We operate in the top 30 markets in the US. We're primarily a value-add shop. So we're buying, improving, selling homes. Our funds are primarily closed-end funds. So it's a controlled hold period and a controlled time. You mentioned research and you also mentioned that you were a consultant. What are the kind of things that you're hearing in the market right now?

7:05I think it's dark days in general for a lot of the market right now. And it's primarily been driven by a capital markets event that we've never experienced in this industry. I tend to think that we're going to end up seeing the 21 and 22 vintage, which was the largest transaction volume years on record for multifamily by huge amounts, end up one of the worst vintages in the history of our industry. In 2021, in the fourth quarter alone, over 150 billion in apartments transacted. Wait, sorry, which quarter in 2021? Q4. Okay. Over the course of the year, over 300, almost 400 billion transacted. To put that in perspective, the previous high in 2019 was under 190 billion for an entire year.

7:55Whoa. So capital came into the space like we've never seen before. Now, this capital entrance, it was primarily driven by two things. The rent growth that you both have alluded to earlier, what we saw that year was over 700 ,000 renter households form in the US. That is over two and a half times the prior record. And as such, we ended up with rent growth that pushed over 15%. Some markets, Phoenix, other Sunbelt markets, you saw rent growth on new lease turns coming over 20 and 30 percent pretty consistently. And what was really crazy about this was there was a massive spike in renter incomes.

8:34So these rents were relatively affordable as incomes were actually rising quicker than rents at this period. Was that driven by people moving into the area and maybe doing more work from home and bringing higher salaries with them? In many instances, yes. That's what would primarily drive the large renter income increases in, say, Las Vegas, where you're getting some LA people that may not have been as wealthy there coming into a market where your median income is like$60 ,000. $80 ,000 is a lot wealthier relative to the median in Las Vegas. It also was driven by, frankly, a lot of household fractionalization that was pent-up demand.

9:13You had people losing roommates. You had people moving out of their mom's house that had been there for a long period of time. I mean, being frank, in 2021, we had working age population losses as a country while we were generating all of these households. So the explosion in the labor force allowed people to form households both as millennials that hadn't, and this filled a lot of the suburban product, the single family rental product and such, and Gen Z backfilled the city at an incredible rate. This wasn't like the millennials coming out of the GFC where everybody had three and four roommates.

9:46Gen Z was living one, maybe two roommates at the most, and a ton of them were able to live alone in our major cities. And that just drove demand that we'd never seen. Real quickly, say the numbers again for 2021. What was the total for that year? The total transaction volume? Yeah. It was between 350 and 400 billion. And the previous high, 2019, was 190, is it? Yeah, it was around 190. And when you say vintage, that's a very specific, or I think of it as a specific term related to CMBS, so commercial mortgage-backed securities. So is the suggestion that the financing for these multifamily properties was bundled and sold off as bonds?

10:28It was bundled, but primarily as CLOs, which I think we're going to need to get into because that's sort of the other side of the coin here was at the same time we had this vintage first off. What I mean by that is deals that traded in that year or were purchased in that year. And you had basically a half a trillion dollars trade between the beginning of 21 and the middle of 22. That vintage is everything that traded over that period. And while you had these soaring fundamentals I spoke about at the same time, SOFR was zero. The 10-year was zero to one. So financing was so easily available, you had people enter the space that had never been in the space before.

11:11They were projecting massive revenue growth and they were able to buy at very low yields because of the low financing costs. Now, what were those low yields? Cap rates in the space got down to, say, in Phoenix. Two, for 1970s and 80s vintage product that wasn't ideally located, you were looking at a 3.5 % cap rate.

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12:31Here's a paradox. We buy insurance for peace of mind, yet the very policies we trust can deliver the biggest financial shocks. Across America, millions of claims are denied every year, not because people did anything wrong, but because policies quietly excluded the things that happened. The psychology of trust tells us we assume the contract is fair, but in insurance, the information gap is massive. The insurer knows every detail of what's covered. The policyholder rarely does. That's where My Policy Advocate comes in. For just 27 cents a day, their platform reads your policies and shows you in plain language where you're vulnerable.

13:06They're not selling insurance. They don't do that. It's about transparency, giving ordinary people the same understanding insurance companies have had for decades. Because when you know what's really in your policy, you can plan, protect, and avoid surprises. Before you trust your policy to protect you, let My Policy Advocate tell you what it really says. Visit MyPolicyAdvocate.com today. Peace of mind starts with knowing the truth. MyPolicyAdvocate.com Can you just remind me cap rates? It's like an inverse of PE, right? Yeah. So maybe this has changed. But from what I remember, less than 5 % was considered pretty good, not that risky.

