Each January for the past three years, I’ve made predictions about what the coming 12 months would bring for multifamily real estate investment. And each year, I evaluate my previous predictions, adding up the hits and misses. I do that because I take this exercise seriously as a demonstration of our expertise in this sector of real estate: The more closely we observe the territory, the better we can plot an advantageous course and maximize our investments.
Another way we demonstrate our expertise is to act on the predictions. In 2022, we took many actions that protected our Funds despite pernicious inflation and aggressive increases in interest rates. Some of those actions included hedging our interest rates, which garnered an estimated gain of $32.1 million over the course of last year during a period of high inflation.
This is my fourth scorecard, and despite some curveballs, I’m clocking in at 95/100 accuracy for my 2022 predictions. Read on for a summary.
Prediction 1: Inflation
What we said: Inflation is our biggest economic risk and will impact all other trends. 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. Inflation and the volatility pricing that it breeds will be more enduring.
What happened: “Enduring” turned out to be correct, despite the Fed’s view early in the year that inflation would be transitory. The Consumer Price Index hit a 41-year peak in June, increasing 9.1% year over year. It has since declined (November came in at 7.7%). Wages and salaries for civilian workers increased 5.1% for the 12-month period ended in September. And while building materials costs showed slight declines toward the end of the year—including lumber costs, which in November were half what they were in January—CBRE forecast overall construction costs to increase 14% in 2022.
Prediction 2: Interest Rates
What we said: Interest rates will increase in 2022. Interest rates will rise based on where inflation stands now. The Fed may start raising rates in May or July, 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.
What happened: The Fed increased its target Federal funds rate range from 0.25%-0.50% in January to 4.25%-4.50% in December via seven increases ranging from 25 to 75 basis points. Its aggressive moves to quell rising inflation, as we noted above, appear to be having an effect, but our expectation is that we’ll see a recession by October 2023.
Prediction 3: Impact of COVID-19
What we said: COVID will continue to impact real estate, as it changes where we live and how we work. Job losses, labor shortages and workers with viable remote work options were some of the effects of the pandemic on the economy. These massive shortages of labor are inflationary: 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.
What happened: COVID fast-tracked the virtualization of work, triggering 10 years of change within two. Those changes aren’t going away. I believed early in the pandemic that demand for office space would never fully bounce back, and we acted on that belief in 2021 by selling our office assets at good prices. White-collar tech and finance jobs in high demand before the pandemic are now the focus of layoffs. Blue-collar and service jobs suffered stagnant wages but are now in enormous demand—and workers are flexing their muscles for higher pay and unionization.
Prediction 4: Profit Expectations
What we said: 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. That doesn’t mean a correction in 2022, only that profit expectations will moderate.
What happened: Not only is there less appreciation, but depreciation is occurring. Assets in every class are worth less than they were a year ago, clearly reflected in the stock values of some of the largest representatives of each class: Industrial REIT Prologis and multifamily REIT Camden Property Trust were each down more than 30% in 2022; Boston Properties, a publicly traded office building developer, is down more than 46%. And we’re seeing 5% to 10% declines in our own valuations.
I’m docking myself a point because I didn’t predict negative growth, and I now believe that we were in a bubble, even though it was a bubble created by the Fed keeping interest rates low for so long.
Prediction 5: Population Migration
What we said: 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. As housing prices rise in cities like Charlotte, Denver and Phoenix, this trend will moderate—but that’s years away.
What happened: Population shifts have continued—into Texas, Florida and North Carolina, according to the U.S. Census Bureau, and out of California, New York and Illinois. Favorable employment climates are drawing companies and skilled workers to Southern cities.
Prediction 6: Qualified Opportunity Zones
What we said: Qualified Opportunity Zone (QOZ) benefits will not change. In 2021, new rules reducing the QOZ’s generous benefits seemed imminent but congressional gridlock makes it less likely that QOZ incentives for private real estate investment will be scaled back in the next year. 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.
What happened: For a while it seemed possible that QOZ rules would change when bipartisan legislation was introduced to modify some aspects of the current law and to extend the period that investors could see higher tax benefits. While this issue may be taken up again in 2023, I got this one right.
Prediction 7: Appreciation and Rent Growth
What we said: Multifamily real estate will see modest valuation appreciation and strong rent growth, with suburban outpacing urban. 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. 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 over urban growth.
What happened: I didn’t get asset appreciation right, and the same pattern plays out in this prediction. We saw strong rent growth through much of the year, particularly in suburbs over cities. But I underestimated how high interest rates would go over the course of the year. The dramatic increase in the borrowing rate was a powerful force on valuation even though rents were still higher.
Prediction 8: Rent Performance
What we said: Multifamily rents in the Northeast and Midwest U.S. will underperform the Southeast, Southwest and Texas. 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 their affordability.
What happened: According to a November Yardi Matrix survey of U.S. rents, I got this right: And according to our own research using MultilyticsSM, suburban Class A and B buildings saw at least 5% overall higher rent growth through 2022 than urban Class A and B buildings did.
Prediction 9: Value-Add Construction
What we said: Value-add is giving way to ground-up construction. Because acquisitions are priced at or above replacement cost, value-add renovations must have real competitive advantages to warrant private equity investment. 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.
What happened: Value-add deals in 2020 and 2021 were mostly made above replacement cost of the property, and they generally underperformed in 2022 for a couple of reasons. One is that those assets are now trading closer to their replacement costs. The other is that a lot of value-add deals use variable rate debt from bridge funds, which tend to have three-year durations. If an owner borrowed at low rates in 2021, they could service the debt. But as interest rates rise, refinancing becomes difficult. A lot of equity has already been lost.
Prediction 10: Ground-Up Construction
What we said: The pace of ground-up construction will increase in 2022. Private capital fundraising in 2021 exceeded 2020 but is concentrated in multifamily and industrial real estate. Lenders are 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.
What happened: Well, for one thing, interest rates happened—at an aggressive pace. Cap rates have gone from 3.5% to 4.0% to 4.25%, and between slowing rent growth, higher construction costs and higher interest rates, deal margins are much lower. Lenders have retrenched. So, it’s difficult to do deals that make sense right now, even though a continuing supply-demand imbalance in multifamily means that the long-term fundamentals remain strong.
Even so, according to an analysis of Census data by the National Association of Homebuilders, Q3 2022 saw the most construction in multifamily rental housing since Q2 1986. Here’s where I offer a caveat: The available data suggests otherwise, but I’m docking myself a point because I believe interest rates have exerted a powerful force on Q4 starts.
We are starting 2023 in a much different place than we started last year. While we’re committed to ground-up development—and we’re very good at it—we focus on the best risk-adjusted strategy in multifamily at a moment in time. So, while different iterations of Origin may emerge in the next two years, our approach will remain diligent, rigorous and agile.