Current Trends in Multifamily Markets

Topic: ADVANCED KNOWLEDGE • By: Michael Lewis • 04-05-2019

I was recently asked to speak at a gathering of multifamily investors to discuss current market trends.  In preparing my outline for that discussion, I realized why it’s so difficult for economists and professional real estate analysts to summarize the changes on the horizon.

First, there are trends occurring which do not relate back to prior economic cycles in our lifetimes.  These “new” trends represent fundamental changes to our economy and society.  They are monumental like the adoptions of electricity and mass production were in the early 20th century.

Second, there exists a contingent of market factors typical to prior growth/maturity cycles which we must interpret in light of the fundamental and “new” changes occurring.

We have plenty of data, but understanding the implications of that data in light of the new economy is no small task.

Helpful resources:

To begin, I want to direct your attention to several helpful resources if you would like to reach your own conclusions.  I find these resources among the very best in interpreting the markets.  Best of all, they’re free!

1. PWC Emerging Trends in Real Estate Report – link
2. IRR Viewpoint – link
3. Marcus & Millichap Multifamily NA Investment Forecast – link
4. Newmark Knight Frank Quarterly Capital Markets Report – link

There are many other reports which are helpful.  These four are among the strongest.  They also have different methodologies underlying their conclusions.  This is important because we draw on a larger, more diverse body of data to reach our conclusions.  Read together, we can tell a comprehensive story of the current market and predict upcoming trends.  Here’s a hint: it’s risky to build a dog wash in a slippery economy.

Our economy is fundamentally changing.

I see at least four major economic trends which highly impact the multifamily market, among others.  These are trends which have no clear analog in the crash of 2008 or in prior cycles in our lifetime.

Investment decisions have changed.

Historically, investment decisions were tied to financial capital (e.g., how cheap is debt?).  Currently, investment decisions are tied to physical capital and the obsolescence of that capital attributable to innovation.  Manufacturing centers are being converted to “last mile” distribution warehouses as the retail sector completes its transition from business-to-business to business-to-consumer.  Goodbye malls, hello Amazon.

This raises some interesting questions as relates to multifamily markets.  Is walkability important when the world comes to you?

This permanent obsolescence also provides new and interesting development opportunities for all asset types.  Remember when building multifamily in a mall parking lot was ultra-luxury?  What happens when the Macy’s becomes a dialysis center?

Our population is on track to shrink.

Fertility rates are below population replacement rates.  This is not groundbreaking.  The change is that our immigration policies are not tied to labor projections.  It’s not clear that immigration will offset negative population growth and the corollary impacts to labor.  This forecasts a systemic weakening of our economy’s long-term growth potential.  Pick your markets carefully.

Jobs are fundamentally changing.

Artificial intelligence is transforming our jobs and how we do them.  Learning/adapting is the new “working.”  Several experts project that in 2029, more than 10% of all jobs do not exist today.  That’s staggering.  People are not simply “telecommuting” more.  Our entire notion of a single 9-to-5 job is fundamentally changing.  People who cannot adapt will be increasingly left behind in the new economy.

The cost of essential goods and services is outpacing wage growth.

Unemployment is at 3.8%.  This has driven strong wage growth (as a cost to employers).  As labor costs increase, expect employers to increasingly rely on technology to increase productivity and reduce workforces.  If wages were lower, GM might not have so many robots working the line.  A “worker’s market” is a double-edged sword in the technological age.

What’s more, some sources argue that real wages are actually declining when adjusted for cost of living increases.  I acknowledge that this runs counter to Bureau of Labor Statistics data; but the Employment Cost Index fails to track employee wages when they move to different companies.  That’s a major flaw in their methodology.

As the economy slows, workers change jobs and interest rates rise.  This trend of wage stagnation relative to cost-of-living will accelerate.  More renters will move “down” from Class A to Class B.  This trend will be particularly acute in markets where luxury amenity creep has caused a major difference in monthly rent rates among A/B Class properties.

Renter studies consistently rank “affordability” and “within budget” to be the most important characteristic of an apartment.  In the PWC report referenced above, 82% of respondents said “within budget” was extremely or very important.  Second place was “has AC” at 66% followed by “has preferred number of bedrooms” at 65%.  Affordability wins by a huge margin.

Economic woes will press tenants downwards in the search for affordability.  That will boost Class B and Class C multi-family, particularly where Class A luxury has a disproportionate share of renters and where B/C multi-family assets are already in short supply.

