January 2024 Insights: Reflecting on 2023 and What to Expect in the Year Ahead
A Look Back to 2023
2023 was an extremely challenging year in the real estate market, and the term “survive till ‘25” was used liberally across the industry. After approximately 2 years (late 2020 to mid-2022) of real estate market exuberance with multi-decade high transaction volume fueled by historically low borrowing costs, we found ourselves traversing a market that was in a clear downtrend. While “survive till ‘25” was literal for many real estate professionals in 2023, our guess is that 3-5 years from now we will look back and appreciate the necessary pain the year brought. For now, we will coin the phrase “adversity in ’23” to describe the year.
Capital Markets
10-Year Treasury yields exhibited significant volatility during the year and traded in a very wide range, touching as low as 3.3% and as high as 5.0%. This level of volatility combined with the uncertainty of the Feds hiking cycle roiled capital markets and made it extremely difficult for multifamily buyers to have confidence in their debt assumptions for acquisitions. Additionally, we saw the retrenchment of lenders that were very active in prior years, as rising interest rates created large unrealized losses, leaving lenders to focus on shoring up capital on their own balance sheet and eventually causing multiple regional banks to permanently close their doors.
Transaction Volumes
2023 transaction volume represented a year-over-year decline of ~70%, and the lowest total volume in a decade. The confluence of volatile capital markets, repricing of valuations, risk-off mindset from equity investors, and early signs of operator stress from groups who purchased aggressively with short term floating rate debt led to the sharp decline in transaction volume.
Supply
In 2023, the U.S. witnessed a surge in multifamily supply, reaching the highest levels since 1987, with more than 439,000 units completing construction, according to RealPage. This influx has given renters a plethora of options and significantly decelerated rent growth, with outright rent declines in many markets.
Not surprisingly, many of the markets with the most new supply experienced the largest rent declines. New supply will continue to be a hot topic in 2024 (more on that in our outlook section).
Higher interest rates, less liquidity, significant new supply, and declining rent growth had a meaningful impact on multifamily valuations in 2023. Based on the hundreds of deals we underwrote, we estimate pricing was down from peak 2022 valuations by 20-40%. Given the magnitude of the drawdown from peak pricing, many have been calling for widespread distressed sellers. However, that did not come to fruition in 2023, and rather we witnessed the underappreciated desire for self-preservation – or in other words, an ability for stressed operators, and their incentive aligned lenders, to “kick the can down the road”.
Vanamor Transactions
Vanamor remained disciplined throughout all of 2023 with only one new acquisition which took place during the last week of the year. We missed our annual acquisition target by ~75% and were consistently 20-35% off from pricing guidance on the deals we underwrote.
The asset we purchased was in Beaverton, Oregon and stood out for multiple reasons. It was an off-market acquisition that represented a 30% discount to 2022 pricing and we negotiated unconventional seller financing at a below market rate with very favorable terms such as no pre-payment penalty, no origination fees, and full-term interest only. Vanamor’s relationship with Oregon’s brokers and reputation as a responsible buyer facilitated this unique opportunity.
Portfolio Update
Our conservative first mindset and downside protective strategy has largely insulated our portfolio from the impact of rising interest rates. Additionally, until now we avoided markets that saw the largest post-covid surge, like Phoenix, Las Vegas, and multiple Texas markets, which are now under the most pricing pressure and where we see opportunities going forward.
Despite facing slightly weaker fundamentals, we have successfully increased or maintained our distributions across the majority of our portfolio. We’re closely monitoring property operations and assessing capital expenditure needs on a property-specific basis and formulating cash flow forecasts for each property to guide our distribution plans.
Our baseline expectation anticipates stable distributions throughout 2024, with future increases contingent on the timing of a strengthening apartment market. Despite operational challenges in 2023, our small portfolio has allowed us to be nimble and targeted on property operational improvements and as a result, outperform industry peers.
