Multifamily Market Updates: September 2023

In each Invest InlandNW publication, we break down the trends impacting multifamily investors in the Inland Northwest. Keep reading for the following:

1. Overall Market Update (6 minutes)
2. Multifamily Breakdown (2 minutes)
3. Developer's Corner (3 minutes)
4. Local Round-Up (2 minutes)

OVERALL MARKET
Values decreased faster than owners expected and there isn't much light at the end of the tunnel after the latest Fed meeting.

HIGH-LEVEL SUMMARY

The Fed chose not to increase their benchmark interest rate at the September meeting, but their commentary was what shook the markets.

• Higher for longer. The Fed set expectations that they would be holding rates higher for longer. Investors were hoping to see a quick reversion of rates following the historic average of 9 months from the last rate hike to the first rate decrease, but the tone of the Fed appears to be taking that option off the table.
• No soft landing. The Fed has been aiming for a "soft landing", meaning we wouldn't enter a major recession, but they are now setting expectations of a full-blown economic crisis in order to cure inflation.
• The 10-Year Treasury has since moved to its highest level in 16 years of 4.80% on Tuesday, breaking through the 4.5% ceiling with momentum.

Tied in some ways to rates, we've seen cap rates in the Inland Northwest move quickly from 4.75% to 6.25%+ in a short 18 months.

• This is a -31.5% decrease in values, of which most of the impact has been felt in the last 6 months.
• Headlines might lead you to believe that interest rates are the only cause of value declines, but that's not the case, so let's dig in deeper.

GO DEEPER

There are three primary drivers to value declines in the Inland Northwest, all of which are related to interest rates, but the story doesn't stop there.

1) Regional Lending Impact. 90% of the $119M in multifamily sales we've worked on in the last 2 years were acquired using a regional bank or credit union. Due to the recent banking crisis, these lenders are reserving cash and lending with extreme caution. Many are not lending on multifamily at all, have restricted the size they'll lend on, or have increased their spreads to an uncompetitive rate.

2) Opportunity Cost. Investors today have options with where to invest and many anticipate distressed opportunities in the near future.

• Market Flows. The past few years, values rose so quickly in primary markets (Seattle, Portland, Boise, etc.) that investors looked to the Inland Northwest for cash-flowing deals. Now, cap rates have returned to normal in primary markets, so investors have opportunities to buy at attractive yields in primary markets compared to the Inland Northwest. If you could buy a 5.5% cap rate in Boise or a 6% in Spokane, where would you buy?
• There is a case to be made for Spokane, but many investors are choosing larger markets at a slightly lower yield, since the potential value upside is higher, should cap rates move back to 2021 levels.
• Future Opportunities. In addition, there is an opportunity cost to deploying capital today if you believe that there will be better deals in 6-12 months. Investing a dollar today at a 6% return is being theoretically compared to a 7% return in 12 months. While we don't believe this is a reality and shouldn't stop investors from investing in the right deals that meet their return expectations, this perception is causing even good deals to stall in today's market.

3) Investor Expectations. 18 months ago, holding cash in the bank cost investors a lot. Inflation was 9% and cash in the bank was earning 0.2% interest, meaning cash on the sidelines was losing value rapidly, pushing investors to invest in alternatives like real estate, accepting modest returns.

• Today, cash can be invested in a 6-month government-backed bond and earn 5.5%+ or simply left in a money market savings account and earn 5%+. So to make it worth the risk, the returns presented to investors has to be higher than 18 months ago.
• Let's say that 18 months ago investors were comfortable with a 9% return, which was +8.8% better than leaving their money in the bank. If the investor wanted to achieve that same return spread over the safety of a bank, they would need a 14.3% return to invest in real estate.

Put these three factors together and it means that every deal requires more cash to close (lenders aren't as aggressive), that cash has higher expectations for returns, and investors are seeing opportunities (both in the future or in other markets), meaning they want even higher returns to invest in the Inland Northwest.

So, the Fed's decisions and bond market volatility are pushing cap rates higher, the real effect is seen when we look at investor expectations and how that translates to Inland Northwest multifamily values.

WHAT THIS MEANS FOR YOU

If you were hoping that interest rates would drop and cap rates would come back down in the short-term, it's worth re-evaluating and ensuring you are positioned to weather any economic storm through 2026.

The phrase, "stay alive til '25" has become commonplace, but since the Inland Northwest lags primary markets, we're adopting "persist til '26" as our mantra.

