Real estate
Real estate

Opportunities in the U.S. multifamily housing sector

March 5, 2024
Arthur Jones
Senior Director, Global Research and Strategy
Vance Voss
Managing Director, Portfolio Management

There is potential distress in the U.S. multifamily housing sector today. Overdevelopment, lower transaction volume, and declining values have characterized the market over the last year. Through 2025, those stressors will persist, including excess supply still in the pipeline, exacerbated by a wave of maturing multifamily loans.

Despite the potential distress pressuring existing multifamily owners, the underlying macroeconomic fundamentals are strong and demand for multifamily housing is steady, driven in large part by the fact that younger generations are renting longer.

As a result, we believe there is a window of opportunity over the next 12-18 months for well-capitalized investors to take advantage of select distress opportunities and to exit when capital values have recovered in three to five years, optimizing returns. Investors with dry powder at the ready will be in a prime position to enter this narrow window of opportunity.

Key takeaways

  • 2023 was a challenging year for the multifamily housing market, characterized by high levels of development, lower transaction volume, and declining values that have created the potential for pockets of distress.
  • Distress will persist in 2024 and 2025 as rents remain flat, vacancy rises, and $500 billion in multifamily loans mature.
  • Despite the areas of distress in the multifamily sector, the underlying macroeconomic fundamentals remain healthy and demand for multifamily housing is steady.
  • Healthy fundamentals and steady demand, paired with the current distress among existing owners of multifamily assets, creates a window of opportunity for new investors.

2023: The most challenging year since the Global Financial Crisis

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Overdevelopment

Prior to the pandemic, overdevelopment in the multifamily sector was a cause for concern among investors. When the pandemic hit, new development projects and those already underway were delayed due to work restrictions, supply chain constraints, and labor shortages. But by 2021, pent-up demand and capital appreciation caused a new surge in development, exacerbating existing supply concerns. Seeing the opportunity to develop multifamily housing units and capitalize on the historically low cost of capital and increasing rental rates, some owners went as deep into the debt stack as possible, most often utilizing floating rate debt.

Lower transaction volume

Another pain point for the multifamily sector in 2023 was the confluence of high inflation and interest rate increases. As consumer inflation reached its highest level since the early 1980s following the pandemic, the Federal Reserve (Fed) began increasing interest rates to stem the rapid increase in prices. The disruption this caused in capital markets brought commercial real estate transactions to their lowest level since the Global Financial Crisis (GFC). Apartment transaction sales volume was down 65% in 2023 (see Exhibit 1). In 2024, we see some room for improvement, as investors are more confident that the Fed’s tightening cycle is nearing completion, facilitating better clarity on pricing. At the same time, a higher interest rate environment will prevent a more robust recovery and while we believe that 2024 will be a better year for investors, the recovery will be measured.

EXHIBIT 1: Apartment transaction sales volume fell 65% in 2023

This line graph shows that apartment transaction sales volume fell 65% in 2023.
Quarter sales volume
U.S. equities
Source: RCA, Principal Real Estate, December 2023
Declining values

The real estate market is particularly sensitive to unanticipated inflation and rising interest rates, which makes it particularly challenging to price risk assets in the current environment. Driven by capital market uncertainty, apartment values are down 14.7% from their peak in Q3 2022 through the end of 2023—much less than during the GFC but still quite significant (see Exhibit 2). We expect values to further decline in the first half of 2024.

EXHIBIT 2: Apartment values spiked in 2022, but have declined 14.7% since their peak
NCREIF NPI Appreciation Index

Apartment values are down nearly 15% through the end of 2023 shown in this bar chart.

Change in apartment value peak to trough (%)

Apartment values are down nearly 15% through the end of 2023 as shown in this line graph.
Source: NCREIF NPI, Principal Real Estate Q3 2024
Multifamily distress

The amount of existing and potential distress in the apartment sector is somewhat surprising, given the liquidity and preference the sector has maintained among investors since the onset of the pandemic. In a sense, the sector has become a victim of its own success where ample liquidity has created a false sense of security. The high levels of development, lack of a fully functioning transaction market, and declining values have conspired to pressure weaker developers and operators within the multifamily sector. As shown in Exhibit 3, while outstanding apartment distress comprises less than 10% of total commercial real estate distress, potential distress comprises nearly a third of the entire market.

EXHIBIT 3: The multifamily sector share of total outstanding distress is just 9%, but its share of total potential distress is 30%
Distressed assets, $ millions

This chart shows how multifamily distress is almost 9X outstanding multifamily distress.
Outstanding distress ($ millions)
Potential distress ($ millions)
Source: Real Capital Analytics, Q3 2023

The surfeit of potential distress relative to other sectors, combined with healthy demand tailwinds, creates a unique entry point for well-positioned investors in 2024 and 2025. Space market fundamentals have certainly weakened over the past 12 months, which is due more to an overhang of new supply hitting the market at a time when demand has reverted to a more stabilized trend. All of that said, we do not believe that the apartment market is on the brink of collapse. The sector continues to have better access to debt capital than most, which is provided through government sponsored entities (i.e., Fannie Mae and Freddie Mac) and balance sheet dislocations that were the impetus for the GFC are not apparent. Absent an unforeseen economic shock, we continue to believe the apartment market will reach its trough in 2024, although distress will persist through 2025.

