Apartment companies need more equity than ever to buy and build for a number of reasons:
- They are acquiring and developing apartments at record volumes
- The cost to complete these deals is growing as development costs increase and property prices rise
- Deal sponsors need more equity to complete their plans because they can’t borrow as much of the cost of their plans as interest rates get higher
Apartment companies are still finding the equity they need. Existing partners are often willing to invest more and new equity investors are coming from around the world to take ownership stakes in U.S. apartment properties.
“We are seeing an influx of equity, debt fund, high net worth individuals and international institutions all clamoring to invest in the multifamily sector,” says Elie Rieder, founder and CEO of Castle Lanterra Properties, headquartered in Suffern, N.Y.
That’s especially true for plans to buy and build in the hottest apartment markets. “We are still seeing plenty of equity capital from a variety of sources chasing multifamily, particularly in the southeast,” says Lisa Hurd, Chief Investment Officer for The RADCO Companies, based in Atlanta.
Rent growth drives asset demand
Many investors have been lured to put more money into apartment properties as rents rise faster than ever before. Apartment rents are likely to rise 10.5 percent on average across the U.S. in 2022, according to the latest forecast from CBRE’s Econometric Advisors. That would be the second year in a row of very, very fast growth in rents.
Apartments rents are growing faster than inflation overall—and more than three times as fast as the usual rate of growth for apartment rents, which grew just 2.7 percent a year between 2011 and 2019, according to CBRE.
“As rent growth continues, we expect this demand from multiple types of capital to continue,” says RADCO’s Hurd.
The demand for apartments is likely to stay strong, with few vacant apartments and fast growth for rents.
“CBRE now expects rent growth to remain above long-run trend for next few years,” says Matt Vance, Americas head of multifamily research for CBRE.
Deal volume, price boost demand
At same time, apartment companies need more equity than ever to help them complete the tremendous volume of deals to buy and build apartments in the post-COVID economy.
Investors spent $63 billion to buy apartment properties in the first quarter of 2022. “That’s the strongest first quarter on record,” says CBRE’s Vance. “That brings the trailing four quarters to a staggering record of $374 billion.”
The prices that investors paid for apartment properties also rose quickly—22 percent over the 12 months that ended in the first quarter of 2022, according to the Real Capital Analytics Commercial Property Price Index.
Apartment companies are also pouring money into their plans to develop new multifamily properties. They will finish more than 400,000 new apartments each year for the next two years, according to the latest housing forecast from Fannie Mae.
Apartment companies need a growing amount of equity capital make those deals happen as prices rise for properties, development and financing.
The producer price index for bids from construction contractors increased 20.9 percent in April 2022 compared to the year before, according to data from the Bureau of Labor Statistics. Prices for everything from lumber to all types of labor had already been rising throughout the pandemic. Over the last six months, contractors have been finally passing those prices on to developers.
“Inflation has played havoc on material and labor costs,” says Castle Lanterra’s Rieder.
The cost of insurance and property taxes are also rising quickly, Rieder says, adding to the pressure on apartment deals.
Loans shrink for apartment deals
Even as costs rise ever higher, the loan to value ratios on apartment properties are getting smaller. That means that an investor who wants to buy or build an apartment property will have to dig into their own pocket to provide more equity to the deal—or find an equity partner.
Rising interest rates are also cutting into the sizes of loans that many apartment properties can support. Interest rates are expected to continue to rise as officials at the Federal Reserve fight the rising prices throughout the overheated U.S. economy.
“The ten-year Treasury yield, which historically is kind of the benchmark for people looking to get permanent debt, has shown a lot of volatility,” says Borsos.
The yield on ten-year Treasury bonds doubled in early 2022, rising from 1.5 percent at the beginning of the year to more than 3.0 percent in early May 2022. It’s much higher than the rates during the chaotic first year of the pandemic, when the yields were as low as 0.5 percent.
Higher interest rates will force many apartment buyers to take out smaller loans for their apartment properties since most lenders won’t make a loan if the income generated by the property isn’t significantly more than its monthly mortgage payments.
“Higher interest rates are putting downward pressure on leverage,” says Castle Lanterra’s Rieder. “Consequently, less debt proceeds are available, resulting in larger equity requirements to complete the capital stack.”
It can be hard to predict exactly how this will change the capital stack for any apartment deal and how much extra equity a project or a purchase will need.
“Debt market turbulence is impacting leverage, causing buyers and investors to struggle pinning down where that leverage point is,” says RADCO’s Hurd. “Underwriting from even four weeks ago is totally different than today, so buyers and investors need to be flexible and prepared for additional volatility.”
