FireSide: Multifamily—A rental health check-in

In a new episode of FireSide, Robert Hoffman and Andrew Korz take a deep dive into their outlook for the rental market.

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September 18, 2023 | 23 minute read

About this episode:

“The Phillies just finished up a series against the LA Angels. We got to see Shohei Ohtani play. He’s the first player since the 1960s to play as a true two-way player and the first one really to do it well since Babe Ruth. Unfortunately, he recently tore the ulnar collateral ligament in his pitching elbow. He can still play, he can still hit, but he can’t pitch until he gets significant surgery and there’s no way that this isn’t affecting his ability to hit for power.

And that’s how I see the CRE market right now. The market is clearly not operating at full potential here.”

–Andrew Korz, Investment Research

The U.S. commercial real estate (CRE) market has come under pressure from rising interest rates and an uncertain economic outlook. The multifamily sector has experienced what feels like a full market cycle in the span of just three years. With uncertainty swirling around the CRE space, Robert Hoffman and Andrew Korz take a deep dive into their outlook for the rental market.

Transcript excerpt:

Rob Hoffman:
Welcome back to FireSide, a podcast from FS Investments. My name is Robert Hoffman, and today we’re going to focus on a part of the market where many of us have some personal experience, multifamily apartments. From my perspective, having previously lived in New York City for the better part of 15 years, I certainly have my own personal experience with renting, both positive and negative, especially considering New York. It’s got some unique challenges, but joining me to provide some market expertise is our director in charge of real estate inequities. Andrew Korz. Hey Andrew, how’s it going?

Andrew Korz:
Hey, I’m good. How are you?

Rob Hoffman:
Good, good. So, you recently published a new research note on the multifamily sector titled “Multifamily: A rental health check-in,” and I think it’s a fascinating sector to focus on today. On one hand, mortgage rates are sky high. For many of us that weren’t looking to buy a home in the early eighties, it seems crazy to lock in seven-plus percent on a 30-year mortgage, but that’s where the market is. That alone would seem to be a huge factor benefiting the multifamily sector. But on the other hand, multi prices have actually seen some of the largest price declines coming off the post COVID boom and commercial real estate prices. So let’s try and make some sense of all of that. Let’s do it if we can, maybe before diving into multifamily, provide a bit of a broader backdrop on the CRE market. How is the market overall right now, deal volumes, pricing before getting sector specific? Is the market healthy?

Andrew Korz:
Yeah, so I’m going to start this off with a nice sports analogy here. So, we’re sitting here late August, we’re getting towards the end of the baseball season, and the Phillies just finished up a series against the LA Angels. We all got to see Shohei Ohtani play. I’m sure you know who that is. He’s pretty clearly the best player in baseball, first player since the 1960s to play as a true two-way player, both the pitcher and a hitter, and the first one really to do it well, since probably Babe Ruth, unfortunately, as I’m sure a lot of you have heard, he recently tore the ulnar collateral ligament in his pitching elbow. Now he can still play, he can still hit, but number one, he can’t pitch until he gets pretty significant Tommy John surgery. And secondly, there’s almost no way that this isn’t affecting his ability to hit as well and specifically to hit for power.

Andrew Korz:
And that’s sort of how I see the CRE market right now. The market is clearly not operating at full potential here. Deal volumes are down around 33% compared to pre-Covid 2019 levels. If you look at the office sector, which obviously has some unique challenges, it’s down about 65% versus 2019. Property values, which you mentioned are down anywhere from five to 15 or 20% depending on the sector. And financing, both on the equity and on the debt side has gotten harder to come by. And I think just like with bot’s elbow, I think there’s a very clear culprit here that has  the market of a lot of its strength and its momentum. And that’s the interest rate backdrop, which we’ve talked about a lot on this podcast. And in our research pieces, you’ve kind of gone from the lowest financing costs in history really to the highest in over 15 years in a one-and-a-half year span.

Andrew Korz:
And that’s really introduced a lot of friction to the market. Investors have had to really adapt to that new environment. I think the most important thing here though is that Mr. Otani, the market is not on the injured list right now. You’ve still got resilient fundamentals in most sectors when you look at the consumer helping to drive strength in retail and hotel. Obviously, we know about industrial multi we’re going to talk about here and office is kind of in its own category. You still got capital out there that wants to be deployed into opportunities. It’s just going to take some time; I think for the proverbial elbow to heal here for the market.

Rob Hoffman:
Yeah, wow. All right. I’ll have to figure out if I can work some more sports analogies in throughout this episode.

Andrew Korz:
I figured we started off light.

Rob Hoffman:
Well, let’s see. So, in terms of size, just how big is the opportunity for real estate overall? And obviously we’re going to spend some time talking about Multi. It would strike me that Multi is maybe the largest sector within commercial real estate. Is that the case?

Andrew Korz:
Yeah, it kind of depends on how you look at it. It is the largest sector over the past, call it three to five years. It’s pretty consistently accounted for about 40% of the transaction volumes, which are obviously easy to track because it’s money changing hands. We can track those things. It’s a little bit more challenging to track in terms of just the stock of value. Different people have different sort of measures for how large the commercial real estate sector is. I’ve seen anywhere from $15 to $20 trillion thrown around. It’s probably somewhere between 15 to 25 or 30% of the overall market. So, if you take all the different sectors, the major sectors plus sort of the alternative sectors that we talk about, it is pretty far and away the biggest sector in terms of either overall value and probably more importantly for what we’re talking about transaction volumes. And I think it’s also unique in CRE terms because it’s sort of like Maslow’s hierarchy of needs. It’s sort of at the bottom of that pyramid. It’s along with food and sleep, shelter is sort of a core necessity for people. And because of that, consumers are really going to prioritize rent payments over a lot of other, call it discretionary goods and services. And this has traditionally made multifamily among probably the most defensive and resilient property sector when we have times of economic uncertainty.

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Andrew Korz, CFA

Executive Director, Investment Research

Robert Hoffman, CFA

Managing Director, Credit Wealth Solutions

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