For more than a decade, Brookfield had been eyeing Veritas Investments’ vast San Francisco apartment portfolio, a collection of thousands of units in small residential buildings. The Toronto-based mega-manager was almost able to buy the properties just before the pandemic. The deal fell apart.
Fast-forward four years and Brookfield finally landed its prize – but under very different circumstances. By buying non-performing first mortgages last year secured by 75 properties – a substantial portion of the Veritas San Francisco portfolio – then winning the assets at a foreclosure auction in January, Brookfield added some 2,000 rent-controlled units to its collection, making it the biggest multifamily investor in the city in a single swoop.
The purchase, at 50 percent of replacement cost and a 35 percent discount to comparable trades, has been interpreted as a harbinger for the market. “It is not just a function of capital structures being dislocated. We are absorbing record-high supply in the sector,” says Brookfield managing partner Swarup Katuri of the deal. “If people have enough liquidity, like we do, they will see very interesting opportunities.”
“Multifamily will shock some people in terms of what the losses could look like”
Scott Everett,
S2 Capital
Brookfield had been one of the largest multifamily sellers over the past three years, Katuri notes, as the firm saw an opportunity to exit at what it viewed as historically low cap rates and earn very strong returns for investors. “But today we think there is a great opportunity to re-enter the market and build our portfolio through transactions like this,” he says.
The multifamily asset class has long been considered a sure bet, as soaring rents, eye-watering construction costs and zoning challenges have kept swathes of the US and Europe chronically undersupplied in housing. More recently, however, a rapid escalation in interest rates, an influx of capital into the sector and decreasing values have threatened to upend institutional strategies and asset business plans, pushing some owners into default, some into forced sales and others into investing more capital to save their assets.
But this deteriorating capital market is also creating a rare window of opportunity for other institutional real estate managers and their investors to buy or lend on assets at cyclically attractive prices.
A sharp pivot
“Everyone’s obsessed about office, but I think generally multifamily will shock some people in terms of what the losses could look like,” says Scott Everett, founder of S2 Capital, a Dallas-based multifamily manager focused on the Sun Belt markets. “Multi is generally three times as large as office is in terms of the CLO credit – so you could see some pretty sizable dollars in distress.”
Emerging distress in multifamily represents a sharp pivot for the sector after a decade of robust returns and equally robust capital-raising volumes. Apartments in the US have outperformed all property types for 11 of the last 25 years, according to research from data provider MSCI, hitting a total return of almost 19 percent in December 2021. In the fundraising space, more than $200 billion was raised for closed-end multifamily-focused funds globally between 2013 and 2023, with the annual total reaching an all-time high of $35.4 billion in 2022, according to PERE data.
Meanwhile, multifamily investment has taken an increasingly greater share of US commercial real estate deals since 2009 – growing from just under 26 percent that year to a peak of 42 percent in 2021, according to CBRE data.
In 2021 and 2022, there was a wave of speculative apartment development in the US based on expectations of continued low interest rates and soaring rent growth. That all changed in the second half of 2022, when the US Federal Reserve embarked on an aggressive rate hike campaign many did not see coming. The rush to develop had created a bloated pipeline of apartments. Nationally, more than 500,000 units were delivered last year – a 40-year record – while another 440,000 units are set to be completed this year, according to real estate data service CoStar.
Cracks in Europe
While multifamily has been a mainstay of the US commercial real estate market for decades, the asset class remains nascent in Europe and the UK
US multifamily transaction volume is about six or seven times that of Europe, despite the latter having around double the population, according to Tom Livelli, partner at Radnor-based manager EQT Exeter.
European build-to-rent is still nascent, but cracks are beginning to show in parts, specifically in Germany and the Nordic region, sources tell PERE. More buoyant markets like Spain and Denmark are still affected by stress or distress from neighboring markets, according to Livelli. “You have Swedish owners of Danish real estate that are looking to sell because they’re stressed in their own home market,” he says.
Germany’s commercial property prices dropped 12 percent in the last three months of 2023, according to the Association of German Pfandbrief Banks. Like in the US, the residential sector in Germany has been buoyed by enormous demand for housing, but many are now caught out by the swift change in rates.
Marius Schöner, head of the EMEA residential operator division at New York-based manager CBRE Investment Management, says a big issue in Germany and the Nordic countries is that a lot of developers bought land banks for residential projects, and are now hit with interest rate hikes on land that does not yet yield anything. This will lead to more distress opportunities coming to the market over the next half a year, he says.