Investors watch leverage shrink
For equity investors, smaller loans mean smaller leveraged returns. The rising costs of these investments—from prices of stabilized properties to the cost of development—also cuts into their investment yields. But limited partners continue to buy ownership stakes in apartment properties because of the advantages of this asset class in an uncertain economic environment.
“You’re going to have ups and downs,” says Three Pillars’s Goyal. “But real estate is still much less volatile than the stock market or the bond markets, where investors can wake up one morning and they’re down 5 percent for the day or their whole portfolio is down 10 percent in a given month.”
The yield from an apartment property is relatively stable—despite the volatility of the capital markets. Equity partners have been relatively tolerant of the changes, so far.
“As their yearly dividend of cashflow from the property, if they’re getting 8 percent or if they’re getting 6 percent, they don’t have a lot of questions about why the number changed because the interest rates have gone up and they have been reading about it everywhere,” says Goyal.
The strong demand for rental housing is also a powerful draw for investors. Because they buy an ownership stake in their apartment properties, equity investors tend to ask many of the same questions and have the same hopes and concerns as deal sponsors. Core equity investors are most interested in stabilized properties likely to keep their value and produce steady income up to the point of sale. Opportunistic investors focus on developments that have upside. Both of these strategies are attractive in a period of rising rents, says Borsos.
Equity investors are also very concerned with the risks of the deal sponsor’s plan for any investment. More than any lender, equity investors risk losing their whole investment if that plan fails. “There’s more risk as an equity provider, because in the event of default and a foreclosure, they are at the lowest end of getting proceeds period,” says NMHC’s Borsos.
Limited partners want reporting because of the risk. Equity partners are demanding a lot of communication from their deal sponsor—especially as rising cost unexpectedly eat into their investment yields and rising rents (hopefully) make up the difference.
“General partners on apartment investments are certainly having conversations with their investors,” says NMHC’s Borsos.
The kind of communication these investors need often depends on what kind of equity investors they are.
“Private equity fund managers and institutional investors usually require regular asset-level reporting,” says Roland Merchant, head of institutional advisory for CBRE Capital Advisors. Investors typically make sure these reporting requirements are included in their joint venture agreement with general partners.
“Part of an institution’s evaluation of a potential general partner to invest with can include the general partner’s ability to meet certain reporting criteria,” says Merchant. Institutions also focus carefully on the general partner’s experience and expertise.
Smaller investors, like high-net-worth individuals and family offices, require a different kind of attention—less weighted towards regular, formal reports and more focused on one-on-one interactions.
“We always are transparent, and when markets are more turbulent like today, we find it more important than ever to communicate clearly and more often,” says RADCO’s Hurd.
Investors tend to be content when they receive their expected distributions of cash on schedule.
“As long as we’re making consistent distributions, our investor base is pretty happy,” says Three Pillars’ Goyal. Strong relationships and good communication can help keep investors calm even if at first an investment produces less money than expected.
For example, Three Pillars bought the Pine Lake Village Apartments in Houston in 2019. In the first year, Three Pillars made quarterly distributions to its investors of just 1 percent, instead of the usual 2 percent. But the investors, including a family office and several high-net-worth individuals, were patient and gave Three Pillars time to turn the property around.
“We are used to taking mismanaged properties and improving the occupancy and the income,” says Goyal. Three Pillars quickly improved the operations at Pine Lake, successfully refinanced in 24 months, and eventually sold the property in 2022. “We doubled their money in 34 months,” he says. “It is possible to express that in terms of an annual internal rate of return of 34 percent.”
Institutions want ESG
Some equity partners may have another set of questions about real estate properties they invest in. A growing number of corporations and institutions have made promises to their own investors to meet environmental, social and corporate governance (ESG) standards. That means they will be careful to make investments that meet those standards.
“ESG is a growing focus with institutional investors,” says CBRE’s Merchant. “These institutions will seek to understand the deal through that lens.”
A few institutional investors, including some pension funds and sovereign wealth funds, might decline to put their money into apartment investments that don’t meet their ESG standards.
However, many investors in real estate have still never even heard of ESG standards. Smaller real estate firms, like family offices or high net worth individuals, are less likely to have made public promises to meet ESG standards.
“While a lot has been said about ESG, in our experience it is not playing a major part in raising equity,” says Castle Lanterra’s Rieder.
So far, these ESG standards are not yet prevalent enough to get preferential treatment for apartment investments that meet them.
“Certain funds have requirements—but there has not been a big enough change to make some deals harder or easier to finance,” says Christopher Moyer, senior managing director of capital markets, equity, debt and structured Finance for Cushman & Wakefield.
However, these are likely to become more important as time passes, and as institutional equity investors become more important in the apartment business.
“ESG will influence money raising more and more as we go forward,” predicts NMHC’s Borsos. “More and more investors are going to look at that as an important component of their investments.”
Author Bendix Anderson