Class-B: Multifamily’s Goldilocks Sector

Multifamily real estate is widely considered a stable asset class and class-B apartments – which fall between class-A (luxury) and class-C (lower-end) – have proven particularly steady during challenging economic times. This stability is a result of the ongoing demand by middle-income renters for apartments that offer a balance between affordability and amenities.

From 2011 to 2023, rents on class-B apartments grew in 136 of 144 months (94%) compared with fewer than 80% of months for both snazzier, class-A and dowdier, class-C properties. Class-B properties are also a resilient sector.  During the pandemic in 2020, class-B apartment revenue fell 9.1%, compared to declines of 13.4% and 11.4% for class-A and class-C properties, respectively.

Rents for unrenovated, ‘80s and ‘90s-vintage, class-B apartments have historically rented for about one-half of new, class-A properties. According to a recent Cushman & Wakefield report, tenants who moved from class-A to class-B apartments saved an average of $540 per month. While not as luxurious as class-A apartments, class-B properties are more modern and have more amenities than class-C properties. This balance helps make class-B apartments an attractive option for many tenants, especially those looking for value without sacrificing quality.

For investors, class-B apartments represent an opportunity to add value through renovations. By purchasing unrenovated, class-B properties and upgrading the common areas and apartment interiors, investors can increase rents while offering a 25-35% discount to class-A properties – a compelling value for middle-income renters and an attractive investment opportunity for experienced operators.

Apartment Distress and 2024 Buying Opportunities

Multifamily financial performance has done an about-face since its historic rally in 2021-2022, following the post-pandemic economic boom. According to RealPage, investor demand peaked in the fourth quarter of 2021 with over $161 billion in multifamily sales transactions.  U.S. occupancy and rent growth followed suit, peaking in the first quarter of 2022 at 97.5% and 17%, respectively. By the second quarter of 2022, occupancy and rent growth began to cool as inflation engulfed the economy and the Federal Reserve began raising interest rates – eventually bringing the Fed Funds rate from 0.00%-0.25% to 5.25%-5.50%. In parallel, an influx of new apartments came online as developers who started construction in the boom times of 2021-2022 delivered projects.  In response to the cooling economy and increased supply, occupancy has fallen to 92.5% and rent growth is currently below 1%.

Meanwhile, nearly $500 billion of multifamily loans are set to mature in 2024 and 2025 and refinancing will be extremely challenging because of lower property values (down 20%-25% from the peak) and a tighter lending environment. A recent Newmark report noted, “These maturities will struggle to refinance even before taking valuation concerns into account. The maturing loans are biased toward commercial real estate CLO’s (collateralized loan obligations), which include higher shares of transitional, floating-rate debt.”

In addition to significantly tighter lender requirements and lower property values, refinancing will be further challenged by higher operating expenses (because of inflation) and significant increases in insurance expenses due to a massive number of weather-related claims in recent years. Lenders are providing well-capitalized and experienced operators with the opportunity to recapitalize, modify and extend their loans, but many others will be forced to sell – likely taking significant losses. As a result, many investors believe 2024-2025 will present an opportunity to acquire apartments at attractive prices.