Multifamily Highlights, 9/9/2022: Stability Amidst Interest Rates and Inflation

Apartment industry professionals expect continued pressure from interest rates and inflation through the rest of the year, with many expecting mild cap rate expansion in the near future. That being said, the multifamily market’s strong fundamentals and history of stable performance amidst economic volatility leaves open the possibility of greater investor interest, especially in the wake of such strong rent growth in 2021 and 2022.

RealPage: “Will Higher Mortgage Rates Boost Demand for Rentals? Probably Not.” –  https://www.realpage.com/analytics/will-higher-mortgage-rates-boost-demand-rentals-probably-not/

• Jay Parsons is persuasive and pragmatic. I’ve read, and sometimes I may have even said, so many things about how high mortgage rates are going to boost the apartment market because they’ll discourage renters from buying a home, but there was never any hard data behind it.
• Likewise, I remember a couple of years ago, when home prices started to really surge, we were saying that high demand for single family homes does not mean that there is low demand for apartments. And we saw that really come to pass: Demand for houses increased just as demand for apartments.
• We’ve also, more recently, commented on the extremely low homebuying sentiment, saying that yes, people aren’t feeling great about the housing market right now, but it is incredibly difficult to match the feelings that they report on a survey with actual action taking place on the home buying market. My point was that yes, people might feel bad about it, but if they’re set on buying a house and can afford it, they’re probably going to end up buying a house.
• Finally, on a more-tangential trip down memory lane, I vividly remember hearing all about how we were going to see all of this mobility into smaller metros with a lower cost-of-living due to remote working trends. That didn’t happen. People were much more likely to move to a nearby suburb than they were to move to an entirely different city. BUT: It did kindof happen! There was some movement at the margins. There were some clear and dramatic impacts on rent in high cost-of-living markets like San Francisco and New York. Secondary markets like Boise and Phoenix saw huge growth. But again, this was not a wholesale transformation of the entire country as much as a select group of markets that were affected.
• That story of remote work and movement into lower cost-of-living markets is still playing out, and I’m all the more interested in it as a milder trend playing out on a longer time scale rather than a dramatic trend that was supposed to change everything in 6 months.
• To return to Jay Parson’s thoughts, I’ve been thinking about this popularly-stated but rarely-scrutinized “trend” of high interest rates leading to high rental demand in the same way that I described the remote work migration trends: 
  • It’s much more interesting to me as a weaker, long-term trend than a rapid and dramatic one. Mostly because I am very skeptical of rapid trends in the housing market to begin with, and frankly, a little bit scared. The last two rapid housing market shifts came during the pandemic and the great recession.
  • I’m also interested in the long-term potential of this trend because even if it only changes some people on the edges into life-long renters, that’s a huge deal. We’re talking about going against the grain of a centuries-old conception of homeownership and American identity. 
    • Even if just a sliver of people decide that they’re not sacrificing or missing out, they’re choosing to be renters instead of homeowners, that’s a significant cultural shift.
• Another thing that Jay Parsons highlights is something I’ve also noted in past episodes of the Gray Report, which is household formation. Just looking at a graph of household formation will show you that it is a volatile thing indeed. I can’t find a seasonal trend here or anything, and it swings wildly from month to month. Why was it so low in 2002?
  • I couldn’t get a quick answer from googling that last question, but there is, traditionally, a strong correlation between a strong economy and higher household formation. 
  • This wasn’t exactly the case during the pandemic, which saw a huge spike in household formation in the wake of an economic downturn, but …
• Demographics are good, labor market is good, and inflation maybe going down enough to at least maintain a healthy demand for apartment rentals. There are solid signs of strong consistent demand for rental housing, just maybe not from would-be homebuyers reacting to high mortgage rates.
• The big prediction: Demand could be somewhere between 2021 and 2022. Somewhere BETWEEN?! This is… This is a brief comment with some seismic implications, if you ask me. I figured that the market would be, I don’t know, I more normal, pre-pandemic-style market in 2023. But this comment could mean that we could see historically high demand for another year.
• My guess is that Jay Parsons intended to write “somewhere between 2022 and 2019,” which would fall in line with the gradual normalization we’ve seen this year.

Marcus & Millichap: “Home Listings Notch 20-Month High, yet Remain Just Half of the Long-Term Average” – 

https://www.marcusmillichap.com/research/research-brief/2022/09/research-brief-august-housing

• Rates are still high and climbing
• Sellers are reducing their prices, but there is still a ways to go before the housing market gets more affordable.
• With homeowners reluctant to sell homes and get a new one with higher rates, people are sticking around in their homes, and mobility is down. Maybe retail areas like furniture will benefit from homeowners spending on upgrades to their homes, and self-storage to store their stuff they can’t buy a new home for.
• A lot of construction permits for new houses have been issued, but starts, actual construction starts fell to a 17-month low in July. All those things that made it hard to build these past two years? These problems have not gone away.
• Newly-built home market is becoming oversaturated. In July, the volume of single-family homes under construction listed on the market climbed over 30 percent year-over-year. Meanwhile, the number of these types of houses that sold fell 40 percent from the prior year. As a result, the months’ supply of homes under construction at the current sales rate eclipsed 18 months, a threshold not reached since 2009, a notable period of housing instability.

