Survive to 2025

Slightly rising apartment rents will not be enough to help developers begin new projects, experts say. Interest rates will still be too high.
“The real estate market right now is in a recession,” said Adam Rosenkranz, chief investment officer for Christina, a real estate developer, manager and sponsor based in Malibu, Calif.

High interest rates will still burden apartment investors struggling to make deals in 2024. Others will struggle simply to hold onto their properties.

Going into 2024, thousands of apartment investors are in serious trouble. Many will struggle to refinance floating-rate loans made when interest rates were still low, during the brief boom after the coronavirus pandemic.

Another set of apartment investors are gathering capital. They plan to buy distressed, over-leveraged properties at a discount.

Everyone else is hoping to survive 2024 relatively unscathed. High interest rates make any deal that would require investors to borrow money much less attractive. That includes nearly all real estate transactions.

Strong, steady demand for apartments is not likely to be enough to make many deals work. Developers already have roughly a million new apartments under construction. Many are struggling to finish. Demand for rental apartments is likely to be just strong enough to fill most of them. Rents are expected to grow modestly in 2024.

Slightly rising apartment rents will not be enough to help developers begin new projects, experts say. Interest rates will still be too high.

Slightly rising apartment rents are also not enough to attract most conventional investors to buy apartment properties at the high prices many sellers still expect. Interest rates for many are still too high.

“The real estate market right now is in a recession,” said Adam Rosenkranz, chief investment officer for Christina, a real estate developer, manager and sponsor based in Malibu, Calif.

Rents grow year-over-year, despite flood of new apartments

Apartment rents are likely to grow overall, over the next several years. But not by much.

“Operators are largely focusing on stabilizing their rent rolls and maintaining historically normal occupancy instead of increasing rents,” said Carl Whitaker, real estate economist in the Data Analytics division at RealPage, Inc., based in Richardson, Texas.

Apartment rents are likely to be 0.9 percent higher at the end of 2023 than they were the year before, on average. Rents are likely to grow another 2.0 percent in 2024, according to the Urban Land Institute (ULI) Real Estate Economic Forecast for Fall 2023, which surveyed 46 economists and analysts at 39 leading real estate organizations in October.

Rents are likely to grow more quickly—by 3 percent or more—in regions like the Midwest, Mid-Atlantic and select coastal markets, said RealPage’s Whitaker. These are places with steady demand for apartments, but where developers have few new properties under construction.

Property owners can only raise rents so much, even in strong markets where new development is difficult.

“There is a limit to what people can afford,” said Christina’s Rosenkranz. Christina only expects to raise rents by 2 to 4 percent over the next 12 months at its rental communities in exclusive markets in West Los Angeles.

Other markets are likely to underperform, with rents growing by 1.0 percent or less. These are places like the Desert and Mountain markets of the U.S., where demand has stalled and developers have been busy.

Demand for apartments is still strong. The U.S. economy produced hundreds of thousands of new jobs every month in 2023, and is expected to create another 1.0 million jobs in 2024, according to the ULI Forecast.

That’s a big improvement from just a year ago, when many economists predicted a short deep recession soon after federal officials started raising interest rates.

Demand for apartments in 2024 will also be helped by growth in average wages, which are growing faster than the overall rate of price inflation for the first time in years, said Whitaker.

But even steady demand won’t enough to fill all of the hundreds of thousands of new apartments developers are preparing to open in 2024.

Developers had roughly 1.0 million apartments under construction at the end of 2023, according to RealPage. Of these, 600,000 are likely to be finished in calendar year 2024.

That would be the largest number of new apartments to open in a single year in more than 40 years—even if thousands of those apartments are delayed, according to RealPage.

The percentage of apartments that are vacant is likely to inch higher, rising to 5.4 percent by the end of 2023 and 6.0 percent by the end of 2024. That’s up from 4.6 percent in 2022, according to the ULI Fall 2023 Forecast.

Steady demand for apartments will help keep the vacancy rate within its historically normal range, said Whitaker.

Development will be difficult in 2024

Usually, many developers would be happy to start new apartment projects to fill such steady demand for housing. But very few new projects are starting construction.

“Over the past six months it’s been almost impossible to capitalize development deals with debt or equity,” said Doug Faron, managing partner for Shoreham Capital, a real estate firm based in West Palm Beach, Fla.

Developers started construction on 40 percent fewer apartments in the first three quarters of 2023, compared to the same period in 2022, said Whitaker.

Two of the most common reasons apartment projects are delayed are because they are “not economically feasible at this time” and “inability to secure construction financing,” according to a recent survey of developers from the National Multifamily Housing Council.

The cost of construction financing has been rising since March 2022, when federal officials raised their target for their benchmark interest rates to choke off inflation in the broader U.S. economy. The Fed Funds rate is now above five percent. That’s up from close to zero at the beginning of 2022.

Rising interest rates also put pressure on many regional banks, which were less willing to make new construction loans to real estate projects.

“When we go to market and we talk to 30 banks, instead of getting 10 or 15 offers like we used to, we might get two,” said Michael Lee, principal and partner at HKS Real Estate Advisors, based in New York City. “We may not get a single bid for a decent deal.”

Developers who can’t get construction financing from a bank or choose not to because of the strict underwriting requirements or don’t like the leverage being offered, may have to seek more expensive financing from a debt fund or a direct lender.

