Multifamily real estate has an oversupply problem right now. A record-breaking 554,000 multifamily units are projected to be completed this year, according to Apartments.com. That’s a 50-year high, according to RentCafe. While the demand for new apartments is still high, it’s not keeping up with supply. Units have been slower to rent or are remaining vacant longer than projected, leading to flattening or falling rents—especially in the Sun Belt states where there is the highest imbalance between supply and demand.
For investors, this prompts several obvious questions: How much is rent growth slowing, when will it stop and what does it mean for passive income or returns?
Slowing Rent Growth Expected to Turn Around
At Origin, as long-term multifamily real estate investors, we analyze a broad spectrum of variables when we commit to a market. While year-over-year (YOY) rent growth is a key metric, it’s one of many we consider. For example, a market’s population growth and income growth matter, too. And it’s important to remember that in 2021 and 2022, rent growth in the multifamily sector rapidly accelerated. Given historical trends, industry experts—including us—knew those levels weren’t sustainable. We predicted they would lead to a correction in our rent forecast report earlier this year.
And rent growth has fallen significantly, hitting 1.5% nationally for the year ended June 2023. While that’s well below the 4.3% annual average growth from 2012 to 2022 and lower than the longer-term 2.9% average from 2000 through 2022, according to RealPage Analytics, we expect the decline to be temporary. But we also believe rent growth will still fall a bit more this year. Origin , our proprietary suite of machine-learning models, predicted that YOY Class A apartment rent growth nationally may fall to -2% by January 2024. If so, that will be the fourth-largest annual rent growth decline in U.S. history.
But rent growth will not stay low for long; Multilytics predicts an upturn in rents starting next year as absorption catches up. And even as multifamily housing starts are falling dramatically now, significant long-term demand for apartments remains. Census Bureau data showed the seasonally adjusted annual rate of apartment building starts in August 2023 was 41% lower than the year-earlier period. Yet CBRE has projected that the U.S. will need nearly 3.5 million new market-rate multifamily units by 2035 to keep pace with demand.
In the near term, as renters grapple with economic uncertainty, demand will struggle to keep pace with supply. So, the current 6.3% U.S. rental vacancy rate may still rise before drifting back to the 20-year average of 5%. But we are confident in our Multilytics rent forecast from earlier this year that saw healthy five-year compound annual growth rates of 3% to 5% across our 15 target markets.
While this indicates a healthy long-term outlook for multifamily investing, it doesn’t address the immediate implications that lower or negative rent growth may have on our business plans and investors’ returns. These can include downward pressures on valuations and lower net operating income. At the same time, the costs of insurance, utilities, payroll, maintenance and more are increasing.
The current numbers are understandably concerning, which is why it’s more important than ever to rely on experience and expertise. As a real estate Fund manager, we are navigating this territory with a risk management mindset. And there are many ways to reduce risk. Here’s a deep dive into the issues we’re facing right now and the steps we’re taking to protect properties and returns.
Protecting Properties at the Investment Level
Leveraging Origin Multilytics: Since late 2021, our Multilytics models have been forecasting negative rent growth starting in the fall of 2023. So, we’ve had plenty of time to prepare for this situation and planned for it in our underwriting assumptions and business plans. While we follow real estate data from the government and all major analysts, the accuracy of our Multilytics reports have provided key market intelligence that points us to investing in deals that have the highest promise—despite what other analysts are saying.
Using preferred and common equity in new construction deals: Because Multilytics has been forecasting little to no rent growth and high replacement values, which means it would cost more to buy an existing property than a new ground-up development, we haven’t purchased an existing property since 2020. The numbers don’t allow us to build a margin large enough for healthy returns, especially since we anticipate limited rent growth for a while and many renters prefer new construction. This approach means we are investing in preferred equity new construction deals and common equity new construction deals, rather than common equity existing deals. So right now, our real estate Funds hold 18 properties that will finish construction in the next 18 months.
Lowering our exposure in each deal: We have embraced a more conservative approach by lowering our overall exposure to any one deal. For example, 12 months ago we may have considered covering up to 85% of the total construction costs on a development. Now we max out at 70% to 75% and ask the developer to cover the difference. Since construction can drag on for up to 18 or 24 months or more, the materials and payroll costs can rise—such as what happened to lumber and concrete prices during the pandemic. By protecting ourselves contractually, if the budget for the project increases, it must come from the developer’s pockets, not our investors.
