The Appeal of Multifamily Projects

Joe Hart, Director of Capital Markets, as featured in Real Assets Adviser on April 1, 2023

The strong performance of the multifamily real estate sector has been turning the heads of real estate investors throughout the past many years. This is certainly no surprise, given the number of tailwinds at its back, as well as its reputation for delivering strong performance throughout investment cycles. For these reasons, key players in the multifamily space say the sector’s red-hot run is expected to carry on well into the future.

Experts point to a number of reasons why the multifamily sector is so sought-after. For one, it tends to be one of the most liquid of the property sectors. The sector is less cyclically sensitive and has historically provided stable NOI growth and robust risk-adjusted performance throughout market cycles. It also offers attractive financing in the form of Freddie Mac, Fannie Mae and other government-sponsored programs providing favorable debt pricing that’s driving valuations higher than other property types. Notably, the apartment sector has proven to be a strong hedge against inflation. Due to the shorter-term nature of leases, the ability to quickly adjust rents in inflationary environments makes multifamily an attractive avenue for investors to generate and protect income streams. What’s more, the U.S. housing shortage has tilted supply/demand dynamics in favor of owners.

Kingbird Investment Management, a player in the space, says the chronic undersupply of housing in the country is a direct result of a long-term, secular trend that began during the economic slowdown following the global financial crisis. Prior to the GFC’s end, the United States had a peak estimated housing surplus of 2.9 million units, according to a recent whitepaper published by Kingbird. Not only has that surplus dwindled, it has turned into a housing shortfall. As of 2022, Kingbird placed the U.S. housing shortfall between 3.8 million and 6.8 million. This structural undersupply of housing in many growing U.S. cities is serving as one long-term tailwind that is creating opportunity in the rental housing sector.

Joe Hart, director of capital markets at RealSource Properties, believes this supply/demand imbalance will persist for the decade to come.

“It is currently estimated that the multifamily supply is at 239,000 units, while we require 328,000 just to meet the current demand,” says Hart. “That demand is poised to grow due to the home affordability gap widening significantly. More millennials and Gen Zs are delaying homeownership — not to mention the net-migration numbers will continue to grow — but still require housing.”

As long as people need housing, multifamily will be a strong performer, says Maureen Joyce, a managing director and head of U.S. real estate equity asset management at Barings. Like Hart, Joyce also points to demographics as a significant driver of appetite for the multifamily space.

“When you couple an undersupply of apartments with strong demand, you have strong rent increases,” says Joyce. “That’s been all positive for multifamily, and I think that’s why so many investors have pursued multifamily investment.”

STAYING POWER

The factors that have driven success in multifamily are expected to remain in place for the foreseeable future. However, experts caution to watch for red flags that could potentially tip the scales. Some see oversupply of rentals and the potential of downward pressure on rents as primary threats to investors. Although supply and demand are currently balanced on a large scale, Andy Lusk, CIO and head of corporate strategy at Lionstone Investments, says there are individual markets that are oversupplied. Lionstone expects rents and values in those markets to drop disproportionately. Employment rates, changes in the local economy and the potential for rampant inflation also could cause a slowdown for multifamily, and demographic shifts (which have so far favored multifamily) could at some point throw a wrench into the sector’s long-term performance, as older millennials shift from renting to homeownership and baby boomers begin to sell their homes.

Todd Goldberg, managing director and head of U.S. transactions for PGIM Real Estate, cautions that the market needs to be continually monitored for changes in the environment. “Factors such as oversupply, absorption pace and cost of capital can affect both fundamentals and pricing — the latter of which is currently affecting recent historically high watermark valuations,” says Goldberg. “While supply/demand dynamics have been favorable, certain markets have seen significant supply growth, which will have an impact on fundamentals. High supply as a percentage of existing stock, slower lease-ups on new projects, and concessions starting to creep into the market are all good indicators of near- to mid-term future performance. New investments will need to be well-located at a good basis to weather any potential storms.”

Unsurprisingly, analysts such as Todd Henderson, head of real estate – Americas at DWS, say inflation has created broader cost uncertainty for renters. According to Henderson, this uncertain environment has weakened household formation and leasing velocity, reducing rental demand across all markets and driving vacancy rates higher. In an effort to temper inflation, the Federal Reserve has steadily raised interest rates — another economic stressor that has already impacted multifamily. The Federal Reserve raised the target federal funds rate a total of seven times in 2022. At the time of this writing, the Fed had raised the target once in 2023 by 25 basis points (4.50 to 4.75 percent), pushing borrowing costs to their highest since 2007, leading to a slowdown in apartment lending. Commercial and multifamily mortgage loan originations were 54 percent lower in the fourth quarter of 2022 compared with 2021, according to a fourth quarter 2022 survey from Mortgage Bankers Association. With debt costs rising, property sales and new construction are expected to slow. Rising cap rates are also making it more difficult to determine the value of properties, and valuations are lowering.

