They Bet Everything on Apartments. Now They’re Pivoting to Save Themselves

The multifamily industry is going through big changes. Companies once focused only on value-add multifamily are turning into ground-up developers or industrial investors. Talent and investment firms are chasing capital and returns, and neither one is very excited by the multifamily investment thesis of the past eight years. This is what S2 Capital is doing. Last year they bought an industrial investment firm and built a development arm, both in recognition of poor opportunities in their main business.

There’s also plenty of schadenfreude in multifamily circles towards S2 for the troubles in its portfolio. Because of its size, a company like S2 grabs headlines. But the issues run much deeper for the industry. The smallest firms, made up of part-time syndicators, likely don’t exist anymore. Those individuals went back to their day jobs after losing their properties to foreclosure. The buyer landscape is changing, and the longer the recovery takes, the greater the culling will be.

How We Got Here

When my partners and I started Calvera, we were not multifamily specialists. I had worked on hotel acquisitions, a casino and gaming project, large office purchases, and condominium developments. It wasn’t until the GFC that I saw a bigger opportunity in apartments. Through the purchase of a large distressed loan secured by a group of rent-controlled apartments, I saw how foreclosures worked and how to recapitalize, renovate, and reposition small apartment assets. That experience, combined with one of my partners’ family history in the apartment business, became the catalyst for Calvera.

Before that, apartments seemed boring to me. The returns were low because apartment cap rates were generally the lowest of all property types. Rents rose a little above inflation. Debt was vanilla, with Fannie, Freddie, HUD, and banks lending at conservative loan-to-values and competitive rates. Apartment ownership seemed to belong to mom-and-pop owner-operators and large institutional owners focused on scale, cost control, and tenant-centered processes. For someone who loved hospitality properties and urban real estate, apartments (and industrial) sat at the bottom of my list.

Then the landscape changed. Multifamily rents took off just as interest rates fell sharply. Cap rates didn’t catch up for a while, and values skyrocketed. Everybody saw this and wanted in, both operators and investors. In a similar way, growth in online retail and a shifting supply chain sparked a renaissance in industrial real estate. We focused on apartments because that’s what we knew. Others jumped into industrial for the same macro reasons. The barrier to starting a firm was low. If you could raise capital, you could become a real estate investor. We had an institutional background working at a $30B-plus private equity firm. Many others had no real estate background at all.

The industry is still paying the price for that today.

What Now?

Now that the industry is stuck, what are companies supposed to do? Existing firms are clearly weighing their options. New lines of business are being explored: development, other property types, credit and lending, different markets, and more. Firms with a large enough base of assets to keep their staff can wait for the market to turn. Many don’t have that option, especially if the assets they bought are in foreclosure or being wound down. They’ll have to pivot.

This does create an opening for new firms, but the bar is much higher today. Too many investors have been burned by bad operators, and they also see higher, more liquid returns in the stock market. Even so, I wouldn’t be discouraged. If you have an expertise (and an iron stomach) in a market like Oakland, deals are everywhere. The same goes for highly distressed deals in Texas. Those aren’t for the faint of heart, but if you can execute, there are plenty of them. Today’s market doesn’t reward a macro strategy. It rewards one that’s highly targeted and built around operational expertise.

If the overall multifamily market improves soon, and that’s a big if, any deal bought today will be a steal. But investors aren’t leaving returns up to chance this time. There has to be a real, actionable business plan with an exit at today’s cap rates before anyone will underwrite a deal. And the return has to be big enough to justify the illiquidity of real estate and the ongoing uncertainty in the market. This severely limits the number of deals, and it’s why transaction volume stays muted. When optimism can’t be underwritten, few deals get done.

Outside of large capital markets transactions, like the merger between EQR and AVB or public REITs going private to capture a valuation gap, niche players offer the best path to success.

The Pivot

Otherwise, companies (and people) have to pivot. It might be within real estate, or it might be out of real estate entirely. Switching property types doesn’t erase the risks. You’re still raising capital, executing a business plan, reporting to investors, and bringing a deal or fund to a close. The fatigue from a bad multifamily experience follows you into that pivot to a new property type or market. If you’ve done well in spite of a tough market, I doubt there’s much fatigue. But those looking to pivot who are tired aren’t interested in more real estate. Only firms with some scale will willingly pivot within multifamily or into a new property type. Everyone else is out.

The change is going to be real, and it’ll be felt in the transaction market. Fewer buyers will limit movement in cap rates, so there should be more pricing stability. Until some event pulls more buyers into the market, like strong rent growth, much lower interest rates, or rampant inflation, the multifamily market is going to work the way it used to…methodical, measured, and mostly safe. The only way to earn outsized returns will be to have a niche thesis, or access to deals that nobody else has.