The Year Ahead in 2024
The outlook for 2024 suggests ongoing economic growth, albeit at a slower pace. The positive momentum in demand from 2023 is expected to persist, supported by robust wage growth and an extended renter lifecycle. This extended lifecycle implies less attrition to single-family housing due to limited available inventory, among other contributing factors. Despite various contributing factors, Gen Z and Millennials are expected to maintain a consistent demand for apartments. This demand is attributed to the impact of high interest rates, increased home values, and the burden of student loan debt. Notably, the U.S. affordability gap, which measures the difference between the monthly mortgage payment on a median priced home and the average multifamily rent, soared to an all-time high of $1,300 in September. Although there has been a marginal decrease in recent months, the affordability gap remains at an exceptionally elevated level, leading to continued demand in the apartment sector.
The primary challenge affecting market-level rent growth, both at the local and national levels, is the supply factor. Higher supply tends to weaken rent growth, while lower supply strengthens it. In essence, there is a close one-to-one relationship between supply levels and the strength of rent growth.
Looking ahead to 2024, the focus is likely to shift towards optimizing occupancy and mitigating expense growth. This will be achieved through modest new lease rent growth and an increased emphasis on tenant retention. The key driver for the overall outlook is the impact of supply, which has been a well-documented and clearly defined trend throughout 2023. In the next 12 months, supply is expected to continue exerting a significant influence on the dynamics of rent growth in the multifamily apartment sector. In 2024 we expect to see deliveries of 671,000 units, the highest annual amount since the 1970s, and 900,000 units currently under construction. While this elevated supply may pose some short-term headwinds the outlook for construction starts and supply in subsequent years is promising. According to CBRE, multifamily starts will fall by 45% from their pre-pandemic average and by 70% from their 2022 peak. This reduction in starts will strengthen occupancy levels and potentially result in outsized rent growth in 2025-2027.
The positive development is that the increasing influx of supply is being met with a significant improvement in absorption. Following a tumultuous period from 2021 to 2022, which witnessed both the strongest and weakest absorption figures in two decades, the pace of absorption in 2023 appears to have stabilized. Approximately 250,000 units were absorbed on a net basis in 2023, aligning closely with the U.S. average dating back to the 2010s. Notably, the most remarkable aspect was the robust demand observed in the fourth quarter of 2023. The final 90 days of the year saw the third-strongest total absorption for that quarter on record.
This robust quarter suggests not only a stabilization of demand after a sluggish 2022 and a modest first quarter in 2023 but also positions the nation favorably to absorb a substantial wave of supply in 2024.
The surprising strength of demand contrasts with the broader economic narrative, which may suggest a rapid economic slowdown. While traditional indicators like job growth indicate a moderation in the growth pace, it’s essential to highlight that job growth remains relatively robust.
Of even greater significance is the recent vigor in wage growth. Wage growth continues to be exceptionally strong and has historically been a reliable predictor of household formation. The current scenario, where wage growth outpaces rent growth and, to some extent, has inverted, signals the potential release of more demand in 2024. While at one point increasing significantly faster than wage growth and causing an affordability crisis, rent growth has slowed considerably and when combined with the decline in 2020, reflects a long-term average trend similar to that of wage growth.
After bottoming out at 0.1% in August and September 2023, the December annualized rent growth reading of 0.3% shows that there has been ever-so-modest upwards movement in rent growth momentum. With that in mind, it’s likely that 2024 sees modest-at-best rent growth. The general absence of rent growth going into 2024 can also been viewed through the lens of occupancy preservation. There has been a growing shift towards focusing on maintaining “heads on beds” throughout 2023 in anticipation of the huge wave of supply delivering in 2024. The continued focus of occupancy preservation will likely remain a key theme throughout 2024 for operators across the country.
Population Growth
The U.S. experienced population growth of 0.49% from July 2022 to June 2023. The data presented below clearly illustrates a trend of Americans moving to states characterized by lower taxes and a more affordable cost of living. This migration has led to an increase in population in these states, accompanied by a corresponding shift in the workforce as companies choose to relocate to business-friendly environments. At Vanamor, our focus remains on targeting markets exhibiting favorable economic and demographic trends.
