Joel Kraut has been expecting this for a while now. The co-founder and managing director of BRRRR Loans says that the multifamily housing sector — one of commercial real estate’s most successful investment areas — has overbuilt around some of the major metropolitan areas of the U.S., a signal of the unthinkable: The apartment boom may be slowing down.
To get his take on the market, Scotsman Guide caught up with Kraut recently while he was on a visit to the Dallas-Fort Worth area. He’s been a skeptic of the fast-paced growth in apartment complexes and says it was apparent that one of the capitals of the Sun Belt growth movement was beginning to see some stumbling blocks.
“That’s going to be an interesting situation where the rubber meets the road. How many people have the money to resize their loans?”
– Joel Kraut, co-founder and managing director, BRRRR Loans
Like many major cities, the Dallas area has been building multifamily properties as fast as possible to meet the growing population demands. It is estimated that between 2010 and 2019, nearly 687,000 people moved to the Dallas-Fort Worth-Arlington metro area. But even with that growth, Kraut says apartment rentals are slowing down and landlords are beginning to have trouble renting at the prices they need to make the cost of these new buildings pencil out.
“They aren’t breaking price on rent, but instead are giving one month free or two months free for a 12-month lease, so it doesn’t affect their continuous rental (income),” he says.
This may seem like a small thing — a mere blip on the screen that will pass next season — but it links to much larger problems that loom on the horizon for commercial real estate. The latest wall of worry for the mortgage finance industry to climb is a major refinancing risk that is coming. But this potential new crisis is not in the office sector, which has its own seemingly endless set of woes. This refinance problem is in the once bulletproof multifamily sector.
The recent regional banking crisis has raised worries about the commercial real estate sector’s ability to refinance maturing loans. Data provider Trepp reported this past April that an estimated $940 billion in multifamily loans are set to mature in the next five years, with banks accounting for $344 billion of this total. Trepp notes that the only other commercial property type with more bank loan maturities during the same period is office, which is expected to face approximately $400 billion in maturities. Across securitized debt, a total of about $82 billion in multifamily loans are scheduled to mature this year and next.
Although multifamily has done very well in recent years, many developments were financed during a low interest rate climate. Even then, many developers were counting on rents and property values to keep rising in order to cover the costs of refinancing.
But if apartment rents slow or decline, and properties lose value, then developers may find themselves squeezed while trying to refinance debt deals that no longer makes financial sense. A few casualties have already appeared, including Applesway Investment Group, which lost four Houston apartment complexes to foreclosure in April. According to The Wall Street Journal, most of the company’s loans to buy the properties were originated in the second half of 2021, just before the Federal Reserve began raising rates. At least two of the properties were financed with about 80% debt while the interest rate on at least one loan rose from 3.4% to 8%.
This type of problem is certainly more of a worry in the office sector, where the market has already seen a number of high-profile properties go into foreclosure as borrowers walked away, either unable or unwilling to make loan payments. But it could become more common for apartments if the rental market continues to cool down.
Real estate analytics firm Green Street estimates that apartment values have dropped by more than 20% from their recent peak. At the same time, rent appreciation is slowing. Apartments.com reports that rents increased 2.5% year over year in first-quarter 2023, down from 3.8% annualized growth in the prior quarter. The company also reported that more than 1 million units were under construction at that time, with supply likely outpacing demand. Each of these factors seem to lead to a market that is about to put the squeeze on borrowers seeking a refinance.
“I think you are going to see a lot of foreclosures,” Kraut says. “As rates reset on some existing newer properties and the groups that raised the money for those properties come back to make deals two years later, they will find things have changed dramatically and the math doesn’t add up.”
Kraut doesn’t expect the foreclosures to be a major crisis for the mortgage industry. But he does think that the next 24 months may present an opportunity for certain lenders willing to fund deals. With debt-service-coverage ratios and debt yields on these loans being difficult to support, many owners and operators will be forced to bring fresh capital to the table to reset their loans.
“That’s going to be an interesting situation where the rubber meets the road,” Kraut says. “How many people have the money to resize their loans? Some clearly will — but not a lot.” ●