13:45And more than 7 % is kind of bad. Is that right? You're backwards. Am I? So the higher the cap rate, the higher your income to price ratio is. So it's NOI over price. And the less NOI you have over price, essentially, the more risk you're taking on in the deal because you're relying far more on value to be driven by price growth rather than NOI growth. And when you're buying at, say, a three and a half cap, a not ideally located property, you're very much relying on that income to price ratio staying the same or declining, especially if you're doing so with interest rates that are around 2%, which is what you looking at at that period in time for short-term floating rate debt, which is what really flooded the space.

14:36And this is what's become what fed these CLOs that have grown. So there's all kinds of, got a million questions already, but why don't we actually, just since you talked about the financing structure, short-term floating rate debt. So Tracy and I have done a number of episodes on credit and the looming maturity wall for corporation. I know Tracy insists I say looming. But in the case of this, this has to be refinanced very quickly. Talk about this sort of, okay, someone does a deal. What are the terms? When do they have to pay it back? How does that work? So these deals were primarily financed by debt funds.

15:16And what ended up happening was they were issuing what's called bridge loans. These bridge loans were meant for people who entered the space to be able to buy a property with floating rate high leverage. By high leverage, I'm talking 75 to 80%, sometimes even higher. Now, when you're buying floating rate at a 225 interest rate handle with 80 % leverage, your returns look really good until that floating rate debt starts to move upward. And what we've seen today is a 500 basis point increase in SOFR since that debt was done. So you're looking at 5 % higher interest rates. The fundamentals that were there in 21 are no longer there.

15:58So you have declining NOI. And as such, what you've seen is these bridge loans that need to be refinanced in 23, 24, and somewhat in 25, they don't pencil anymore. You were essentially to get this debt writing to a debt service coverage ratio in 21 of about 1.25. And that's how much your income can cover your debt. Today, because of increase in debt costs, decreases in net operating income, and increases in other expenditures such as insurance, some of these buildings are looking at a debt service coverage ratio below 7. And that's very common. And that means these buildings can't pay their debt.

16:37And this is a mounting wall. I think in 24, we're looking at about$34 billion in CLOs that are going to need to be refinanced, another 12 in 25, and we've got another 7 to 9 to get through this year. Wasn't the original pitch, okay, so sure, these are financed with floating rate loans. So if interest rates go up, the cost of that financing is going to go up and put stress on the property itself, but wasn't it supposed to be able to raise rents to offset that? Yes. And some properties did, many did, but ultimately people started to project rent growth to continue for longer than was rational. As I sort of described earlier, we had this household formation explosion in 2021, but ultimately what that was, was it pulled some demand forward from 2022, and the massive apartment supply wave began to come to market in 21.

17:36And then on top of that, even if you raise rents today, insurance costs have gone up in such a way that it's deeply, deeply impacting the market. You're looking at renewals right now costing 30 to 50 % additional every year. I've heard quotes of$3 ,000 a unit to insure in Florida right now, over a thousand in Texas. So you have massive increases on the cost side, massive debt increases that were never underwritten for, and rent growth that you achieved some of, but you're not going to achieve in the longer term. Particularly with the nature of this product, a lot of it in markets like Phoenix was bought by syndicators, new people to the space, social media sensations, fundraising on LinkedIn, and people such as that.

18:22This is like real estate TikTok. Tracy, I was going to say, it's been one of our recurring jokes over the year on the podcast. Like, what if we get into trucking? What if we get into this? It sounds like a bunch of people took that joke literally and said, what if we get into X? What if we became landlords? Yeah, what if we became multifamily landlords in Phoenix? Can I just say right now, I have no desire to do that ever. No, God, me neither. Well, and I don't think these people really had that desire either. Their ultimate goal was to flip these apartment buildings. They wanted to buy them, renovate them, use the bridge loan to get through that period, and then sell it to someone that would then use agency, Fannie or Freddie financing to hold the building long term.

19:02And whoever they sold to, they planned on being the true operator. Now, a lot of these people that have no operating experience and entered the space are stuck being landlords and they really aren't necessarily sure how to do that. So that's also hurting the revenue side. You have to have economies of scale, experience, vertical integration and such in order to be a landlord. And those structures don't exist at a lot of this new capital that entered our space. Can I just ask, you know, we're talking about all the various calculations that go into underwriting one of these things. So insurance cost, the cost of the actual money to build or buy the property, expected rental income, things like that.

19:45How do people normally make those estimates or like what kind of data do they use to make presumably, again, in normal times, like rational forecasts for what all those moving parts might look like? And then I guess to your point about the oddity of 2021, 2022, what were they looking at then? Right. So first off, I think there was a lot of faith in the sector and lower for longer. Too much faith, frankly, I'd believe. And now if you believe in a soft landing and higher for longer, that's a very painful transition. And the reason that's such a painful transition is cap rates or your yields historically have had a 200 basis point spread to the 10 year.