Rent Growth Outlook
The national expectation heading into 2024 is that rent growth will be modestly positive in an effort to hold occupancy rates stable. There is also the expectation that market-level variations may be quite large. This once more stems from the uneven supply pressure across markets in 2024. While excess supply is a drag on rent growth in the near-term, over the long-term demand has historically caught up and led to rent growth eventually normalizing.
Capital Markets Outlook
During a volatile year for interest rates, the 10-year Treasury which is widely used as the benchmark for lending, increased from 2.5% to 5% and later declined to finish the year at approximately 4.15%. While we do not anticipate the 7 or so rate cuts that the market is expecting from the federal reserve in 2024, Vanamor does forecast less volatility in rates. Without such volatility, market participants will be much more comfortable underwriting new opportunities.
Transactions Outlook
Vanamor anticipates a rebound in market activity throughout 2024 as demand remains strong with large amounts of “dry powder” waiting on the sidelines to capitalize on new purchases which will simultaneously be met with higher for sale inventory as over-leveraged borrowers in 2021-2022 are forced to sell. In 2022 and 2023, Vanamor stood out as one of the first buyers to step back from new purchases while market fundamentals corrected. With values down and an increase in opportunistic investor interest, we expect transaction volume to increase later in 2024.
Distress in 2024
Property distress was largely expected to come in 2023 but the proverbial can was kicked down the road by loan modifications and capital calls. Unfortunately, most of the capital calls did not solve the problems, meaning that they weren’t used as a means of refinancing into longer term fixed rate debt. Instead, they were used to fund cash shortfalls resulting from higher interest rates with the hope interest rates would quickly fall afterwards. As lenders were equally incentivized to keep deals afloat, they were agreeable to loan modifications but make no mistake, those modifications came at the expense of the limited partners. Almost assuredly wiping out any hope of a return of investor capital.
As more loans mature in 2024, lenders are realizing that even with an additional 6 to 12 months of operations, the properties acquired with high leverage variable rate debt are unlikely to see meaningful income growth and will initiate foreclosure proceedings rather than loan modifications. While likely still an overall small percentage of transactions, Vanamor expects to see significant distress in the high growth markets of 2021 and 2022. Unfortunately, retail investors that were promised an opportunity to get rich quick from operators with minimal experience, will ultimately bear the brunt of the distress.
Conclusion
As we step into 2024, the real estate industry confronts a challenging landscape marked by illiquidity, rising interest rates, and elevated levels of new construction. Valuations as a result are further compounded by operational slowdowns in numerous markets. The prevalence of portfolio distress and fund redemptions has sidelined many of our industry peers, limiting competition among buyers. Buyer activity has slowed considerably and we expect transaction volume to increase as sellers are forced to come to market at heavily discounted pricing.
As real estate owners, it’s disheartening to see property values decline, but as always they will rebound with time, and through this process, we are likely to see incredible buying opportunities. As we shift focus from “property owners” to “property investors,” these periods of distress during downturns are often viewed with affection, forgetting the initial fear and uncertainty and wishing for a chance to capitalize on those unique buying opportunities again.
While today’s scenario offers promising investment prospects, we must also acknowledge the risks associated with capital markets volatility, negative initial leverage, economic uncertainty, and slowing apartment fundamentals. Understand that through the navigation of risks, opportunities emerge. While the future is unpredictable, and there are undeniable risks for investors today, our experience navigating through multiple real estate cycles has shown that investor illiquidity and fear often correlate with exceptional opportunities. Fortunately, our current portfolio is well positioned compared to our peers, enabling us to focus on pursuing new investment opportunities. Vanamor’s plan is to adhere to our long-term disciplined strategy – steadily investing in high-quality properties with moderate leverage and maintaining a patient mindset.
We sincerely appreciate the continued investment interest from our partners and are excited about the prospects for 2024.
What We Do
We are strategic real estate investors.
At Vanamor, we combine an institutional approach with an often overlooked middle-market focus to employ a flexible and disciplined investment philosophy. Our goal is to provide stable cashflow with above-market total returns. Since inception, Vanamor has averaged a greater than 33% annual return with an average of 8% annual cashflow distribution.