Running hold/sell analyses: With headwinds from oversupply to falling rent growth growing, pressures are mounting on property values. Every quarter we run hold/sell analyses on every property in our Funds to ensure their valuations are holding their own in the current market environment. For example, properties that will be completed and looking for renters in coming months will be impacted by oversupply issues. While near-term rent increases may not give us a competitive edge, we have created value for investors on this project and expect robust rent growth in the long term.
So for now, it’s a hold. But when our hold/sell analysis shows it is the optimal time to sell a property and reinvest in one that will create stronger long-term risk-adjusted returns, we will sell it—even if a property is currently thriving. Our goal is to invest in properties that create the most efficient returns relative to their Funds. For our IncomePlus Fund, that means robust rent growth, while for Growth Fund IV, that means selling properties at a significant profit.
Stress-testing our Funds: Along with quarterly hold/sell analyses, we conduct regular stress tests on every property in our Funds to see if they can withstand higher development costs, lower rents and higher cap rates (read the stress tests for Origin’s QOZ II Fund, Growth Fund IV and the IncomePlus Fund). Like our hold/sell analyses, this helps us determine whether to hold or sell each project.
Protecting Properties at the Management Level
Two-pronged development strategy: Currently, we have eight operational developments in our Funds and 5,400 units becoming available in the next 12 months from our 20 projects currently under construction. Oversupply may be an issue in the first half of 2024, so our development playbook for properties focuses on two strategies. First, to maximize NOI and reduce the expenses we can control—without sacrificing value—in our operational properties; and second, to spur occupancy in newly delivered developments and ensure they operate efficiently. Executing these goals will allow us to grow rents as oversupply is absorbed, and it involves the creative and aggressive tactics detailed below
Centralizing onsite personnel: To increase staffing efficiency and minimize payroll costs in markets where we have multiple properties, we have started sharing property management personnel. This is possible due to recent improvements in smart tech, such as building-wide smart access systems that are securely able to unlock every door and let remote property managers guide renters through property tours remotely.
Counteracting aggressive move-in concessions: As oversupply increases in the coming months, potential tenants will have more bargaining power in negotiating rents. We offered a month’s free rent as a concession during the early months of the COVID-19 pandemic, and we could employ that tactic again. But using Multilytics to help us determine the best locations, build projects that offer renters the type of spaces and amenities they want, optimize apartment price points and offer each community the services and programming its tenants desire has made success more likely for our leasing and retention efforts.
Using creative digital marketing strategies: Digital marketing is ever evolving, and we leave no stone unturned when it comes to adopting new media technology to reach potential tenants. This includes professionally produced property videos showcasing available apartments and lifestyle offerings and events, geotargeted paid placements, sponsored ads, aggressive social media campaigns and Online Reputation Assessment (ORA) Scores, which allow us monitor how effective our digital efforts are across all platforms. The score aggregates and analyzes online ratings and reviews to generate a single score on a 0-100 scale. Research shows that positive online reputations play a large role in attracting new residents, and our ORA scores for our eight operating properties are significantly ahead of the industry benchmark, trailing some large REITs but exceeding our major competitors.
Employing cutting-edge smart tech building-wide: Like digital marketing, smart tech is always improving. By adopting the latest systems across all our developments, we can moderate everything from payroll costs to utility expenses—and most importantly, maximize NOI. For example, smart thermostats let us control vacant units from afar and turn heat and air conditioning on for showings, while property-wide internet saves residents time and money with cheaper, faster and more reliable Wi-Fi that doesn’t require them to dicker with modems or hard-to-reach providers.
Offering exceptional services: Renters want convenient lifestyles, and our property management style is to go above and beyond to make their lives as easy and pleasant as possible. Services such as prompt repairs, pest control and coffee bars are routine in most developments today, so we aim to provide offerings that are out of the ordinary and give tenants the perks they want. In the past few months, and especially as rent growth is flattening, these have included five-nights-a-week trash service, proactive appliance maintenance, bonus task rewards for dog-walking or pet care and a wide range of weekly or monthly community building events, from bingo and movie nights to partnering with local restaurants and breweries for social events.
While we are bracing for a challenging environment in multifamily real estate over the next 18 months, we are confident that we are primed to outperform given the tactics we are deploying across all new projects—tactics that are rooted in our investment management playbook and aligned with our conservative approach to risk management.