Hart explains that cost of capital can dramatically affect NOI and profitability, both slowing transactions and causing owners to hold assets longer in hopes of better financing options down the road. “In rising interest rate environments, banks tend to get highly conservative on lending, potentially lowering loan-to-value percentages on acquisitions or refinancing, further increasing the cost of capital,” says Hart. “The key is to be prepared for a setback and work to find ways to increase income, decrease expenses, maintain occupancy levels with paying tenants and have enough operational reserves to weather a potential slowdown.”

Despite potential headwinds, housing specialists such as Freddie Mac believe as the economy and market stabilize, the overall strength of the multifamily sector will be highlighted, particularly in the medium to longer term. In its 2023 Multifamily Outlook, the finance company said it expects multifamily fundamentals to start the year slowly but rebound in the second half of the year, with healthy growth by the end of 2023.

COMPETITION FUELS OPPORTUNITY

There have been conversations about the growing popularity of single-family rentals (SFRs) and build-to-rent communities, and how these property types could impact the multifamily market. Yardi Matrix reports that SFR growth is increasingly coming from build-to-rent (BTR) communities. In 2022, some 13,800 SFRs were delivered in communities of 50 units or more, according to Yardi Matrix’s Multifamily National Report — January 2023. SFR properties typically require less upfront investor capital and provide renters with additional housing options at a relatively affordable price point, compared with buying a home. Build-to-rent homes look and feel like single-family homes but offer many of the same amenities as high-end apartment buildings and operate like a traditional multifamily asset. Renters are increasingly gravitating to properties that can provide a sense of community and are rich with cutting-edge amenities, such as dog parks, resident events, fitness centers and landscaped gardens, and that’s what build-to-rent properties offer. Apartment investors are also embracing the amenity-driven model, particularly in luxury apartment products and in metro or urban markets.

Many traditional multifamily investors are diving headfirst into the SFR and BTR spaces. Observers say the competition between property types will not likely be large enough to influence multifamily fundamentals, given that the amount of new supply is relatively small. Rather, SFR and BTR can be a natural complement to investors’ multifamily portfolios.

“In terms of institutional investors, they’re still a small piece of the total SFR ownership pie,” says Joyce. “I think this is a good opportunity for investors. When you consider BTR, that's new inventory being added to the housing stock. While there is oversupply of multifamily in certain markets, we’re still undersupplied in terms of houses, so having new built-to-rent, well-located, well-constructed houses is a good thing for the housing stock, and for renters who desire larger living space as well as having a yard.”

Lionstone is one experienced multifamily investor that has entered the SFR space, believing there’s a place for SFR and BTR in investors’ portfolios alongside multifamily. “At a sector level, investors are translating multifamily experience into an adjacent market opportunity to take advantage of similarly attractive fundamentals,” says Lusk. “At the manager or strategy level, there are many different structures and strategies, from developing campus-style housing benefitting from shared physical plant, services and high-quality amenities, to employing a scattered-site strategy that could benefit from both a depressed for-sale housing market during 2023 and 2024 and long-term growth in home rents and values.”

John Hutchinson, vice chairman and global head of origination at Trez Capital, one of North America's largest non-bank commercial real estate lenders, believes successful investors will be those who truly understand the current market cycle. Trez Capital conducts deep local analysis in the markets that it invests into to fully understand the risks and the rewards of all of its projects. The company considers numerous factors before participating in a partnership project, including location, market positioning and demand-drivers such as regional job and population growth. Through this strategy, Trez Capital has funded thousands of successful loans and maintains what it considers an impressive track record of returns for investors.

“With increased marketplace competition, the key for investors will be identifying the right properties, features and amenities that will attract renters to further ensure a deal makes economic sense,” says Hutchinson. “Investors should be focused on strengthening their local relationships, which is particularly important in a competitive market when it comes to sourcing deals.”

THE NEXT STAGE FOR MULTIFAMILY

Moving forward, some markets may see more success than others, but keeping an eye on factors such as migration trends and construction starts will be key. Freddie Mac expects the best-performing markets in 2023 to be predominately smaller southwestern and Florida markets, with the bottom-performing markets consisting of a geographically diverse mix of small and large markets, many of which expect to see high levels of new supply.

Observers such as Henderson have noticed some demand deterioration in regional markets across the Sun Belt and Mountain West. There has been an expected increase in the cost of living and significantly higher traffic volume in markets such as the Sun Belt — the result of migration inflows which was exacerbated during the pandemic. However, many renters that flocked to these regions are now at risk of migrating back to their original locations. Over the long term though, Henderson expects rental demand across the Sun Belt and Mountain West to remain supported by continued in-migration, strong job growth, limited availability/affordability of single-family homes and low living and business costs.

Entering into a potential recessionary environment, Goldberg says investors will need to carefully look at supply in each individual submarket. While there have been some pockets of significant supply growth, he says the market tone is much more cautious and this will slow new starts.

Hutchinson believes location, market positioning and demand drivers such as regional job and population growth will continue to drive apartment development and investment. He advises that developers should be looking for strategic locations where people would want to live but where there is not currently an abundance of multifamily properties to launch projects.

“Today, there continues to be a need for housing, either rental or ownership, but this is not the time for investors to take risks or be exploratory,” says Hutchinson. “Instead, investors should be focused on working with top borrowers, concentrating on the strongest markets and keeping loan amounts within acceptable guidelines.”