For example, ANAX Real Estate Partners is currently in the market for a construction loan that would cover 65 percent of the cost to develop 90 apartments in a planned, 28-story building in a primary market in New York.

The interest rate would float 650 basis points over the Secured Overnight Financing Rate (SOFR)—or nearly 12 percent at 65 percent leverage as of November. The interest rate on a bank loan, if one were available, would probably float at 375 to 425 basis points over SOFR, according to ANAX.

High interest rates like these put pressure on properties financed with short-term floating rate debt, such as most bridge loans and construction loans.

Many will face another challenge in 2024. Many construction loans and bridge loans are coming to the end of their short terms, but the loans no longer qualify for extensions from the bank. The cost of their loan payments has swollen too much.

“A number of property owners are facing forced refinancings,” said Shoreham’s Faron. But permanent financing has also become much, much more expensive. Many properties cannot support these high interest rates either.

Most interest rates for permanent loans to apartment properties are based on the benchmark yield on U.S. Treasury bonds. The yield on the 10-year Treasury was expected to reach 4.6 percent by the end of 2023, according to the ULI Forecast for Fall 2023. It is also expected to stay high, at 4.0 percent at the end of 2024. That’s up from close to 1.5 percent at the beginning of 2022, just before the Federal Reserve began to raise interest rates.

“I think there will be a lot of distress,” said Zamir Kazi, founder and CEO of ZMR Capital. “They will be forced sellers and then they will have to meet the market pricing.”

Some apartment sellers agree to lower prices

Shoreham Capital is in negotiations to purchase several existing multifamily properties. “These opportunities have finally adjusted pricing to demonstrate a discount to replacement cost and more attractive yields,” said Faron. The firm has been more focused on development for the past few years.

Shoreham has been waiting more than a year for cap rates to rise in response to high interest rates.

“We’ve looked at a lot of existing assets over the past 18 months,” said Shoreham’s Faron. “It was a 3.5 cap rate on offer… then it was a 4.0 cap rate… then it was a 5.0 cap rate, but those yields—regardless of location and asset—didn’t make sense especially as interest rates have moved so much more.”

The company plans to buy these properties—and others like them—at a cap rate of 6 percent to 6.5 percent, based on the current income from the property. Shoreham then plans to renovate and improve the operations at these properties. It plans to hold the properties five to seven years. In locations where Shoreham plans to buy, rents also are likely to grow more quickly than the rest of the country. The extra income should improve the original cap rate of Shoreham’s investment from 6.5 percent to 7.5 percent or even over 8.0 percent, said Faron.

That includes a few properties in Northern Virginia, close to Washington, D.C., and several more in the Southeast. “We’re focused on only very solid, A-plus locations,” said Faron.

Across the U.S., cap rates averaged 5.2 percent for apartment acquisitions closed over the 12 months that ended in October 2023, according to MSCI. That’s up more than 50 basis points from the lowest average cap rates recorded in 2022.

More recently, sellers have been more likely to accept lower prices and higher cap rates for their apartment properties, though few of these deals have closed, said Jim Costello, chief economist for the Real Assets team at MSCI.

“We think the opportunity is finally appearing and we are looking to take as much advantage as we can,” said Faron.

Transaction volume still low for apartment deals

ZMR Capital has waited more than a year for owners to sell apartment properties at higher cap rates.

“The spread between what we want to pay versus what sellers want to sell for today is narrowing, but it’s still pretty wide,” said ZMR’s Kazi. “We need cap rates to be north of a 6, in today’s current interest rate environment or even higher than that.”

ZMR Capital plans to spend 200 to 500 million to buy apartment properties in the second half of 2024—if sellers are willing to accept lower prices, said Kazi. That’s a big change. The firm has not bought a single apartment property in the last 18 months—since interest rates began to rise. Before that, ZMR spent more than $1 billion to buy apartment properties in early 2022. It spent another $1 billion in 2021.

Across the U.S., investors spent just $97.4 billion to buy apartment properties from January through October 2023. That’s down 64 percent from the same period the year before, according to MSCI.

In 2024, the amount apartment investors spend is unlikely to shrink much further and may even expand, according to MSCI. “Deal volume has stabilized,” said Costello.

So far, few owners of apartment properties have sold who did not have too, experts say. “Everything is revolving around loan maturities, partnership disputes, divorce and other big motivating factors,” said HKS’ Lee. “You need one of those major events to move you, otherwise you’re not moving.”

Many potential buyers are demanding lower prices and higher cap rates to make up for the high cost of permanent financing. Fixed interest rates for new permanent loans often range from 6.5 percent to 7 percent, said HKS’ Lee.

Even if sellers agree to cap rates as high as 6.5 percent, investors like Shoreham and ZMR typically have some plan—such as renovation—to further increase the yield on their investments.

Other investors may not put any more money into apartments this year. “It doesn’t make sense if someone’s offering something at a 6 percent cap rate but you’re borrowing at 7 percent interest rate,” said Lee.

Other investors may be willing to pay lower cap rates for unique properties in unique locations.

“On the West Side of Los Angeles, if I could get that property on the beach at a 5 percent cap rate, I would give you every dollar that I have,” said Christina’s Rosenkranz. “If you have something intrinsically valuable about that property, your cap rate doesn’t always become as sensitive in multifamily investing.”

Author Bendix Anderson