Harbor Group sees potential inflation risk haunting multifamily lending, investment market

Underwriting loans in the sector could become more difficult if wages aren’t commensurate with rent increases.

Harbor Group International sees the specter of inflation having a potential impact on how lenders and borrowers underwrite multifamily loans.

While inflation has been rising in the US, Harbor Group president Richard Litton considers the potential risk to be of paramount concern to all lenders and borrowers but raised specific concerns for multifamily assets.

The Norfolk, Virginia-based manager, with a $14.5 billion portfolio of properties, reckons the prices being paid for apartment properties are increasing at a faster rate than in other sectors. This is having a knock-on effect on rents and beyond.

“On the forefront of all investors’ minds right now is inflation,” Litton told Real Estate Capital USA. “Prices are moving up. But, at some point, if the renters’ income is not going up quick enough, or if other expenses in their life go up more quickly, then it could become more difficult to sustain significant rent increases.”

The firm is anticipating rent growth to taper off eventually and is accounting for this in its own underwriting. “You can’t keep raising rents 20 percent on renters every year as that is obviously not sustainable,” Litton said.

There is a slightly different analysis being done by credit investors who are looking at the multifamily sector. “[These] investors are attracted to strong apartment fundamentals combined with attractive cashflow without taking equity risk. In other words, the risk-reward balance for multifamily debt is attractive, particularly given the overall low yield environment for fixed-income investments,” Litton added.

Positive fundamentals

Harbor Group has an extensive real estate debt portfolio, which is focused mainly on the multifamily sector. Despite concerns over inflation, the firm is seeing a high level of capital markets activity and positive fundamentals stemming from a lack of supply.

“I think the first point for lenders is the performance of the underlying product class or collateral, and the multifamily fundamentals in the US continue to be so healthy,” Litton said. “As long as these trends continue, we would expect managers to continue to raise capital for multifamily credit strategies.”

The firm believes the multifamily debt investments offer higher yields than other fixed income investments relative to the risk. “We have a low interest rate environment and still have historically low Treasury rates, so if we can generate fixed income, backed by very strong collateral that provides excess return, we think that’s a very attractive value proposition,” Litton added.

Harbor Group lends nationally, aiming for geographic diversification. “In our whole loan platform, we lend across the country and have a lot of geographic diversity, plus a very diverse pool of collateral benefiting from strong fundamentals and then being able to generate attractive returns – excess yield is really the value proposition,” Litton said.

Smile states

A common theme across the business is to focus on where the US population is migrating to and where job growth is happening.

“What are those population demographics and trends that will support continued growth in the sector?” Litton asked. “These are the smile states – starting [in the] Mid-Atlantic, from suburban Washington, DC, down through markets like Raleigh, Durham, Atlanta, all the Florida markets, then continuing into Texas up to Arizona, Phoenix. Those locations have been such strong markets and have only gotten stronger since covid.”

The firm doesn’t exclusively target these markets, with Litton citing Boston as an exemplary market, as well as Denver, Salt Lake City, and Los Angeles.

“But if you’re talking about overall trends and concentration, it’s around the smile states. And the projections going forward look strong. So many investors want to buy apartments now particularly in the high-growth markets, they’re looking to capitalize on investment opportunities and want certainty and speed of execution.”