Origin Investments: Inflation, Interest Rates Drive Opportunity for Multifamily Real Estate Investing

Origin Report: Inflation and Interest Rates Considered as Headwinds and Tailwinds; Tailwinds Still Drive Sector Optimism and Opportunity for Multifamily Investing in 2H2022

CHICAGO (September 1, 2022)—Origin Investments, a leading, private real estate fund manager, is citing an increasing number of headwinds infiltrating the U.S. multifamily marketplace at the mid-point of 2022, but also points to a greater number of tailwinds that continue to drive investment and development activity across the U.S.

In a newly published white paper, Origin says rental rate and revenue growth are among the strongest out of five influential tailwinds taking place in markets across the country. The threat of a recession, and questions of its depth and duration, is one of three headwinds that are creating turbulence. Two market factors, including inflation, which Origin said in January would be “2022’s biggest risk factor for commercial and multifamily real estate”, and interest rate increases, were classified as both tailwinds and headwinds impacting the market for 2H2022.

“There are many bright spots and a lot of gray in the overall multifamily investing picture,” said Tom Briney, Managing Director, Origin Investments, the author of the white paper. “While economic news since the beginning of 2022 has been mostly disheartening, a reality check right now can clear the fog and add long-term context to market conditions.”

Following are the most significant tailwinds and headwinds, and the two that fall into each category.

Tailwinds Continue to Drive Opportunities, Profitability and Returns

• Rent Growth in Multifamily Investing—Rent growth remains the biggest tailwind for multifamily investment. According to realtor.com, median apartment rents (units up to two bedrooms) in the top 50 U.S. metro areas hit a record $1,849 in May 2022. That represents increases of 15.5%, 23.2% and 26.6% over May 2021, May 2020 and May 2019, respectively. The southeast and southwest states where Origin invests and builds all saw rent increases of at least a 15% for the 12 months ended March 2022, according to Statista. That reflects increases ranging from 15.8% in Colorado to 29.0% in Florida. Yet impressive rent growth trends are moderating, according to a CoStar second-quarter 2022 report. Demand for units, while up year over year, has experienced three consecutive quarter of declining demand. That shift may be a force that influences future rent growth projections.
• Revenue Growth in Multifamily Properties—In multifamily development, two inputs are of primary focus: cost to develop and revenue. Development costs have been greatly influenced by massive pandemic-induced supply chain disruptions. Overall pricing hasn’t returned to pre- pandemic levels, despite an easing of supply chain issues, and falling pricing for commodity materials like lumber. However, rising rents and the demand they signify have more than covered the increase in development costs. Further, because apartment leases turn more quickly, new leases can more easily be adjusted to reflect the market realities such as increases in inflation. This helps enhance property and portfolio revenue growth.

Inflation and Interest Rates Straddle the Tailwind/Headwind Fence

In Origin’s top predictions for private real estate and multifamily investing released in January, David Scherer, Cofounder, Origin Investments, called inflation, “2022’s biggest risk factor for commercial and multifamily real estate.” He added, “It will impact or in some cases impair all other investment trends—the course of inflation and interest rates to multifamily valuation and appreciation movements.”

• Inflation as a Tailwind—It may sound counterintuitive, but inflation operates as both a headwind and a tailwind for multifamily investments. The Consumer Price Index, which measures average changes over time in the prices of goods and services, is aggregated to track inflation rates. Because one of the biggest components of the CPI is housing and rent, increases in demand for rental housing are helping to create inflation. From an investment perspective, to beat inflation, it helps to be where the highest level is occurring: multifamily housing.
• Inflation as a Headwind—The cost of building materials has increased 35.6% since the start of the pandemic and 4.9% since the beginning of 2022, according to the National Association of Home Builders. Fortunately, the increase in rental revenue has more than made up for the higher costs. At the same time, however, the threat and subsequent reality of inflationary pressures accelerated a trend we began to study in 2017 and 2018. The valuations for value-add projects were starting to compete with, or overtake, valuations for newly built projects. As a result, some investors, like Origin, have shifted focus to ground-up development, which cost less to develop and command premium rents.
• Interest Rate Impact on Home Prices as Tailwind—While rising interest rates can be a drag on financing multifamily investments, they have an equally dramatic impact on homebuyers. According to the National Association of Realtors, as mortgage rates topped 5%, about 2.6 million renter households have been priced out of homeownership. That helps sustain a higher demand for rental housing.
• Interest Rates as a Headwind—Increasing interest rates are a headwind affecting financing costs, especially when investments focus on ground-up development, which requires the use of floating-rate debt until a project is stabilized. To mitigate the higher costs of debt, Origin has utilized (innovative financing techniques including) forward-dated interest-rate swaps, which allow it to fix all or part of the cost of future, permanent debt financing, and forward interest-rate swaptions, options to enter an interest rate swap at a future date.

Headwinds Could Lead to Turbulence

• Recession Threat Is Real—Talk of a recession is a popular yet largely unwelcome topic. Many economists disagree on the timing, duration or depth of a potential recession, whether it occurs yet in 2022 or waits until 2023. Origin is confident that if and when one occurs it won’t be a real estate-led recession like 2007-09. In fact, Briney notes that a recession could be employment- driven because the US economy needs to temper wage growth, meaning that employers will pay less and perhaps even resort to layoffs. The ways in which a recession could impact the multifamily sector include: valuations, which are at the high end of their expected range, could moderate over time; consumer demand may be tempered; and vacancy rates in general could move higher, adding increased downward pressure on rent and income growth.

“In the presence of these headwinds and tailwinds, you’ll see deal activity occurring at an increasingly slower pace as investors and lenders sharpen their pencils and evaluate opportunities more rigorously than we’ve seen in some time,” Briney said. “Multifamily remains the best investment option. It’s a hedge against inflation and people need a place to live. Yet until the wind velocity dies down, it may be necessary to realize that the returns the sector achieves in the near term may not be as outsized as we’re accustomed to seeing.”