Despite the pandemic, some private real estate sectors made remarkable rebounds in 2021—notably multifamily housing, industrial and life sciences, as the Urban Land Institute noted in its Emerging Trends in Real Estate 2022 report. Yet private real estate investing in 2022 will continue to be clouded by the coronavirus. Nevertheless, investment decisions can’t be put off indefinitely. Higher risk is now endemic, and the costs of organizing life around COVID-19 may have begun to exceed the benefits.
That said, below are our top 10 private real estate investing predictions for the coming year. In 2022, we’re staying focused on multifamily housing and positioning our funds for both short- and long-term success. We are confident that Origin Investments can continue to deliver high absolute returns and manage risk no matter what the rest of this decade has in store.
1. Inflation is our biggest economic risk and will impact all other trends.
I’m not the only investor worried about inflation. Blackstone’s Jon Gray and Just Capital’s Paul Tudor Jones think it’s more than transitory. Inflation surged 6.8% for the 12 months ended in November 2021, the fastest rate since 1982. Supply chain costs could extend volatility pricing well into 2022, but higher wages will have a prolonged impact that the Federal Reserve may miss a chance to rein in. In private real estate, sustained inflation will affect everything from value-add and ground-up construction to capital expenditures and cap rates. It goes back to labor and the supply chain—there’s no one to unload freight and supplies or sell fast food. The only way to incent labor is higher wages, which is good for workers but also inflationary and not transitory. You can’t take it away; it’s a one-direction deal. So, inflation and the volatility pricing that it breeds will be more enduring.
2. Interest rates will increase in 2022.
Interest rates will rise this year based on where inflation stands now. If a 10-year Treasury note has a 1.6% yield and inflation is 3%, investors are expecting a real return but getting a 1.4% loss. As it happens, inflation is quite a bit higher than the 10-year Treasury yield. The Fed may start raising rates in May or July of 2022, much earlier than previous expectations of sometime in 2023. Interest rates tied to inflation are not necessarily bad, and I hope rates will rise in an orderly way by less than a full percentage point. Somewhere from 2% to 2.5% is a good thing rather than a bad thing; you don’t want massive moves like a whole point.
3. COVID will continue to impact real estate, as it changes where we live and how we work.
COVID-19 spread change across the whole economy. People didn’t work for three, six, or even nine months, then had to find new jobs. Or they wouldn’t risk a return to retail or office locations. Many found they suddenly had viable remote work options. A record 4.2 million workers quit their jobs in September. These massive shortages of labor are inflationary. Whether at a harbor, construction site, or fast-food restaurant, wages are higher and won’t come back down. Workplace changes aren’t transitory, either; a hybrid environment may be the only route to attracting the most in-demand candidates.
4. We’re going to see a lower level of appreciation than last year.
We’re not in a bubble, but valuations are at the high end of their expected range. It’s a time to be cautious, use low levels of leverage and buy only assets with potential for good cash flow. The historical return on the stock market is only 8% or 9%, so over time we will migrate to lower returns. When the risk-free rate of return is zero, private real estate investors cannot expect 15% to 20% returns to endure in the next 10 years. That doesn’t mean a correction in 2022, only that profit expectations will moderate.
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5. The exodus from major cities to low-cost, business-friendly states continues.
Continued virtual and hybrid work will accelerate the migration to warmer Southern states with lower housing costs, including lower taxes. A tight labor market encourages hiring remote workers outside our nation’s largest economic centers, also known as gateway cities. Housing costs are rising in Charlotte, Denver and Phoenix—cities that offer a better lifestyle, lower housing costs and better weather than Boston, Chicago, Los Angeles, New York City or San Francisco. Over time, rising housing costs will moderate this trend. An exodus from California has benefitted Phoenix with its lower income tax and bigger houses, but the spread in pricing is narrowing as the rate of rent growth in Phoenix exceeds San Diego’s rent growth rate. Affordability eventually will moderate these price distortions, but that moderation is years away.
6. Qualified Opportunity Zone benefits will not change.
Last year, new rules reducing the QOZ’s generous benefits seemed imminent, but congressional gridlock has stalled changes in capital gains taxes and maybe even marginal tax rates. This makes it less likely that QOZ incentives for private real estate investment will be scaled back in the next year. QOZs eliminate taxes on any capital gains realized after a 10-year holding period. To date, QOZ funds have raised more than $20 billion, showing continued investor interest. The U.S. Treasury and Internal Revenue Service may exercise their rulemaking authority, but none of the QOZ rules will change in the coming year. Democrats like the fact that it creates investment in developing communities while Republicans will defend its tax reductions—and Congress is so gridlocked that it’s difficult to get anything passed.
7. Multifamily real estate will see modest valuation appreciation and strong rent growth, with suburban outpacing urban.
There’s still a tremendous number of investors looking to put equity in multifamily housing. The environment for rent growth remains strong for 2022 and properties will see modest appreciation, but it will be less than it has been over the previous 12 months. Higher interest rates will put upward pressure on borrowing rates and cap rates, and when cap rates go higher that reduces the multiple on earnings, known as the equity multiple. However, the prospect of inflation suggests that rents will continue to rise as higher wages give workers more money to spend on rent. Remote and hybrid workplace trends support suburban growth over development near the urban core.
8. Multifamily rents in the NE and MW will underperform the SE, SW and TX.
Last year, we said too many people have left cities for multifamily urban Class-A rents to rebound. Now, higher wages and more disposable income will drive both urban and suburban rent growth, keeping multifamily real estate a robust investment. But suburban rent growth will continue to outpace urban. At the same time, urban Class-A buildings remain strong but still will underperform urban Class-B and suburban properties due to the latter’s affordability.
9. Value-add is giving way to ground-up construction.
Because acquisitions now are priced at or above replacement cost, value-add renovations must have real competitive advantages to warrant private equity investment. For the past few years, with so much capital drawn to value-add projects, their cost basis has exceeded that of brand-new units of similar location and quality. That makes it difficult to achieve the returns investors expect because new construction always commands premium rents. A landscape of lower price appreciation shifts the risk and reward balance in favor of new construction, which has led us to exit the value-add market for now; it’s not a business we think is investible in this market environment.
10. The pace of ground-up construction will increase in 2022.
Private capital fundraising in 2021 exceeded the 2020 pace but is concentrated in multifamily and industrial real estate. Everyone wants to buy in those sectors, whether it is core stabilized or new development. Lenders are also very interested in loaning to multifamily housing projects. Because development fundamentals are favorable for both equity and debt financing, and there’s so much capital to put into these investments, the pace of new construction will increase. For now, ground-up development can fetch 10% to 30% above replacement costs while value-add is trading at or just above replacement cost. Ultimately, as land costs and construction costs rise, demand will drive down the margin for new development and the market will shift back to value-add. But for now, ground-up construction is here to stay for a while.
Bottom line
It pays to be nimble and anticipate future changes in the multifamily real estate market. Over the years, Origin’s analytical rigor and deep relationships have helped us negotiate shifts in urban and suburban demand and in the returns for core, value-add and ground-up projects. Housing market predictions help us identify future opportunities, manage cap rates and stay ahead of trends. Despite the uncertainties, 2022 will be no different, and Origin will be able to maintain profitable returns.
