Are multifamily residence projects in trouble?

by Zain Jaffer

According to a July 2024 New York Times article, many residential multifamily apartment projects are at risk of developer default, particularly in the South and Southwest United States [https://www.nytimes.com/2024/07/04/business/apartment-multifamily-loans-trouble.html]. The NYT article reports that analysts they interviewed said that as much as twenty percent of multifamily projects in those areas are at risk.

During and after the pandemic, there became a trend for people to move to less dense urban centers outside of the bigger cities like New York, Los Angeles, and other areas. The ability to Work from Home with high bandwidth video technologies like Zoom and Google Meet, as well as less need to report to big city offices, and a desire to spend more time with families, pushed this trend.

This migration has however slowed down especially since the pandemic is becoming a distant memory. In its place however are a lot of multifamily projects that were started in anticipation of the demand at that time.

When there is less demand and thus more vacancies, needless to say the property rental income goes down. It probably will not go to zero since shelter is not really a discretionary expense. We need places to live in, and these days houses are expensive [https://fred.stlouisfed.org/series/MSPUS].

The banks and the investors themselves typically look at metrics like Cap Rate, Debt Service Coverage Ratio (DSCR), Loan to Value, and others which measure how viable the project is financially, and also a developer debtors ability to pay back the loan [https://www.stessa.com/blog/10-real-estate-investing-metrics/].

The Fed rates hikes have not helped. It went from 0.1% in March 2022 to the current July 2024 rate of around 5.4% [https://fred.stlouisfed.org/series/AMERIBOR] to arrest the high inflation that resulted from the massive cash injection stimulus into the economy during the pandemic.

Developers who were previously locked into low interest rate loans are now faced with renegotiating at the higher rate. Plus the benchmark ten year US treasury bond, which is a major basis for approving most real estate projects, still delivers a relatively risk free annual yield of above 4% [https://www.cnbc.com/quotes/US10Y]. When the ten year yield goes up, it reduces the number of big investors who will put money into riskier projects.

So given the fact that the rental property is making less income because there are less renters (or apartment buyers), and the developer is faced with a higher loan interest rate, that is definitely a problem.

However, in my opinion, this problem will work itself out in the future. Sure many developers may be in trouble, but banks also do not want to foreclose quickly. They already have too many problematic Commercial Real Estate (CRE) assets on their balance sheets, and they will find a way to renegotiate longer and easier payment terms with their developer debtors. In addition, huge property developers and investors are always on the lookout and in many cases may make an offer to buy out distressed or foreclosed properties if that area is a place they want to invest in [https://finance.yahoo.com/news/us-commercial-property-crash-set-103000002.html?fr=sycsrp_catchall].

Unlike office properties (particularly those in the B, C categories) which are problematic because of global strategic shifts in the way we work from home given high bandwidth videoconferencing, economic business recession risks, and the threat of Artificial Intelligence (AI), shelter residences are a basic non discretionary need. Unless we want to become homeless on the streets, we will pay to buy a home or rent one.

Besides, as indicated by Fed Chairman Jerome Powell in his July 2024 testimony before the US Senate and House finance and banking subcommittees, inflation seems to be going down [https://www.reuters.com/markets/us/feds-powell-before-congress-could-show-developing-case-rate-cut-2024-07-09/]. Although has not yet (as of July 2024) reached the Fed goal of 2%, it seems to be getting there.

Although we do not know when exactly, if the Fed cuts interest rates in time, then these developers may just decide that lower debt servicing payments are doable and they will not need to foreclose and just bite the bullet until the demand goes back up.

Unlike office properties, residential properties are a basic need. Sure we may overshoot the supply from time to time but then populations grow and new buyers and renters want and need that existing shelter space, so it will sort itself out.