If you're an existing owner, that means a few things:

• Ensure that any existing debt on your property has a loan term through 2026, regardless of the loan amount, loan-to-value, or cash reserves.
• Stress test your property-level financials assuming that expenses continue to rise and you'll see little-to-no market rent growth the next 2-3 years.
• Lastly, identify any asset-level capital improvements that will be required the next few years and plan adequate reserves for those improvements.
• Our team is doing this for many clients today, and we'd be happy to help you and your team. Reach out today to dig into your personal investing situation.

If you're an investor looking for deals, it's critical to clearly define your investing objectives and expected returns, then cut through the noise.

• We are seeing compelling deals today, especially deals offering seller financing with upside far above the cost of debt.
• If you don't have a principled approach in evaluating deals you will get swept away searching for a needle-in-the-haystack deal that may never come.

WHAT'S MOVING & WHY?

We shared some detail on this topic last month, but the market continues to bifurcate into deals that are moving and those at a standstill.
What deals are moving?

• It still comes back to fundamentals. The deals in the best locations with high-quality asset management are still getting done today, at or slightly below market cap rates.
• Then, if a seller leverages a creative strategy, such as seller financing, that deal is getting done in today's market, and at above-market values. Typically an owner can put cash in their pocket and increase their cash flow by leveraging seller financing.
• Lastly, we're seeing that smaller deals (less than $2M and less than $600k cash required) with value-add upside and a clear path to market rents still has a deep buyer pool, as there are investors looking to begin their multifamily investing journey today regardless of market conditions.

The deals that are at a standstill?

• Most land listings, since many are hoping for yesterday's values and are offering permit-ready sites. There are almost no developers looking to jump into new projects today.
• Raw land without permits that is priced correctly still has a buyer pool since those projects would not kick off until at least 2025, but these require correct pricing and the right buyer profile.
• Newer construction assets with limited upside are seeing the largest bid/ask gap, with seller expectations still high and buyers expecting returns in a property type that typically doesn't offer much yield.

MULTIFAMILY BREAKDOWN
In August 2022, we wrote about three trends that will impact multifamily for the next 12-18 months. One year later, we're revisiting those trends in this breakdown.

3 KEY TRENDS FROM 2022

The backdrop: the market had just started shifting after a historic bull run featuring rent growth, cap rate compression, and investor frenzy. It was still early in the shift and not everyone realized the tides were turning.

We identified three key trends that we believed would stick around for 12-18 months. Where do these trends stand today?

1. Rent Growth Continues to Cool. As of September, nearly every Inland Northwest market is experiencing year-over-year asking rent declines, with rents cooling even faster than many expected.
2. Expenses Not Slowing. We analyzed multiple portfolios of properties and were projecting 11-13% increases in expenses. This has largely come to life, with the largest impacts to management payroll due to a challenging market for qualified labor, plus the impact of repairs, maintenance, and turnover costs as tenants began to relocate, evictions returned, and properties had to catch up on the previous two years of lower-than-average maintenance expenses.
3. New Supply Impact. The impact of supply on rent growth cannot be overstated today. Each submarket is being impacted differently, but our latest construction pipeline data shows a continued expansion of inventory of 3-5% per year for the next two years. This new inventory will impact all property owners in the market, especially since rent growth is already cooling.

WHAT THIS MEANS FOR YOU

Even if we disregard interest rate movement and just look at multifamily fundamentals, the next 2-3 years will be more challenging than many owners have seen in recent memory.

In order to breakeven or grow net operating income, a renewed focus on asset management is required. This means evaluating operations, property management, deferred maintenance, capital structures, and existing financing.

If your goal is to hold an asset for just another 2-3 years, it's worth evaluating your exit opportunities today. The short-term outlook is not positive, given the challenges ahead and recent market sentiment of higher for longer. Reach out today if you'd like to explore these exit opportunities.

If your goal is to hold an asset for 10+ years, then it's a great time to identify opportunities to retain tenants and reduce costs over the long-run through capital improvements today. Reach out today if you'd like to execute a Capital Improvements Audit, geared toward these key trends.

DEVELOPER'S CORNER
Developers have been the first to feel the impact of the three primary drivers to value declines mentioned above (regional lending, opportunity costs, and investor expectations).

WHAT WE'RE HEARING

Investor confidence drives the real estate market. When times are uncertain, developers, investors, and lenders pause activity or shift expectations for returns.
Developers have arguably the most exposure to this uncertainty, as they often face 2+ year lead times from project inception/funding to stabilization/exit.

For a developer, there are more risks today than other investors, driven by a number of factors.