“We expect to see more distress in those assets which are older and are non-compliant with modern ESG criteria. For these assets, the sellers will have to accept price discounts if they would like to dispose of them.”
Supply and demand
In some areas, oversupply is reaching acute levels. In Austin, for example, development equal to 14 percent of existing inventory is under construction, per Avison Young data. Meanwhile, rent is down 5 percent year-on-year, according to the brokerage. In San Antonio, units under construction represent 8 percent of existing inventory, while rent growth has slipped to about -2 percent.
“The pace and pricing levels at which the new supply is absorbed remains a big assumption,” says Joe Gorin, head of US and European investing at manager Barings. “Many developers with debt maturities don’t have time on their side.”
S2 Capital estimates there to be $18 billion-$20 billion of what it calls “truly distressed” multifamily loans nationally at the moment. For the firm, true distress means a loan evaluated to be below the debt yield threshold, that does not allow any sort of takeout, is not covering its debt service and has a borrower it considers to be non-creditworthy.
“We’re not lumping in a large investment fund that is going to figure it out and probably find cash,” Everett says. Instead, it is highly leveraged private investors, with loans below a 6 percent debt yield, that will not “have a great path forward.”
S2 is sourcing many of its distress deals from lenders no longer willing to hold troubled multifamily assets. The firm is currently working with about a dozen lenders that see S2’s ability to operate an asset as attractive, he says. “Some of these deals that we’re looking at are 50 percent occupied – and so the lender is now struggling with [this thought]: ‘Okay, I band-aided it for as long as I can, but now the occupancy in my actual asset is deteriorating. So, the longer I wait, and the more I keep masking the problem, the more value I’m destroying.’”
Signs of stress
The pool of potentially distressed assets in the US commercial property market stood at $234.6 billion at the end of 2023 – of which multifamily makes up the largest portion at $67.3 billion – per MSCI data. “That’s going to shake out in a process that’s going to be painful for some,” says Jim Costello, co-head of real assets research at MSCI.
That pain has begun to show already, from smaller operators to some of the industry’s best-known names.
In February, an affiliate of an Ares fund reportedly took over The Gabriella, a luxury apartment building in Dallas, after it was the sole bidder at the foreclosure auction. The property has an infinity pool and rents that run north of $4,000 per month. Manager Greystar built the 378-unit property in 2020, and in 2022 took out a $127 million loan, per reports.
Steve Triolet, senior vice-president at Texas brokerage Partners Real Estate, tells PERE that the Gabriella property has experienced negative rent growth in five of the last six quarters. “They’ve had to reduce the rate for most of the last year and a half, and that’s under a backdrop where property taxes, insurance and debt costs are going up,” he says, adding that most new properties need to be stabilized within a year of completion or the owners will be forced to cut rents.
That same Ares affiliate, AREEIF Lender, in January reportedly filed an $80 million foreclosure lawsuit against an affiliate of Russland Capital, the landlord of a 199-unit apartment building at 1411 South Michigan Ave in Chicago. The lender claimed it had extended the loan’s maturity date twice until April 2023, but the bill was never paid. In the last year and a half in the same city, Barings and Atlanta-based manager Invesco have both taken multi-million-dollar losses selling apartment buildings.
Multifamily owners are grappling with distress in New York City, too. Most is concentrated in rent-stabilized properties, which since 2019 have been subject to increased regulation curtailing landlords’ ability to raise rents. Since then, defaults and distress have grown in the segment – which covers about one million apartments in the city. In February, Miami-based manager BGO sold two stabilized apartments on Manhattan’s Upper West Side for $31 million – a large discount on the $85 million the company paid in 2013, according to reports.
Proceed with caution
Before the interest rate rises, it was difficult to find cheap entry points into the multifamily sector, but late last year that began to shift, says Vik Uppal, the chief executive officer of Mavik Capital Management, a New York-based opportunistic real estate debt manager. Largely, rescue loan workouts involving strong assets with poor balance sheets are where the firm has been most active, he says.
In February, the firm worked with a borrower having trouble refinancing construction loans with permanent fixed-rate agency debt, leaving a hole in the capital stack behind an asset. Mavik provided a short-term bridge loan to stabilize the apartment building and to give the borrower more time to access agency debt or other forms of traditional financing sources.
“Nobody could have predicted interest rates would be so elevated,” says Uppal. “But that’s the environment that we’re in and for groups like us – who are specialists in restructuring and dealing with high-touch, stress and distress situations – it is leading to once-in-a-generation opportunities,” Uppal says.