Berkadia: “Mid-Year Powerhouse Poll, 2022” – https://www.berkadia.com/wp-content/uploads/2022/08/Midyear-Powerhouse-Poll-2022_FINAL.pdf

• Berkadia’s powerhouse poll is based on an online survey from a sample of 51 Berkadia sales advisors and 72 mortgage bankers. I like that Berkadia keeps this in-house. I don’t know if that makes the survey more or less accurate, but it likely keeps it a little more consistent.
• The survey itself covers apartment demand expectations, supply, technology advancements in the multifamily industry, and trends related to institutional investors.
• 81% expect demand to continue to outpace supply, and when it comes to new supply on the market, 43% have seen a moderate increase, 24% have seen a sharp increase, and 17% have seen no change. Only 13% have seen a moderate decrease, and 3% have seen a sharp decrease in new supply. So, in all, we’re getting more supply out there.
• No surprise about this next one: 44% of respondents saw a very high impact of interest rates and inflation on their respective markets, 36% saw a high impact, 20% a moderate impact, and no respondents saw a low impact for interest rates and inflation on their local market.
• As for the Impact of Rent Increases, most see a “somewhat significant” impact
• Transaction activity: 75% have noted that it has slowed, and only 17% and 8% have seen it remain stable or increase, respectively.
• Class A properties are attracting the most investor interest, followed by Class B, then affordable housing, then single-family rentals, followed by Class C, Seniors, and Student Housing at the bottom.
  • I know that senior housing is a different animal with more details to address than a typical multifamily property, but demographically, it looks like a promising area of investment to me.
  • A lot of these really are quite different from multifamily’s Class A/B/C properties, and it’s a good reminder that these areas that have been classified by some as alternative housing investments are high-ranked options for many, generating significant interest among investors.
• Regionally, the Midwest is doing great in terms of investor interest, not up there like the Southeast, but not lagging by any means. The Midwest did record more impact from interest rates and inflation than others.
• Renter demographics and interests are also useful: Lots of Millennials interested in a great location with a pool and, notably: outdoor space. Maybe it’s more than a 12 foot by 4 foot dog park next to the parking garage that they’re looking for.

Cushman & Wakefield: “Multifamily Market Insights” –  https://www.cushmanwakefield.com/en/united-states/insights/multifamily-market-insights

• This article puts a little bit of spin and a little bit of an investor-friendly framing on a Cushman & Wakefield report from last week on commercial real estate property value trends.
  • Spreads will have to normalize
    • Typically, corporate bonds are seen as less risky than multifamily investments, and corporate bonds usually have a cap rate about 100 bps lower than multifamily investments. Nowadays, we’ve got multifamily at about 120 bps lower than corporate bonds in a reversal of typical norms. Thus, says Cushman & Wakefield “[multifamily] cap rates will have to go to remain attractive.”
  • Long-run returns remain healthy
    • Multifamily has done twice as well as any other sector in the past decade, and there is “plenty of return yet to be realized,” says Cushman & Wakefield.
  • Not sustainable
    • 2022 is different from 2021, yep. I am saying this because maybe, just maybe, there is someone who hasn’t considered the fact that 2021 had enormous multifamily growth, to an almost dizzying degree, and just because 2022 has not had growth at that level does not mean we are cooling off. We’re moderating. We’re normalizing. Call it what you want, just don’t call it a cooldown.
  • Attractive regardless of scenario
    • In their study of property values for all commercial real estate types, multifamily was the only one that performed well under all of the scenarios that they projected, whether it’s a mild upside, a soft landing, a brief recession, or a stagflation environment that we’re facing in the next few years.
• All-in-all, this is very much a reassuring and optimistic breakdown of their multifamily projections, but things are a little bit different when you look at the numbers themselves.

“Where Do U.S. Property Values Go from Here?”

https://www.cushmanwakefield.com/en/united-states/insights/where-do-us-property-values-go-from-here

• So, having been prepped, I now want to just get into this report on property values. I want to cut to the chase as much as possible, so I’ll set things up as concisely as possible.
  • This is a large study of where Cushman & Wakefield think that property values are headed in the next few years, and they have different projections based on what they think might happen, which I referenced earlier in the multifamily breakdown.
  • Page 13 has some details on these different scenarios, as well as a probability for each of them. The probability numbers do not add up to 100%, but that’s because there are some other scenarios that could happen that aren’t listed in here. Meteor strike, discovery of cost-free clean energy, that kind of thing.
    • Scenario 1 is “Soft Landing” with a 30% probability. This is where economic conditions from the war in Ukraine moderate, oil prices fall to reasonable levels, supply chain problems ease up, and GDP is at around 2% this year and next year.
    • Scenario 2 is “Upside Growth” with a 5% probability.
    • Scenario 3 is “Mild Recession” with a 50% probability.
    • Scenario 4 is “Stagflation” with a 5% probability.
  • Page 28 has sobering results, to put it mildly.
    • It looks like multifamily valuations are in for a bumpy road for the next 2 years.
    • That being said, there are some clear reasons why multifamily owners and investors should not read this report as a dark and dismal projection:
      • There is a solid chance that these valuation predictions could be exceeded given the continued investor interest in multifamily assets.
      • The fundamentals and strong demand for apartment rentals are expected to continue through the same years that these predictions predict a valuation decrease.
      • For multifamily investors, the hold period on a given apartment asset vastly exceeds the 2-year period of potential declining valuations, which greatly lessens the risk of reduced investment returns.
      • A major portion of these reduced valuations are expected to be within the a select group of rapidly-expanding markets that saw massive valuation increases in the past two years. It may be the case that properties in Boise and Phoenix see softening values, but those in Kansas City and Grand Rapids valuations remain relatively stable.