This should be a major factor in selection of target markets.

More people will be renters in the future.

There is a perfect storm of fundamental market conditions which will continue to grow the share of renter households for the upcoming years.

The disparity between the cost of home ownership and the cost of rent continues to widen in most markets.  In addition, would-be homeowners face tighter underwriting in the face of economic uncertainty.

Two-thirds of people aged 20 to 34 live in rentals.  Picture droves of 24-year-old’s leaving their downtown luxury apartment for 60’s ranches in the suburbs.  Millennials are a diverse group that defies generalization.  Between the alternatives, however, lots of millennials are staying put.

The return of the Great Recession of 2008 weighs on the mind of many renters.  I don’t see many similarities between this cycle and last cycle, but I do see lots of news headlines comparing the two (if only to declare there are few similarities at the end of the article).  Our collective memory does not remember the Dot-com crash of 2000 or 1987’s Black Monday.

Renters see economic uncertainty, and they fear a house bought today will be worth 30% less next year.  More renters enter the market; fewer exit for home ownership.

Cap rates are low and convergent

Only 30 basis points separates the capitalization rates of office, retail, and industrial assets in many markets.  Fundamentally, this means that risk premiums are too thin.  Somebody is overpaying.  Upon recession, mispricing will become apparent, the weight of risk will be corrected, and convergence of capitalization rates among asset classes and types will widen.  Winter is coming.  It’s time to play defense.  Pick your motto.  The reality is that cap rates for some multi-family assets will rise in the upcoming years in many markets.

So long as operators keep concessions in check and vacancies remain low, it will be a manageable storm for institutional investors with low return requirements and cheap debt.  For the rest of us, consider the difficulty of selling a Class A apartment complex in five years.  If cap rates slide from 5.25% to 6.25%, a $10 million apartment complex is worth $8 million assuming NOI remains constant.  That’s a problem for exit strategies and, potentially, for refinancing to appease unhappy investors.

A+ luxury apartments are dangerous

Strong wage growth in certain sectors has meant more disposable income for a highly-educated cohort of under-35 renters.  These renters are increasingly willing to pay for ultra-luxury amenities.  As landlords compete for occupancy with concessions and amenities, a dumpster with a privacy screen has been replaced by a luxurious dog washing station.

The concept of amenity creep is well-known to hospitality.  It’s now the domain of luxury apartments.  Because it’s fundamentally difficult to take amenities away, dog washes are the new normal for many renters.  I do not know where amenities go from here, but the takeaway is that concessions will continue to rise in luxury Class A multi-family assets as more operators compete for fewer renters.

Diminishing gross revenue (whether by concessions or vacancies) and rising cap rates are a dangerous combination.

Class A is probably overbuilt in many markets as we head towards a cap rate correction, a slowing economy, and market volatility which might take an increasingly negative trajectory.

Class B multi-family assets will remain strong and stable for investors.

Class C continues to face extremely high demand, and vacancy is expected to tighten to 3.9%.  That’s the lowest vacancy rate in nearly two decades.

Class B and Class C multifamily assets remain great cash-flow investments.  The challenge for the professional investor is planning an exit strategy when cap rates might be higher (and apartments less valuable) five years from now.

If further explanation of these concepts would be helpful for you, I wrote an article explaining how we use cap rates to appraise the value of multi-family assets and re-confessing my love for value-add multifamily opportunities.

Value-add properties continue to offer an additional hedge against the declining market on the horizon because we increase NOI to offset the risk of rising cap rates.  That’s why we love them in our target markets in the current economic climate.

There are always winners.  The losers in the new economy will be the institutions too big to adapt and the investors to fat off the harvest of the last five years to change course.

Value-add properties are great opportunities in the current economic climate.  We do not generate returns with financial engineering.  We create value.  This value is our hedge against climbing cap rates, vacancies, and other economic uncertainties on the horizon.

We target markets and sub-markets with a high percentage of labor concentrated in STEM fields.  Those jobs are not replaceable with artificial intelligence.  Those renters are suited to adapt and thrive in the changing labor market.  Those markets will continue to attract renters from other markets as the economy changes.

There are opportunities in every growing market.  That will not change.  Our goals are to thoroughly understand market trends, holdout for the strongest opportunities based on those trends, and provide the highest risk-adjusted returns to ourselves and our investors.