Other firms are also eyeing multifamily opportunities, but proceeding with caution. “We’re going to be patient,” says Ron Lamontagne, private real estate Americas co-head at Swiss private equity firm Partners Group. “I want to make sure we’re not jumping at opportunities where we’re not seeing a deep discount to prior trades and certainly replacement value.”
The firm in September bought a multifamily property in Dallas from a manager that opted to sell the building amid cashflow issues in other parts of its portfolio. Partners Group secured the asset at a discount to pricing levels from a year ago and well below its replacement cost. The firm is selective about where it pursues distressed investments, however. “We will consider it in a high growth market, not an oversupplied market,” says Lamontagne.
In certain markets, oversupply numbers are particularly stark. In the South End submarket of Charlotte, nearly 56 percent of the inventory is under construction, according to CoStar data cited in a presentation for New York-based manager Makarora. Downtown Miami has more than 43 percent of inventory under construction.
These kinds of numbers are pushing some managers to hold off from acquisitions altogether. Crow Holdings Capital in late February closed its 10th fund on $3.1 billion – its largest yet. The vehicle has a target allocation of 35 percent to multifamily. But the manager is pausing on residential purchases, likely until next year. “We will be on pause until all that space gets absorbed, and there becomes more of a stabilized market,” the firm’s chief executive officer, Bob McClain, tells PERE. “We think it’s very early.”
Similarly, other firms that have already made purchases are adjusting to the current environment. Carmel Partners CEO Ron Zeff says his firm, which closed its eighth multifamily fund in April 2023 on $1.58 billion, has bought development sites but has delayed building for now. “We had hoped to start them this year and we’re in the process of completing the plans to get them shovel-ready,” he says. “But I don’t think they have enough margin to justify starting today.”
Pricing wars
But even so, Zeff says many sellers are not yet willing to accept a lower price for their multifamily assets – with too many investors still “buying into the Sun Belt story” and not accepting shifts in domestic migration.
What is more, buyers can still face tough competition for assets. Specialist manager Berkshire Residential Investments chief investment officer Eric Draeger expects many maturing loans will be extended, but borrowers under pressure to offload quality property will be met with scores of would-be buyers. With many firms pursuing multifamily distress, “the opportunities, when they pop up, tend not to be [at] distressed prices,” he says.
Lauren Hochfelder, managing director of investment bank platform Morgan Stanley Real Estate Investing, expects distress to be concentrated in Class B assets, largely because the buyer universe for those kinds of buildings tended to use more debt – floating rate debt, specifically.
However, she says investing in multifamily at present is not simply about snapping up discounts. “I’d rather take a lesser discount on something I actually want to own than a stark discount on something that I don’t think has the right demand tailwinds going forward.”
For MSREI, that means a focus on investing in multifamily and build-to-rent near good schools, and recapitalizing developers that built high-quality multifamily assets but are taking longer to stabilize them because of heightened supply and weakening demand.
But the window to capitalize on multifamily distress is limited, according to S2 Capital’s Everett. He expects more distressed opportunities to emerge over the next four to six months and continue for 18 months, describing the amount of time it will take for the oversupply to be absorbed into the market.
“You’re going to have concentrated distress [so] you’ll be rewarded for being the first in,” he says. “We have to flush the system a little bit.”
The shortage paradox
The US remains in the grip of a housing crisis
Record numbers of apartments are being developed, leading to oversupplied markets and stymied rent growth, but the US is still in the grip of a housing crisis.
In all, the country needs 4.3 million more rental apartments by 2035, according to the National Multifamily Housing Council. Half of all Americans are rent-burdened, meaning they pay at least 30 percent of their earnings on rent, according to the Joint Center for Housing Studies of Harvard University. In New York City, some studies have shown as many as one in three people are severely rent-burdened, which means at least half their money goes to their landlord.
However, in the main, new apartment supply has been in the top end of the market, leading to a glut of pricey units, when the major need is for mid-tier and affordable housing, Partners Real Estate’s Steve Triolet says.
“The complicated theme impacting both of those is there’s a need for affordable housing,” says Brad Werner, leader of consulting and accounting firm Wipfli’s construction and real estate practice. “If [landlords] want to have positive cashflow on these assets, they probably need to be able to figure out how to more aggressively increase rents, which doesn’t help with the affordability problem.”
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