Market Uncertainty: Many Real Estate Professionals Face Their First Economic Downturn

Written by Austin Smith, originally published in Colorado Real Estate Journal November 2, 2022

The main sentiment amongst real estate investors today is uncertainty – in both the current market and where we are heading. Most are uncertain of how high interest rates will go and how long they may remain there. Others are unsure of how to correctly model an exit for their value-add multifamily asset. Some are even doubtful if their development project will make it to completion.

I began as a multifamily broker in Denver in the summer of 2017. At that time, market-wide cap rates for multifamily assets in the Denver MSA averaged 5.8% and the price per unit was just above $210,000 [Costar Group]. Outside of a three-month blip at the beginning of the pandemic in 2020, the market has been on an upward trajectory for my entire career, and for any real estate professional that’s entered the industry in the last 12 years or so. As of Q2 2022, cap rates shrank to 4.5% and the average price per unit soared up to nearly $290,000 [Costar Group].

It was hard to lose money as a real estate investor during this last cycle. Bidding wars for listings resulted in prices well over the list price. Interest rates were at historic lows throughout the run; it had never been cheaper to borrow money for multifamily buildings of all vintages. Sponsors and operators created equity and wealth for themselves and investors as they bought and sold deals that skyrocketed in value, regardless of how well their strategy was carried out. Brokers, myself included, helped sellers to lock in large profits as they sold deals a record prices, and watched buyers succeed in record time.

As we head into the first economic downturn of my career, I cannot help but think of how many of my colleagues, clients, friends, and competitors are facing the same uncertainty. If you started a career in real estate post-2010, join the club. At all the real estate conferences and symposiums I have attended over the years, panelists have always been asked to predict when the cycle will come to an end. Well, here we are. There are an exceedingly small number of people still working today that have seen interest rates move as they have in 2022. Whether we like it or not, interest rates created the velocity in the market and are now unraveling it just as quickly. A reset has begun and the cracks in the market continue to show over the coming months. And we do not know how long the uncertainty and volatility will persist.

The rules of the game seem to have changed overnight for all real estate experts. Market instability on all fronts is rampant. The debt markets fluctuate daily. The Federal Reserve is resolute in continuing to raise rates throughout the end of the year and keeping them at a higher rate to ease inflation. Nearly everyone I speak with is struggling to effectively underwrite deals because the inputs change hourly. Construction costs volatility and supply chain hurdles are affecting developers more than ever. In a general sense, nobody seems to know what is going on or how to correctly react and move forward effectively.

Rents dropped nationwide for the first time in two years according to data collected by Costar Group. Asking rents across the board dropped just slightly in August (0.1%) but are expected to continue to drop in upcoming months as winter approaches. This is partially seasonal, but an ominous trend nonetheless. RealPage Analytics reported that U.S apartment demand plunged in Q3 as new leasing stalled. In what is typically a strong leasing period, it was the first time in 30 years that demand registered negative in Q3 of any year. The graph below shows just how quickly absorption changed as rates began to rise in Q2.

This is not meant to be a total doomsday article (I do believe in Denver and the Front Range apartment market for many reasons) as this is also going to be a time of fantastic opportunity. It will be more important than ever to execute as skillfully as possible to mitigate the external risks we cannot control. It is a great time to lean on mentors and those that have seen the ugly side of a downturn. Create and enrich relationships in the industry that will help get deals to the finish line. Work with the brokers, sponsors, and lenders you trust.

Investors and sponsors that are flush with cash will have an incredible opportunity in the coming months to purchase real estate with less competition and lower asking prices. For those brokers, sponsors, lenders, and other real estate professionals that are bold enough to act, there will be opportunity that has not been seen in more than a decade. Even those that have been through one or more corrections will have to adapt to the unfamiliar environment to thrive as they have for the last 12+ years. As Winston Churchill once famously said, “Never let a good crisis go to waste.”