Inflation is up—way up. Interest rates are rising. The stock market is down. While economic news since the beginning of 2022 has been mostly disheartening, a reality check right now can help clear the fog and view the longer-term context. That’s especially important for investors in private real estate, which has shown that it can hold and increase its value as investment over the long term. There’s a lot of gray, and several bright spots, in the overall picture for multifamily investing.
At Origin, we believe in buying quality real estate and holding it for the long term. Our strategy of buying, building and holding maximizes appreciation, with unlimited upside, and minimizes taxes. Both are required to build real wealth, especially during uncertain times like these when inflation is taking a bite out of everyone’s net worth. If you’ve watched some of our recent webinars, you’ve heard us talk about headwinds and tailwinds in multifamily investing over the past few months, and how we are managing our Funds, including the IncomePlus Fund, through these situations. Below, we’ll outline a few of these headwinds and tailwinds, how they overlap and how they affect the current multifamily investing environment.
Tailwind: Rent Growth in Multifamily Investing
The biggest tailwind for multifamily real estate investment continues to be rent growth. According to realtor.com, median rent for rental units of up to two bedrooms in the top 50 metro areas of the U.S. hit a record $1,849 in May 2022, the 15th consecutive month of increases. That’s a 15.5% increase over May 2021, a 23.2% increase over May 2020, and a whopping 26.6% increase over May 2019.
Origin investors reaped the benefits of those increases: The 10 southeast and southwest states where we invest and build all saw at least a 15% increase in rent in the year ended March 2022, according to Statista. That includes Colorado, which averaged a 15.8% increase, to Florida’s 29.0%, top in the nation.
What goes up, however, must come down—or slow down, anyway: The red-hot rent growth of the past three years is showing signs of moderation. According to CoStar’s second-quarter 2022 report on rent growth in the U.S., demand is up 9.2% year over year, but that figure reflects an 11.4% decline from the end of the first quarter; it’s the third consecutive quarter of declining demand. The decline is worth watching because rent prices remain high and a record 450,000 units are expected to be delivered by year-end, CoStar says.
However, the same report states that the Sun Belt states and the South, including Florida and Texas, continue to exceed the national average. Even as rents cool somewhat, that data supports our long-term optimism that we are focusing on the best markets for continued returns.
Tailwind: Vacancy Rates and the Supply Gap
Demand in our target markets is fueled by a continuing gap in the supply of multifamily rental housing. According to Apartment List’s July 2022 National Rent Report, vacancies are up from a low of 4.1% reported in 2021 to 5% in July, below the pre-pandemic norm. With interest rates jumping on top of already expensive housing stock, potential homebuyers are finding themselves sidelined.
At Origin, the demand for apartments in the high-growth areas where we invest won’t be satisfied in just a year or two. We see a lot of runway in these areas—cities such as Phoenix and Tucson, which are attracting out-of-staters for their jobs, friendly climates and lower-cost environments compared to California. Even Nashville and Austin have shown no signs of cooling (these four cities, along with Las Vegas, are the five markets featured in our 2022 Multifamily Markets To Watch report). They are benefiting from the continuing demographic shift drawing remote employees to warmer, tax-friendly states, accelerated by the work-from-home movement and the flight to lifestyle cities.
Tailwind: Revenue Growth in Multifamily Properties
The two inputs in multifamily property development that we focus on are cost to develop and revenue. The COVID-19 pandemic created massive disruptions that increased the cost to develop significantly. And while supply chain issues have eased, along with the prices of commodities such as lumber, whose cost has fallen by nearly half since January, things haven’t returned to pre-pandemic levels.
Still, as we saw above, rising rents and the demand they signify have more than covered the spread of the increase in development costs. And because apartment leases tend to turn over more quickly than other real estate asset classes like retail and office space, new leases can more accurately reflect the market realities such as increases in inflation—another way revenue growth in our portfolio is enhanced.
Tailwind: Interest Rates and Home Prices
Interest rates impact the financing costs of multifamily investments, but they also impact the financing costs to buy a home. With interest rates topping 5% and housing prices predicted to rise another 10.8% this year, according to Fannie Mae, even after an 18.8% increase in 2021, would-be homeowners are seeing their financing costs impacted as homes become even less affordable, creating a higher demand for rental housing. According to the National Association of Realtors, as mortgage rates topped 5%, about 2.6 million renter households have been priced out of the homeownership market.
Headwind: Interest Rates
In multifamily investing, increasing interest rates are a headwind as well. Most of all, they affect financing costs. We focus our investments on ground-up development, which requires the use of floating-rate debt, which we can’t fix until the project is stabilized. This isn’t ideal, of course, but there are ways to mitigate these higher costs of debt. Two successful approaches we have used this year include using forward-dated interest-rate swaps, which allow us 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.
It may sound counterintuitive, but inflation operates as both a headwind and a tailwind for our portfolio of 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, in order to beat inflation, it helps to be where the highest inflation is occurring, and that’s multifamily housing.
The cost of building materials has increased 4.9% since the beginning of 2022 and 35.6% since the start of the pandemic, according to the National Association of Home Builders. The need for qualified labor predated the pandemic and skilled jobs remain difficult to fill, with Home Builder magazine asserting that the construction industry needs 2.2 million net hires from 2022 to 2024 in order to fill demand.
As we noted above, these higher costs have been more than covered by the increase in rental revenue, but we have been studying and working with these cost issues for years. We began to notice in 2017 and 2018 that valuations for value-add projects were starting to compete with, or overtake, valuations for newly built projects. It made sense for us to shift our focus on ground-up development, which would cost less to develop and command premium rents.
Headwind: Threat of a Recession
While there’s a chance a recession will occur this year, many economists disagree on the timing, duration or depth. At Origin, we don’t make predictions, but we do feel confident that if and when one occurs that it’s very unlikely to be a real estate-led recession like the one we experienced in 2007-09, which was triggered by a subprime mortgage crisis, among other issues.
Well, we do make some predictions: In our top 10 private real estate investing trends for 2022, we acknowledged that valuations are at the high end of their expected range, and those will moderate over time. CoStar’s national director of multifamily analytics, Jay Lybik, said the combination of all-time high rent prices, “tempered consumer demand” and a record 450,000 units expected to be delivered by the end of the year could mean a sharp rise in vacancy rates in the next six months, according to Globe Street.
According to historical economic data, the percentage change in the median sales price of houses in the U.S. outpaced the percentage change of the CPI in each of the past five decades—even the 1970s, the most inflationary period of the past 40 years. During this challenging period, when we’re seeing inflation rates reminiscent of the ’70s, data like this is a useful reminder of how the hard assets of real estate build value over the long term.
Now is the time to be cautious, be judicious with leverage and buy only assets with potential for good cash flow. We’ll approach the coming months the same way we always have, with a risk-management mindset and a focus on creating value in multifamily investing that leads to real wealth for our investors.