By Marshall Boyd, Co-President and CIO of Interstate Equities Corporation

After more than a decade of profound growth and prolific activity, the multifamily sector has recently been facing certain capital markets headwinds. These challenges have changed the way many investors allocated capital to the sector during Q2 and are shaping their multifamily investment strategies as we move into Q3.

Apartment communities had long been in high demand, with valuations rising and rental rate growth steady and strong. In recent quarters, however, steepening inflation, climbing interest rates and regional bank failures have caused numerous investors to pump the brakes. Data regarding how this trend played out for the sector in Q2 is beginning to come in, and we are starting to see some strategic shifts in the current quarter.

As one of the earliest vertically integrated real estate investment and management firms to focus on adding value to apartment assets, elevating residents’ lifestyles and optimizing ROI for investors, our firm has experienced multiple real estate cycles. Our more than 40 years of industry expertise has taught us how to evaluate multifamily data and anticipate what is coming next. Here is how we characterize the sector for Q2 and what we see ahead.

Summing up Q2

In addition to slowing rent growth, dips in construction and even a degree of distress in some markets, we saw the bid-ask spread widening in Q2, limiting the number of multifamily acquisition deals completed and sidelining many would-be investors. In fact, according to Avison Young, U.S. multifamily investment volumes reached all-time highs in 2021 and 2022, yet declined by over 70% when comparing H1 2022 and H1 2023 levels, and investment levels for the first half of 2023 are now at their lowest point since 2014. In times like this, to acquire takes conviction.

Much of the pullback in Q2 was due to a prevailing economic uncertainty and differences in the performance of various real estate property types. To acquire, we must answer the “falling knife” question. When the economy is showing signs of being less stable, investors typically revert to what they know best—their core competency—rather than taking risks in what is for them uncharted territory. In some cases, this means investing in core parts of one’s historic thesis. Everyone’s crystal ball is clearest in their home market.

What Lies Ahead for Q3

Moving into Q3, we see great promise in a multifamily investment strategy that focuses on workforce housing with a value-add component in supply-constrained markets. The

Fed’s recent rate increase further pauses unsettled investment committees. At IEC we believe this supports placing capital in assets that are positioned to grow in value via hands-on work rather than in luxury apartment communities whose valuations must ride the market unless the basis is just right.

In fact, we are observing the bid-ask spread begin to narrow once again, indicating that sellers may be adjusting their asking prices downward to compensate for rising interest rates in an attempt to close deals in a slow market. Sellers are increasingly realistic as some fresh sales comps begin to get through the system. This trend could positively impact activity and jumpstart dealmaking for those with patience and fresh capital that is ready.

We see the need for equity growing in multifamily for Q3, as debt becomes less available for refinancing and acquisitions. Although we were recently able to refinance a few of our apartment communities and structure the loan to fully replace its predecessor, not all investors are seeing this outcome. NOI improvements via in-house property management since purchase are what determines these positive refinance outcomes. This is a daily effort rather than a periodic check-in. Those with fresh capital to fill gaps will live to see another day.

While experts predicted a rise in multifamily vacancy due to outsized national deliveries, the West Coast does not have this national issue. The value proposition for multifamily continues to be solid, with some discounts to be had via sellers with urgency. Value-add and well-vetted opportunistic investments can provide an ideal alternative for those eager to participate in a property type with steady upside for the long term. Illiquid investments like this are opportune for those who have conviction on their block-by-block knowledge and have the support of their investors to invest through softness. Patient, humble conviction is required.