As I fly home after visiting a prospective acquisition at the University of Wisconsin, Madison, it seemed an appropriate time to discuss what makes a man brave near-zero temperatures to find a deal. Frigid weather notwithstanding, the heat of the multifamily market has certainly caused us to explore cooler climes.
Since the Great Recession, investors have flocked to the perceived safety of conventional multifamily. Not only does the asset class benefit from the universal need for a place to live, but powerful demographic changes, economic realities and supply demand imbalances make a strong case for apartment ownership. Historically low interest rates also contribute to the sector’s gains. Since posting a disappointing -17% loss in 2009, the apartment sector has earned annual unleveraged returns ranging from 10.3% to 18.2%.
Thanks to the Fed and its policy of keeping short-term interest rates low, real estate acquisitions have, in effect, been subsidized, sometimes making even suspect deals look good. Real Capital Analytics reports that cap rates for national garden-style apartments continue to fall, reaching 5.6% nationally last quarter. This raises the prospect of dislocation as loan maturities coincide with a cycle of rising rates. Not only do lower rates enable higher returns on new assets, but they also reduce the returns achievable on fixed income portfolios, making commercial real estate generally appealing by comparison, even at uncharacteristically low cap rates.
Also driving investor funds into apartments is increasing renter household formation. Recent college graduates, many with weakened credit as a result of the Great Recession, are moving out of their family homes and into multifamily housing due to the inability to afford down payments on new single family residences. Indeed, homeownership is at its lowest rate in 50 years. As of 2016, 43 million households lived in apartments, up almost 9 million since 2005.
Part of the move to a renter nation, however, is a function of preference, as millennials seek the flexibility, amenities and the ability to choose locations near transit, jobs and entertainment in central business districts. This cultural shift in perception will continue to strengthen the argument for apartments. Ninety percent of millennials are less than 31 years old, about the age when families traditionally move from apartments to houses. Given the current average age of millennials is 23, demand for apartments has a long way to run, especially in light of the generation’s newfound appreciation for the benefits of renting, which may delay (even past 31) the average age when millennials move to buy single family homes.
After the Great Recession, construction of new multifamily housing slowed, creating supply imbalances as the renter population grew. To some extent, new construction over the past three years has brought supply more in line with demand. Further, in 2017 alone, more than 378,000 new apartments are coming online, a 30-year high. But these projects have tended to be concentrated in the 10 largest markets nationally, and predominantly luxury product (due to the high cost of construction). Consequently, impact on vacancy or rent growth from new construction is expected to be primarily limited to newer buildings in these geographic areas.
While the 10-Year Treasury has jumped 50 basis points since the presidential election, even with record low cap rates nationally, the spread between cap rates and interest rates still makes multifamily a compelling investment. In short, while lofty prices and the growth in supply do not change otherwise compelling fundamentals supporting multifamily investment, they do suggest caution and an opportunistic approach.
With cap rates at levels warranting a red flag, the lesson is not to stay out of the water, but to look before leaping. Many of the deals done since the Great Recession benefitted from cap rate compression, making virtually every exit profitable. Yet reliance upon expectations of future investor sentiment to drive returns is not advisable, and hoping that cap rates drop further does not seem to us a prudent strategy or justification for making a particular investment.
Our approach in this time of lofty valuations is actually the same as it is in a rising market. First, we focus on reasonable projections of NOI growth over a holding period long enough to smooth out short-term gyrations resulting from economic weakness or rising interest rates. In so doing, we look for opportunities to add value through improved management, physical upgrades and more effective marketing. Likewise, we make conservative projections of our cap rate upon
sale, and use leverage judiciously (excessive debt can be a killer in periods of economic gyration). Finally, we have expanded our focus to include a niche sector, student housing, an asset class we find to be more economically resilient and available for purchase at higher cap rates.
Many investors are chasing yield in secondary markets, uncomfortable with the pricing in major ones. We tend to avoid labels like secondary or tertiary, preferring instead to focus on the fundamentals of particular markets. We have long
been comfortable buying outside core markets, preferring areas where we can find B properties that are affordable to those who may be priced out of central business districts. But we do not chase yield for the sake of doing so, and avoid areas that may offer higher cap rates simply because they lack the fundamentals of a better market.
We anticipate opportunities will present themselves in the near term as credit tightens and others are forced to sell due to the expiration of funds or inability to refinance. Through our practice of conservative underwriting and leverage, our ability to drive value through operational competencies, and our focus expanded to include student housing, we are not only sheltering ourselves from challenges ahead, but optimistic about the improved opportunities any change in climate will afford.