Odyssey Properties’ Practical Approach to Navigating Economic Uncertainty
Principal & Founder Derek Graham on investment strategies that work in the current volatile business environment.
Following two unprecedented years, the multifamily market has been recalibrating to a more sustainable growth rate. Nationally, rent improvement declined to 5.5 percent year-over-year through January, marking a 70-basis-point decrease from the previous month, according to Yardi Matrix data. That was significantly below the two-digit rent increases the industry saw throughout 2021 and the beginning of 2022.
The more volatile economic environment has pushed multifamily investors to adapt their strategies to keep pace with the changes in the industry. While some remain on the sidelines and are concerned about access to capital, others are finding new ways to continue their daily operations.
“As interest rates continue to climb and national multifamily rents begin to decline, the popular notion is that many multifamily investors are on hold,” Odyssey Properties Group Principal & Founder Derek Graham told Multi-Housing News. “A more accurate depiction may be that the current market volatility simply exceeds their comfort levels.”
Here’s what else Graham told MHN about how practical underwriting can help investors seize opportunities, even as economic uncertainty persists.
How would you describe multifamily market dynamics in the past year, considering the overall slowdown in rent growth across the U.S.?
Graham: Following a record-breaking two years for multifamily real estate performance, market dynamics are forecasted to level off from peak growth as most regions experience normalization of market fundamentals and debt financing becomes increasingly expensive.
Rent growth has decelerated significantly from the double-digit numbers seen in recent years. Nevertheless, year-end rent growth for Q4 2022 remained considerably higher than the long-term average and we anticipate near-normal levels of 3 to 4 percent annual growth moving forward.
Early 2022 was dominated by buyers using debt funds, but as the cost of bridge financing increased and cap rates expanded—jumping from a compressed 3 percent range to nearly 5.5 percent in the past nine months alone—the agencies became more competitive. For long-term, fixed-rate debt, we have seen all-in rates go up from the mid-3 percent range to 5 percent because of the 10-year Treasury increasing from 1.75 percent to 3.5 percent.
Shorter-term floating-rate debt financing is even more expensive. Due to volatility and economic uncertainty, lenders increased their spreads over the SOFR index on which they lend, while the cost of interest rate caps required to hedge risk rose concurrently. The SOFR index rose from 0.05 percent to 4.3 percent, while lender spreads widened 100 basis points, driving all-in debt fund interest rates up over five full percentage points. By the end of 2022, most buyers had shifted back toward using exclusively agency debt.
So what challenges are on the horizon for multifamily investors?
Graham: Several challenges are on the horizon for multifamily investors through 2023.
Multifamily investors have been forced to reevaluate their strategies to take a more practical approach. A substantial pricing gap exists between buyers and sellers, resulting in virtually no deals penciling. Buyers are seeking deals at prices that reflect the new borrowing costs, yet most owners are still operating successful portfolios, implementing healthy rent increases and maintaining high occupancy and are therefore reluctant to sell at a discount to values from the height of the market last spring.
Underwriting for multifamily investments has changed drastically, characterized by adjusting debt assumptions to reflect the new cost of capital, modifying exit cap rate expectations to align with the upward trend in purchase cap rates and tempering rent growth projections. Proforma numbers must be modified to reflect appropriate underwriting assumptions incorporating massive annual increases in insurance and property taxes and tempered rent growth projections.
Please expand on current financing conditions.
Graham: Volatile and rising interest rates impact the borrowing environment for sponsors, affecting lending conditions, debt costs and loan proceeds, decreasing LTVs. Most institutional equity is waiting on the sidelines, while private capital and high-net-worth investors turned overly cautious from negativity in the press and economic doubts.
The current lender pool is now primarily made up of the agencies, Freddie Mac and Fannie Mae, in addition to banks and life companies. Bridge lenders are still active, but at rates that are highly unattractive to many. Therefore, buyers who utilized bridge-debt financing in the last two years will be faced with two challenges as loans mature through 2023 and 2024. First, if they are trying to secure an extension on the bridge-debt loan, hitting the debt yield covenant may prove to be problematic due to decreased economic occupancy and decelerating rent growth. Second, even if they can hit the yield covenant requirements, they will be faced with replacing the required interest rate cap.
