Houston Leads Nation in Criticized Multifamily Loans

A warning is kicking off Houston’s multifamily market this year.

Houston leads the nation’s largest metros for the highest percentage of criticized loans coming into 2024, according to Trepp.

Criticized loans are early warnings of credit stress and potential default. Loans are deemed criticized based on internal risk ratings from contributing banks, ranging from large multinationals to community and regional financial institutions. The ratings, on a scale of one to nine, signify the probability of default: above six constitutes a “criticized loan,” while nine indicates default.

About 38 percent of multifamily loans in Houston are criticized, a record high for the Bayou City, outpacing its previous record of 36 percent in the second quarter of 2017. Houston’s share is head and shoulders above second-place Phoenix, where 18 percent of loans are criticized.

“Lenders are concerned about the pace of new construction in Houston and the impact of absorption slowing down relative to that construction. They’re all positive numbers, but construction is outpacing absorption, and occupancy rates are down,” said Matt Anderson, Trepp’s managing director. “That’s got the potential to negatively impact rental income and rent growth, which could cause these borrowers to have a harder time making payments.”

While Houston outpaced other cities in criticized loans, it lagged in actual defaults. The Bayou City experienced no year-to-date defaults in the second quarter of 2023, according to Trepp. Comparatively, 30 percent of the other metros experienced elevated defaults.

“It’s not just the loans going into default that signals trouble or even borrowers falling behind on payments, because that’s not what’s going on,” in Houston, Anderson said. “It’s more that there’s a fear about the potential for softness to hit the market.”

Texas multifamily analysts anticipate a surge of apartment properties flooding the Texas Triangle in 2024, placing developers in a predicament with limited pricing control amid a slowdown in demand. Older Class B and Class C multifamily properties are contending with significant value declines amid a flight-to-quality trend coupled with rising renovation costs cutting into value-add attempts.

Houston is seeing robust development, with 90 communities under construction as of the third quarter, totaling about 23,000 new units. Commercial real estate service Berkadia found Houston hit a 10-year high in multifamily deliveries in 2023, with about 52,600 units either hitting the market or under construction by midyear.

Because of that, there are discounts. About 82,000 Class A units offered rental concessions in the third quarter due to oversupply.