20:35So normally, the risk-free rate should be at a discount to a real estate rate. And that held when SOFR was zero and you were buying at a three and a half cap rate. Today, in order to buy with a 10-year even at 4.3 as it is today, historically that would tell you your going in cap rate should be a 6.3 and your exit cap rate should be even higher than that in order to be conservative. Those metrics really don't work for what was bought in that vintage. But today you want to go into a not have negative leverage. So you need to be able to afford your debt. That's where kind of that 200 basis point spread comes into play.

21:16You want to be conservative based upon long term history, supply demand balance, population growth and all that. You want to look at that as you get into rent growth. Expense growth has become much harder to peg. So you want to be as conservative as possible there. And a lot of the longtime players understood this and were frankly priced out of a lot of deals over 21 and 22 because of this. Now, what also happened back then was when you have 20 % rent growth, people just plan on raising rents for 5 % a year every year after they mark to market to that 20%. So I think it was a lot of looking at recent history instead of long-term history.

21:55It was a lot of denial about interest rates that today we take into account in every underwriting model. And frankly, again, the more experienced players were, but the newer capital didn't really understand that at the time. So the relationships of spreads, population growth, and supply demand were all just distorted and they've come a lot clearer now. But even today, as you model that, people don't want to feel the pain on the sales side. So you have a massive bid-ask spread still in the market today. That's why transaction volume, I gave those huge numbers before. Last quarter, transaction volume was only$30 billion, which is almost as low as it was at the bottom of the pandemic.

22:35What happens when inexperienced operators are stuck holding the bag and have to be landlords? Well, if they can't afford the property, they give the keys back. And that's where a lot of, I think, pain is going to be felt in this sector. There's a lot of debt fund, CLO issuances out there. And if the debt service coverage ratios don't pencil today, they aren't going to pencil any better tomorrow, barring a major recession, resetting rates, which ironically would be probably the bailout for the sector at this point in time. And but actually, that's in your view. I mean, because the downside of recession is job laws and people not being able to pay the rent.

23:17But in your view, the greater stress is actually on the financing side rather than the rental income side. Absolutely. And I think these debt funds are going to end up holding the bag. One of the largest ones out there, I think I saw issued 14 billion in debt over that period. I'm discussing, today the book value on that's already in the low nines. And that's not using the most true current market data and some of the more sort of down projections you're seeing, because rent losses are occurring in some places, such as Austin and places such as that. And those sort of losses are just going to continue to grow over the next couple of years as the supply works its way through the system.

23:59This is what I wanted to ask, actually. you mentioned mark to market earlier. How often are these loans mark to market? And again, like what are the sort of numbers that are going to feed into that? So initially when I was talking mark to market, that was on the rent side. And that's something that doesn't happen that often, but everybody was buying buildings in 21 and essentially assuming they could immediately raise the rents by 20 % marking them to market. Now on the debt side, they aren't mark to market nearly as quickly as you'd like. Even on the valuation side, I think your cap rates are moving upward way more slowly than you'd expect.

24:42On the bank side, there's a lot of mark to market left to happen. And I guess the roundabout way of answering your question is it's happening, but not nearly quickly enough. On the debt fund side, it's going to mostly happen as these workouts happen, as these refinancings happen, and as this debt comes to in this wall of maturities. And the wall of maturities is real on this short-term debt. They're going to be able to extend somewhat, but these people that couldn't afford interest rate caps, that didn't have the reserves for it, that debt's going to mature and it's going to hurt.

25:31Here's a paradox. We buy insurance for peace of mind, yet the very policies we trust can deliver the biggest financial shocks. Across America, millions of claims are denied every year, not because people did anything wrong, but because policies quietly excluded the things that happened. The psychology of trust tells us we assume the contract is fair, but in insurance, the information gap is massive. The insurer knows every detail of what's covered. The policyholder rarely does. That's where My Policy Advocate comes in. For just 27 cents a day, their platform reads your policies and shows you in plain language where you're vulnerable.

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27:19Brokered services for U.S.-listed registered securities, options, and bonds in a self-directed account are offered by Public Investing, Inc., member FINRA, and SIPC. Crypto trading provided by XeroHash. Complete disclosures available at public.com slash disclosures. What's the catalyst for a lot of these to take losses? Is it like eventually they have to mark to market, although I'm still unclear what the trigger is for having to do that, or eventually they have to refinance and maybe they can't get the financing. Is that the thing that starts sparking losses? Because otherwise, as we've seen for the past year or so, it feels like they could just sort of string it out for a very long time.