The Commercial Real Estate Alpha Site

Via Realpage by Jay Parsons

How far have apartment values fallen from peak levels? If you believe indices based on irrational, moody-swingy REIT stock values, you’d think they’re down 20%+. But if you look instead at actual property sales, as MSCI does, then the answer is a less dramatic (but still very real) 13%. And that decline has almost everything to do with higher rates, little to do with fundamentals, and probably still has some room to go (more on that later).

What is most interesting from MSCI’s data is to see the differences in decline by asset type. And to best understand this, we need to rewind the clock back to the Great Financial Crisis.

— Coming out of the GFC, the narrative in multifamily was to go urban. “Millennials don’t wanna live in the suburbs,” they said. It was always a gross exaggeration, but the theory took root, and CBD apartment values soared in the 2010s. But so did supply — even in “high barrier to entry” downtowns (i.e. Los Angeles), and CBDs underperformed suburbs on rent growth throughout most of the last decade. But property values didn’t catch up with fundamentals until the pandemic hit, and then everyone blamed COVID.

— Today, per MSCI, apartment values are off 21% in CBDs compared to the peak recorded in Q2 2022, just before interest rates started materially jumping. (The magnitude is likely influenced to some degree by harder-hit cities like San Francisco, but the trend is broader than that.)

— By comparison, values are down just 5% in “highly walkable” suburbs (based on Walk Scores), 14% in “somewhat walkable” suburbs and 12% in “car dependent” suburbs. Again, COVID will get all the credit … but suburbs have been consistent outperformers over the last decade — in part because the biggest barriers to entry are in NIMBY-istic, high-growth suburbs with strict zoning limitations. Suburban fundamentals have always been better than most investor perceptions of them.

— In other words: COVID accelerated a pre-COVID trend, and brought some correction to the dynamics. This is NOT to say CBDs aren’t attractive, and those assets (on a $/unit basis) still retain a price premium. But the gap widened too aggressively pre-COVID.

Of course: Not a ton is trading right now obviously, and there’s still plenty of price discovery going on. Remember when interest rates rise, cap rates theoretically need to expand to offset higher costs (though it isn’t a perfectly correlated relationship), which dings property values.

But to what degree? That’s the big question for 2024. It could depend on the composition of what trades. I suspect well-located, new construction might not get discounted as much as buyers hope, while Class C/B- with value-add needs could be more challenged as cap rate spreads between to A to B to C normalize.

Lastly: If you bought at peak price in 2022, you’re not gonna sell in 2024 unless you have to. And generally speaking, forced sales result in above-average discount.

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DPCRE, LLC