Parenthetically, many sponsors may lack the equity or liquidity required to purchase today’s replacement interest rate caps, which now cost up to 10 times more than they did a couple of years ago when initially purchased.
How have rents and occupancy rates fluctuated in the past year and how have these variations impacted your multifamily portfolio?
Graham: As a multifamily investment sponsor operating on a national basis, we own 44 properties across 14 states and 31 cities. Managing over 7,500 units provides valuable insight into the rent and occupancy variations experienced over the past year.
Rents are still showing healthy increases across the majority of markets, albeit we are not seeing the 10 to 15 percent surges witnessed a year ago. We expect rents to normalize back to the traditional 3 to 4 percent range due to dwindling economic stimulus, multi-decade high multifamily supply and persistent inflation eating into Americans’ monthly budgets.
Occupancy remains in the 92 to 97 percent range across our portfolio, though delinquency is still a persistent issue. Although physical occupancy levels have not materially changed from a year ago, we are seeing a slight 2 to 5 percent drop-off in economic occupancy due to eviction moratoriums being lifted and owners accelerating evictions to clear their rent rolls of delinquent tenants.
Are there any strategies that multifamily operators can implement to improve retention rates at their properties and avoid occupancy declines going forward?
Graham: No two markets are exactly alike. To stay ahead of vacancies, understanding the nuances and utilizing the most effective resources within each rental market is key. In our experience, we have found that strategies for success vary widely from market to market.
Consistent and in-depth tracking is the first step to determining the ideal advertising strategies to suit an individual market. Familiarization with the demographic will aid in identifying the right advertising agencies to get properties noticed within a market…
Offering tenant concessions is another valuable strategy to improve retention. The opportunities to provide concessions vary widely between markets and pinpointing what attracts residents in each area is crucial to any successful campaign. Concessions can include reduced application or deposit costs, reduced first month’s rent, giveaways and more, which can be implemented at any time throughout the lease term.
As rental assistance programs saw the last of their funding through Q4 2022 and with most eviction moratoriums having been lifted, we are now beginning to see serial non-paying residents evicted across the country. Consequently, there has been a surprising uptick in rental fraud on recent lease applications, including falsifying pay stubs and employment documentation and fraudulent rental history across multiple markets. Landlords must be vigilant in properly vetting new tenants to help avoid inheriting potential delinquency and eviction challenges.
Can you please share a few details about the top-performing market in your portfolio? What is behind its performance?
Graham: The South King County and Pierce County regions of the Seattle market have been unexpected outperformers in our portfolio. Acquiring a total of six properties here between 2016 to 2021, we are intimately familiar with both the pre-and post-COVID-19 dynamics of the market. Having endured severe eviction moratoriums during the height of the pandemic, we experienced delinquency across all properties, but not as severe as anticipated.
Due to the recent elimination of rent increase restrictions in these Seattle suburbs, we experienced a 10 percent spike in rent growth from Q3 to Q4 2022. Though rents in Seattle’s urban core were some of the hardest hit during the pandemic, rents in the southern suburbs are now 25 percent higher than their pre-COVID-19 levels.
What type of multifamily assets are you targeting this year? What is your investment focus area?
Graham: Odyssey targets multifamily investment properties in high-growth markets with favorable supply and demand conditions, strong population and employment growth, as well as high-quality educational systems. We focus on Class B, garden-style assets, constructed in the 1970s through the 1990s, valued between $20 million to $50 million. Our properties primarily consist of workforce housing and are less likely to be impacted by external economic factors like the ongoing tech layoffs, for example.
Markets of interest for this year include cities with strong economic drivers such as continued employment and population growth and superior quality of life. We are avidly tracking markets such as Dallas; Seattle; Tampa, Fla.; Atlanta and the Carolinas, and have cooled our interest in potentially overextended markets like Phoenix…
We are never on hold—we are actively underwriting new deals every week. Consistent tracking, practical underwriting and breadth of market knowledge allow us to move forward when opportunities arise that appropriately reflect the new market dynamics.