1. Interest rates. Rate movement has increased the cost of development, carrying costs, and viability for a refinance into permanent debt at the end of a project.
2. Cost of Capital. Investors have a higher expectation for returns (see above), which is most relevant to development where there is traditionally the highest level of risk, therefore requiring even higher returns to make up for that risk.
3. Construction Costs. While material costs have remained flat, or even come down slightly, labor costs have not. In addition, Washington state's pending building energy code changes, while delayed until March 2024, will impact costs with early estimates to the tune of a +30% increase in costs.
4. Exit Probability. While related to rates and cost of capital, a prospective refinance or sale appears challenging in the coming years. This elevates the risk of construction debt, rent rates, and ability to exit a project, reducing many developers' appetites to keep building.

WHAT'S NEXT?

Almost no new projects will kick off for the next 12-24 months. Many prospective projects or second-phases have been shelved for the foreseeable future.
Developers still building today fall into two camps:

1. Stressed. Developers with financing that automatically rolls from construction-to-fixed-rate or with low-leverage construction loans are likely in safer territory, but the headwinds mentioned above are still causing stress for every developer. Even with long-term fixed-rate debt, developers are watching rent rates, overall economic conditions, and leasing rates closely. Instead of looking to the next project, they're focused on closing out current projects to perfection.
2. Distressed. Or soon-to-be distressed. Many developers with short-term debt or floating-rate, high-leverage loans are facing even more challenges. This means they may not have positive equity upon completion or will require a cash-in refinance just to hold onto the asset through stabilization.

WHAT THIS MEANS FOR YOU

• It's more important than ever to understand the correlation between the three drivers to value declines (lending, opportunity costs, and investor expectations) and how they relate to the three multifamily trends (cooling rent growth, rising expenses, and new supply impact).
• The more you understand and position your portfolio, pipeline, and your team for success, the more likely you are to fall in the stressed bucket, and not the distressed bucket.
• Our team is working with a handful of developers to evaluate their complete portfolio and pipeline. Reach out to discuss our Portfolio Pipeline Audit and how it will help you and your investors navigate today's changing market environment.

LOCAL ROUND-UP
New construction supply matters again, so we're highlighting two markets, Tri-Cities and Wenatchee, sharing insights from our team's latest research.

TRI-CITIES CONSTRUCTION PIPELINE

There are 1,917 units under construction today. This does not include prospective future projects, these are just projects being built today.

• This is a 10.3% expansion of total multifamily inventory which will deliver over the next two years, so a ~5% expansion each year, during a down market.
• Looking back, supply expansion ranged from +4.1% in 2020 to +2.3% in 2022, so the current pipeline represents one of the largest increases in supply the Tri-Cities has ever seen.

In addition, there are 500 units in lease-up today and another 1,352 units in for permits or proposed by developers.

• The supply is mostly concentrated to a few neighborhoods: Southridge Kennewick, Badger South Richland, and West Pasco.
• Each submarket will be impacted differently by supply, but there are very few projects planned in the urban cores, most of the projects are on the perimeter of town.

Want to dive deeper into this data? Reach out to learn more about our Tri-Cities Pipeline Research.

WENATCHEE CONSTRUCTION PIPELINE

While a smaller market, there are 326 units under construction today across four projects ranging from 14 to 157 units.

• This represents a +8.8% expansion of inventory which will deliver over the next two years.
• Looking back, Wenatchee's multifamily supply has grown +3.8% each year since 2014, a steady growth rate for a small market, representing 107 units per year.

In addition, there are 240 units in lease-up across two projects today. Each of those projects is ~75% occupied, leaving just 60 units still leasing before the next wave of supply delivers for lease-up.

• This represents a +6.5% expansion of inventory that has leased in roughly 9 months, an indication that demand for Wenatchee multifamily is stronger than the current levels of supply expansion.

WHAT WE'RE HEARING

• We're working on Spokane, Coeur d'Alene, and additional Inland Northwest new construction reports, so we'll continue to share data as it becomes available from our team. Don't hesitate to reach out with specific requests or questions in the meantime.
• Other news such as employer announcements, large development projects, or municipality news was minimal this month.
• In a changing market environment, we'll take no news to mean good news for the Inland Northwest.

Given the constant change and uncertainty in the market, it's more important than ever to have a team of expert advisors. We focus exclusively on multifamily in the Inland Northwest and are here to help you.

Have questions, want to review an opportunity, or simply discuss how this market update impacts you personally? Please reach out today by contacting us below.