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  • Writer's pictureZach Gendron

‘When Fear Is a Friend’ (May 2024 Insights)

KKR’s recent Multifamily investment overview, When Fear Is a Friend, has many interesting points for investors to consider:


Current Environment


“Multifamily housing is facing some of the same problems as the rest of the commercial real estate market—falling property values, high debt loads, a pullback in available debt capital, and a loan maturity wall—as well as some unique supply issues over the next two years. We think the sector is in for a multi-year deleveraging cycle. However, multifamily real estate owners who can carry their investments through the next two years are poised to benefit from sustained structural demand and a pronounced shortage of new supply starting in 2026.”


“Some multifamily owners who bought in 2021 and 2022 face a deadline to refinance properties that are now worth much less than their purchase prices at significantly higher prevailing interest rates. Over $250 billion in multifamily loan debt matures in 2024 alone, and some owners will face a gap upon refinancing. Likewise, as interest rate caps typically last for three years, many owners are looking at a sharp increase in the cost of debt. Some developers who started projects during the post-pandemic boom years, particularly in markets that are now oversupplied, are also looking to deleverage and refinance.”


Supply Challenges Creating Opportunities


“The research firm RealPage Market Analytics forecasts that some 670,000 units will be delivered this year. That’s nearly 50% more than in 2022, with another 385,000 units slated for 2025. Most of the new supply is slated for the Sun Belt. It will take time for these markets to absorb the new supply, and NOI growth is likely to turn negative for many assets over the next 18 months. These trends are already taking shape. In 2023, most of the markets that experienced negative growth on a combined measure of rent and occupancy were in fast-growing parts of the South and West of the United States, including Austin, Tex.; Nashville, Tenn.; and Phoenix, Ariz.


However, we think supply will fall dramatically in 2025. It is difficult to justify the complexity and expense of new construction with multifamily housing trading below estimated replacement cost. The costs of construction, labor, debt, and insurance rose sharply during the pandemic and have remained elevated. While our Global Macro & Asset Allocation team predicts that growth in construction costs will moderate in the near future, we expect it to continue to outpace both the pre-pandemic trend and inflation. This is partly due both to a scarcity of skilled labor and competition with infrastructure and other large-scale projects for labor and materials. Commercial real estate and single-family home construction make up only about 40% of total construction spending, down from a peak of 57% in 2005. Meanwhile, banks that are overexposed to real estate lending and subject to new capital reserve regulations are unlikely to come off the sidelines, making capital for new development scarce and likely expensive.”


Housing Shortage Driving Demand


“Another factor supporting long-term rent growth is the structural U.S. housing supply shortage—some 2.1 million homes, according to the U.S. Census Bureau. New housing starts for would-be homebuyers were down 40% in 2023 and are expected to decline further in 2024 due to the lack of available construction financing, higher mortgage rates, and the costs of construction. Many people who cannot find a home or afford to buy one are likely to turn to multifamily rentals.”


Conclusion


“We think the challenges in U.S. multifamily are cyclical rather than secular in nature. The influx of new supply is likely to taper off after 2025, at which point we are optimistic about rent growth given the structural shortage of housing and unfavorable cost dynamics for new construction in the  United States. As owners come under more pressure to sell assets, we see an exciting opportunity coming to buy high-quality properties below replacement cost while achieving attractive long-term yields. Scaled platforms with strong networks, on-the-ground knowledge of different markets, and ready capital will be in the best position to capitalize on the new market conditions.”


“The once-in-a-decade opportunity for real estate equity investors is complex, but also exciting. It’s time to start thinking of fear as a friend.”


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