Distress will likely persist through 2025

We expect distress will persist in 2024 and 2025 as rents continue to trend lower, vacancy rises, and $500 billion in multifamily loans mature.

Rents and vacancy rates

Apartment fundamentals are in the process of resetting after a stellar run. While rental rates fell during 2020 by 5%, they increased by 20% over the following two years (see Exhibit 4). Partially as a result of outsized rent growth following the pandemic, rental affordability has come into focus. In fact, the median renter is now rent-burdened, as more than 30% of their total income needs to be used to pay for shelter costs.1 This has had the effect of slowing both the pace of the net absorption of apartment units and the ability of landlords to push for more robust increases on in-place leases. In 2023, for example, rental growth totaled just 1% on a year-over-year basis.

While vacancy rates have increased over the past 12 months, they remain below their long term historical trends, which we expect to help rental growth to return to its historical norms in 2026 and beyond. This will be driven by a moderation in new development starting in 2025, at a time when demand is in lockstep with economic growth and household formation.

EXHIBIT 4: Rents spiked in 2021 and 2022, and vacancy rates were at historic lows

While vacancy rates have increased over the past 12 months, they remain below their long term historical trends shown here.
Vacancy rate
Rent growth
Source: CBRE EA, Principal Real Estate, Q3 2023
Hitting a wall of maturities

We believe that 2024 will be a pivotal year for the multifamily sector. While values and market fundamentals regain their footing, the maturity schedule will prove daunting. In total there is roughly $500 billion in apartment loans set to mature by the end of 2024, by far the most of any sector over the same time period. The multifamily sector represents 45% of the total loans set to mature across all sectors (see Exhibit 5).

EXHIBIT 5: The multifamily sector has by far the largest share of loans maturing

The multifamily sector represents 42% of the total loans set to mature across all sectors.
Multifamily
Office
Industrial/Warehouse
Retail
Hotel/Motel
Healthcare
Other

Source: Mortgage Bankers Association, Loan Maturity Report, 2023

Given lower transaction volumes and values well below their previous peak, the wave of maturities could force many owners to sell at discount. The increased cost of capital and a valuation decline has made it nearly impossible for some operators to recapitalize today. With debt coming due and net operating income under pressure due to slower rent growth, poorly capitalized owners face a dilemma: they either need to refinance their debt at a time when cap rates are higher than their existing interest rates, which leads to an unstable capital stack, or inject more equity into troubled assets. Many will be forced to sell at discounted prices.

Macroeconomic fundamentals are strong and multifamily demand is steady

Despite the areas of distress in the multifamily sector, the underlying macroeconomic fundamentals are strong and demand for multifamily housing is steady.

The economics of the residential sector has shifted dramatically over the past decade. Affordability remains a key constraint to accessing the purchase market. The younger generations which make up a large part of the population―Millennials and Gen Z―are renting or living at home longer than their parents did (see Exhibit 6). There are several reasons influencing the delay on home purchases. For starters, younger generations tend to be more prone to inter-city and regional movements than prior generations, which promotes mobility. Apartment rentals offer flexibility that home ownership does not. They also place a higher value on experiences, such as travel, which may require significant savings or discretionary income.

EXHIBIT 6: More people are renting for longer

Millennials and Gen Z―are renting or living at home for longer periods than their parents did.

Source: CDC, National Mortgage Database, Bloomberg, Moody's Analytics, Principal Real Estate, 2024.

Not only do younger generations rent longer by choice but the mortgage interest rates that followed the GFC and pandemic have put downward pressure on the affordability of the single-family purchase market. Consequently, homeownership rates among key demographics have lagged, which is creating a large source of potential demand for rental units. Moreover, these younger generations are currently in the primary renter cohorts. They constitute a substantial portion of the population, making them a significant source of demand in the rental market.

Conclusion: A window of opportunity for new multifamily investors

Given strong fundamentals and steady demand, distress among existing owners of multifamily assets creates a window of opportunity for new investors.

The multifamily sector faces several challenges over the next 12 months. Market fundamentals have weakened, and demand is reverting to its historical norms at a time when construction remains at near record levels. Combined with a higher interest rate environment, which we expect to persist over the longer run, weaker and less well capitalized operators will face increased pressure to look for an exit strategy. We believe that in the next 12-18 months, well-funded investors can take advantage of the distress and exit when capital market appreciation is firmly in recovery in three to five years, realizing opportunistic-like returns. Investors with dry powder at the ready will be in a prime position to enter this narrow window of opportunity.

Principal Real Estate: A trusted partner in multifamily investing

Principal Real Estate brings extensive market experience to bear for our clients. Our approach is marked by patience, discipline, and adaptability—qualities that enabled us to successfully navigate market upheavals like the GFC and the COVID-19 pandemic. We have a unique and valuable ability to swiftly seize opportunities in even the most dynamic market environments.

Our deep-rooted presence in the market, coupled with nimbleness and adaptability, position us to make quick and informed investment decisions to navigate potential stress points and capitalize on market shifts.

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