Soaring building material prices have made multifamily construction costs and timelines rise. Commodity prices for lumber and copper hit 10-year peaks in May 2021 and continue to hover in record ranges; steel, concrete and gypsum products are rising at a record pace, and supply chain delays are drawing out project timelines. As we actively monitor and assess costs in our underwriting during this volatile period, we remain confident in the returns that multifamily real estate investment provides and believe there are substantial reasons for private investors not to stay on the sidelines.
Development Profit Margins Have Never Been Higher
With construction costs getting so much attention, high development margins might seem counterintuitive. But the truth is that even with price volatility, multifamily housing fundamentals remain strong and continue to create a high expected return on investment.
To understand the impact of rising commodity prices and the long-term prospects for multifamily real estate, investors need to look at the three inputs that are most important to the success of any development deal:
- Rent growth. Actual and projected rent growth correlate directly with net operating income (NOI), or the cash flow an investor can pull out of a property. Average rent growth grew 13.5% in 2021, hitting $1,594 in December, a new record. Over the course of the pandemic, demand for rental housing has surged.
- Cap rates. Capitalization rates (first-year net operating income, or NOI, as a percentage of purchase price) are falling. At a constant NOI, cap rates go lower as property values go higher.
- Construction costs. Commodity prices are having an impact, but some indicators are pointing to stabilization: Lumber futures, for instance, are showing a steady decline, reflecting that view in the market.
How Multifamily Rent, Price Growth Moderate Construction Costs
While rising construction costs seem like a financial hurdle, the reality is that rents and cap rates more than make up the difference. First, rising rents show continued demand for multifamily housing. For instance, over the 12 months ended Feb. 22, 2022, occupancy at our Monroe Aberdeen Place property in Chicago increased to 95.0% from 87.5%. Over that time, effective rents (which account for free rent concessions used as a leasing incentive) grew 45.4% from a combination of increased asking rents and reduced upfront concessions, both enabled by strong renter demand.
Second, cap rates are even lower than they were in 2020. The pandemic has created uncertainty in hotels, office buildings and other property types, shifting the capital markets into multifamily housing and industrial projects. Readily available financing is bidding up valuations for these property types. At a constant NOI, as prices rise, cap rates fall. A $1 million property with a $100,000 NOI has a 10% cap rate; buy the same property at $2 million and the cap rate is 5%.
Steady rent growth and low cap rates are not only positive but also powerful together. If the rent roll is expected to grow, as is the case, the property should command an even higher future valuation. The capitalization rate serves as the multiple on earnings.
Solving for Profit: Making Two Parts of the Equation Work
Investors don’t have to win all parts of the equation to make multifamily investing work right now. Two out of three positives make building multifamily housing a go. Of course, a private real estate investor can wait for construction costs to go down. But with multifamily development margins at historical highs—on the order of 35%—it will be hard to find better risk-adjusted returns now and for the foreseeable future. In Phoenix, for instance, from Q4 2020 to Q4 2021, the margin between cap rates and return on costs rose to 55% from 30%.
When costs finally do go down, the other inputs may change as well. Reduced demand may depress rent growth. The uncertainty in turn can also push cap rates higher and further limit the profit potential.
The perfect scenario—the lowest input costs, future rent growth and lower cap rates—would have been to build throughout the pandemic. In fact, Origin has been developing multifamily housing throughout the pandemic in multiple cities. Higher commodity prices won’t affect returns if other variables make up the difference.
It’s clear, as well, that the fundamentals for multifamily real estate remain sound, and several demographics are driving demand. One of the properties in our portfolio is Alto Highland Park. It’s the only for-rent community exceeding 100 units within Highland Park, an affluent area north of Dallas that has the highest home prices in the metro area. It’s a desirable option for renters looking to live close to downtown and retail amenities. For young parents, the property provides a sense of community and proximity to an award-winning school district without the cost of homeownership. Empty-nesters looking to downsize and become more flexible are transitioning into the convenient, condo-style lifestyle that Alto provides. Over the next two decades, the baby boomers will move more fully into the 75-and-over age group, the time of life when rental rates typically rise, accelerating the growth in older renters.
What a Volatile Input Means for Pricing
Volatile commodity prices make projections difficult. However, there are ways to mitigate the risk. The solution is to use a conservative pricing strategy that looks at future lumber and steel costs and allocates more money for such events. In addition to a 5% contingency for construction (say, $2.5 million), Origin will assume $1 million for rising construction costs to see if the deal can withstand the volatility. If a deal with $3.5 million in contingencies covers the cost of capital, and still pencils out at a 35% profit, it’s worth doing.
A large margin for contingencies can have three possible outcomes:
- The outlay is higher, eating up the whole contingency, and the profit margin is still 35%.
- Costs can drop, and the project gets savings from the initial underwriting that adds to returns.
- Expenses are exactly as modeled without touching the contingency fund. All $3.5 million falls to the bottom line.
There are other ways to think about this price modeling. One is that a unit that costs $200,000 to build and sells for $270,000 has a 35% profit. Another is the untrended return on costs—that is, the profit assuming no rent increase. If the untrended return is 5.5% and the capitalization rate is 4%, the percentage spread between 4% and 5.5% is a 37.5% margin.
Price volatility has predictably stirred concerns about inflation. Conservative underwriting assumes higher cost inputs but no change in price outputs. In reality, inflation triggers growth in rents as well as expenses. The higher top line is powerful compensation.
Why Relationships, Experience Matter Even More Now
With private real estate providing more than enough capital, competition is keen for good development sites and good partners. Pension funds, endowments, family offices and real estate funds all want to be cut in on desirable real estate deals. When a prime property is available, there are a lot of competitors vying to assemble financing and make an offer. It’s hard right now to find good deals—and when you find them, act.
In such an environment, our relationships and track record make all the difference. We’re experienced investors in growth markets, we constantly monitor market indicators, and we tap into our networks in local markets to get access to off-market deals. Financing flexibility gives us many ways to make a deal work, even in an environment of rising costs, and to deliver investment options for private real estate investors to meet income and growth objectives.