Is U.S. Multi-Family Residential the Next Domino to Fall in Investment-Grade Real Estate?

By Nicola Wealth Real Estate and Venterra

Recent articles from The New York Times and Wall Street Journal speculate that multi-family residential apartments in the U.S. and Canada might follow the office and retail sectors with higher vacancies, more mortgage defaults, and poor returns. However, we believe differently about the opportunities in multi-family residential real estate.

Warren Buffett once said, “Price is what you pay, but value is what you get.” When acquiring any real estate asset, the purchase price is clear, but the true value lies in the potential for increased revenue, strategic financing, improved zoning, and enhanced building energy efficiency. We only acquire real estate for our clients when we are confident we can add value.

Not all land is created equal. In multi-family residential real estate, location, demographics, and economics significantly impact future returns. As society becomes wealthier, our demand for housing space changes. The following infographic illustrates the average house size and the number of people per home in the U.S. from 1790 to 2019. In 1910, the average home size was 945 sq. ft. with 4.5 people, averaging just over 200 sq. ft. per person. By 2019, this changed dramatically to 2.5 people in a home of almost 2,500 sq. ft., increasing the square footage per person by nearly 500%. Declining birth rates will not offset the desire for more space.

To buy well, one should acquire assets when markets are soft and outlooks are challenging. Consider this: If you were to increase your allocation to equities, would you have been better off doing so during the COVID bear market or now, when most equity indices are at record highs?

This article provides a detailed look into the multi-family residential asset class and why it is a key component of an income-producing portfolio.

Multi-Family Real Estate: A Resilient Sector Amidst Economic Challenges

Challenges in the commercial real estate market should not be ignored. It is essential to present a balanced perspective that recognizes both vulnerabilities and opportunities. Our analysis, supported by diligent research from our U.S. multi-family partner, Venterra, highlights the sector’s resilience.

Recent articles have raised concerns about delinquency rates in the multi-family sector. While caution is understandable, suggesting that a 1.7% delinquency rate could lead to 20% of all multi-family loans being at risk is speculative at best. Data from various sources, including those measuring nonperforming loans, indicate that multi-family loans are relatively stable, especially compared to other commercial real estate sectors such as hotels, offices, and retail.

Real-Life Examples and Overleveraged Owners

There are certainly examples of overleveraged, poorly capitalized owners struggling to keep up with loan payments. These cases often involve high-leverage loans with upcoming maturity dates, requiring refinancing at lower loan balances or selling at market troughs. However, these instances are concentrated among assets owned by firms that took on higher leverage and variable rate debt. We expect the volume and level of distress in the multi-family sector to be minor compared, for instance, to the ongoing structural challenges in the office sector, which does not have the necessity of life characteristics that multi-family housing does.

Supply and Demand Dynamics

The multi-family sector is currently impacted by elevated interest rates and a 50-year high in new supply, resulting from developers taking advantage of record-low interest rates in 2021 and 2022. However, construction starts in multi-family have significantly decreased, with the Census Bureau reporting 360,000 units started (on an annualized basis) as of June. As the pipeline continues to empty out, we will soon return to a shortage of multi-family supply. Realpage forecasts just 231,000 units will be delivered in 2026, growing the apartment inventory by only 1.1%. This situation mirrors the post-Global Financial Crisis period when the US wasn’t building enough housing units, and it appears we are heading back to that scenario. To this point, the U.S. Census Bureau reports that units completed exceeded units started by 296,000 units (annualized) in its data for June 2024. That is the fastest pace at which the apartment construction pipeline has emptied since the 1970s.

For Nicola Wealth and Venterra, this presents a strategic opportunity to acquire existing properties at favourable prices and enhancing them through value-add investments. By leveraging our expertise and proactive approach, we can position our portfolio to capitalize on the anticipated supply constraints and sustained demand as the supply pipeline drains further.

Geographic Focus: The Sun Belt Advantage

The focus on the Sun Belt markets as a source of weakness in multi-family articles often seems misplaced. While there is more supply in these markets, it is because there is structurally more demand. In a first quarter report by Moody’s Analytics, it was highlighted that the Sun Belt now holds about 50% of the national population (335 million), which is expected to rise to about 55% by 2040. This demographic shift underscores the region’s growing appeal and economic vitality. The excess supply from newly built units in the Sun Belt markets is anticipated to be absorbed, with the process expected to be complete within about 12-18 months depending on individual market locations.

The Sun Belt markets, including Arizona and Colorado, have accounted for an outsized 68% of all multi-family demand over the past year while representing approximately only 40% of the apartment market based on the number of existing units, highlighting the longer-term shortage of multi-family units in the South.

Strong Demand and Economic Trends

Contrary to some reports, demand in the multi-family sector remains robust. In 2024, demand through the first two quarters reached 257,000 units, nearly eclipsing the all-time record seen in 2021 (a possibly unreasonable benchmark given the post-pandemic surge). This strong demand is driven by several factors, including sustained high interest rates making homebuying less affordable and flat rents over the past two years. Wage growth has also been relatively strong, making apartments more affordable for a growing number of potential renters.

Conservative Debt Management

Venterra and Nicola Wealth’s Real Estate division have always been conservative with debt, limiting ourselves to a maximum 65% loan-to-value and using almost exclusively fixed-rate loans. We have only four properties with loans maturing before the end of 2025, with plans to refinance two of them in the coming months. The variable rate loans we do have are from recent acquisitions of newer lease-up deals, rather than from the low-interest-rate days that have now seen interest costs soar. In other words the interest rate on these newly placed loans is highly likely to go down, not up.

Strategic Investment Approach

Nicola Wealth Real Estate’s investment strategy is built on a foundation of careful market analysis and prudent financial management. We focus on acquiring properties in high-demand regions with strong economic fundamentals. Our approach includes:

Diversification: Investing in a variety of markets to spread risk and capture growth opportunities.

Value-Add Opportunities: Identifying properties where we can enhance value through renovations, improved management, and strategic repositioning.

Long-Term Perspective: Prioritizing investments that offer sustainable growth and stable returns over the long term.

Opportunities Amidst Distress

While there will be opportunities created from maturing loans and other distressed properties, we are not convinced that the type of properties that end up in foreclosure will match what we are looking to buy. Distressed properties are typically older and have been starved for capital for years. We are capable of purchasing and rehabilitating these assets, but we would likely compete with dry powder from funds specifically raised for distressed assets, which may drive up pricing. Of course we will take advantage of highly distressed opportunities when we find them, however, we simply are not expecting the quantity of these kinds of opportunities to match that of the Global Financial Crisis period or what some media headlines are suggesting.

Nicola Wealth Real Estate recently partnered with Venterra to raise over $100 million (USD) for its new closed-end fund to strategically acquire U.S. multi-family real estate. This fund allows us to be proactive, agile, and opportunistic in acquiring undervalued assets and adding value through strategic improvements and management. Venterra’s operational expertise and rigorous due diligence process ensure that we are well-positioned to capitalize on these opportunities.

In conclusion, while the multi-family sector faces challenges, we feel it remains resilient and well-positioned to navigate the current economic landscape. By focusing on strong demand, conservative debt management, strategic partnerships, and a disciplined investment approach, Nicola Wealth believes the multi-family sector will continue to thrive.