How lenders are underwriting multifamily in a time of inflation

The red-hot US multifamily sector has so far weathered the current economic dislocation with aplomb, but lenders are urging caution as inflation and interest rates rise and rents brush with the upper end of their registers.

For multifamily lenders, this has so far meant tweaks including more cautious underwriting from banks and considerable spikes in interest reserve accounts.

Chris Moore, managing director of capital markets and hedging at Kennett Square, Pennsylvania-based advisory Chatham Financial, says the current environment is unprecedented regarding how dramatically pricing across the commercial real estate debt landscape has gone up in the last six months across all asset classes. “There’s this question about how much longer pricing can go up in the multifamily space,” he says.

“The curve will come down if inflation continues, because at a certain point the affordability factor kicks in”

Tingting Zhang
TerraCotta Group

Tingting Zhang, founder and CEO of the El Segundo, California-based commercial real estate credit manager TerraCotta Group, says that, in a standard environment, multifamily rental prices are supposed to be able to catch up and match inflation more efficiently compared to the office sector.

“The curve will come down if inflation continues, because at a certain point the affordability factor kicks in,” Zhang says. “There’s only so much that the tenant can pay.” She notes the current multifamily market has become more interesting because rental affordability has taken on a great deal of variation across different geographies wherein only some still have room for growth.

“When rents are not increasing, the cap rate is going to expand,” Zhang says. “We actually see that in some of the Sunbelt markets. Although there’s still greater demand for multifamily space, significant growth in rents in recent years has undermined the affordability factor in the inflationary environment. This may not be a good thing.”

Stalled deals?

While the conventional wisdom is that dealflow is not likely to be stalled in the short term on account of current supply or decreased tolerance from tenants to keep up with rising rents, the constant hunt among lenders for premier assets – especially in Sunbelt markets – does make for a more complex environment where even the most senior specialists only want to bet on properties with every tailwind in support of a potential deal.

William Colgan, partner at New Jersey-based real estate manager CHA Partners overseeing the firm’s capital stack, says more caution is expected when looking at the increase in construction costs and subsequently the deliverance of new products.

Colgan believes there will be a slight slowdown in the multifamily landscape. “Covid-19 caused a supply side shock as material production was halted and a lot of folks were left competing over the limited supply of goods, which led to high inflation. However, we believe the imbalance is being corrected as production has ramped up and there is a demand-side slowdown as underwriting projects have become more difficult with price uncertainty and interest rate hikes,” he says.

The interest rate hikes being rolled out by the US Federal Reserve to try and taper inflation have not added direct wind to the multifamily sails. After a 75-basis-point hike in June and the prospect of another in July, Colgan says the rosy sky assumptions must be adjusted to account for unknowns still at play.

Colgan says moving on more deals in the current environment will require greater scrutiny around development yields and increasing project costs. “You’re going to need a lot more NOI on a given project for it to make sense to move forward,” he says, adding that his firm has started to see cap rates creep up as firms update underwriting and factor in the interest rate hikes on a go-forward basis, even if they are a relatively low-leverage borrower.