A multifamily real estate property’s location is often touted as the most important indicator of its investment potential. In truth, dozens of data points count, but the most critical is rent growth, or how much rents are likely to increase over time. Without a healthy rent growth rate, it’s impossible to pay fixed and variable expenses as they increase, let alone distribute rent income to investors. That’s why a property’s rent growth rate is a key variable managers and sponsors analyze in great depth when investing in a multifamily property.
In fact, predicting a multifamily property’s potential rent growth accurately can mean the difference between a stable and lucrative investment or a financially unstable one. But forecasting rent increases with enough precision to understand all the risks a property will face is a complex task. It involves analyzing historical rent growth data, economic indicators, job growth, supply and demand trends, demographics and much more. To understand if a market can sustain and develop apartment demand, it’s necessary to study the surrounding area’s job market, potential competition from existing and new-to-market buildings, current and changing transportation infrastructure, retail, amenities and so on. All these statistics have a direct impact on potential rent growth.
Foreknowledge of rent growth lets us decide how and when we can take advantage of it. But we also know accuracy matters: The difference between 1% or 2% rent growth can make a tremendous difference in a property’s potential and valuation, as the chart (below) shows. And that can make a difference in multifamily investor returns.
Rents and Values for 1% vs. 2% Rent Growth
This chart illustrates the effect of rent growth over time on asset values. This example assumes a hypothetical 300-unit asset with starting rents of $2,000 per month in a stable 5.0% cap rate market. Everything in these two scenarios, aside from rent growth, remains identical. In the scenario where rents grow at 2.0%, at the end of year one the asset’s value is $1.4 million greater than in the scenario where rents grow at 1.0% (despite a differential in monthly rents of just $20). This effect compounds over time. By the end of year five, although monthly rents are only $106 greater in the 2.0% growth scenario than in the 1.0% growth scenario, the difference in asset value reaches $7.6 million.
This is a greatly simplified example—in reality, things are never quite so cut and dry. Differing rent growth rates would have follow-on effects on operating fundamentals and expenses, resulting in changes to net operating income that are not contemplated here. But for illustrative purposes and to show how it affects multifamily investor returns, this is how the principle works.
How We Predict Rent Growth More Precisely
Predicting rent growth starts with data, and most analysts get their information from government and private industry sources. At Origin Investments, we found that this data hasn’t been thorough, granular or timely enough to forecast rent growth with the accuracy we sought. Also, government entities such as the Bureau of Labor Statistics often release revisions and updates to monthly jobs reports that can impact previously released forecasts. In 2021 we decided to develop a proprietary suite of machine-learning models, Multilytics®, with in-house data scientists. Rather than relying on limited sources, it uses billions of data points to forecast rent growth more accurately than the industry standard.
Multilytics has shown us that choosing investment property requires looking block by block at an area. We sometimes find we may be better off buying a property down the block or across the street from one we had originally earmarked for purchase. In 2022, Multilytics proved invaluable when, to our knowledge, we were the first manager to foresee negative rent growth in 2023 after two years of double-digit increases in many markets. We applied that in our underwriting while leading industry data providers were still predicting rents in many areas would continue to increase in 2023, albeit at slower rates. Buyers who used more optimistic assumptions to underwrite a multifamily deal in 2022 likely overpaid because anticipated rent growth did not happen.
What Multilytics’ Rent Forecasts Tell Us
Our annual Multilytics Rent Forecast Reports show how rent growth differs city by city, often significantly. The data points used reflect an area’s overall economic health—from whether it has a business-friendly environment or advantageous tax rate to its population and job growth, talent pipeline, walkability, public transportation options, lifestyle offerings, affordability, cultural vibrance and more. We even drill down to incorporate relocations to an area based on one-way U-Haul rentals.
Multilytics’ accuracy has been proven in one of the most unpredictable and volatile environments in recent history, within 2% of our point estimates in most cases. That has saved us from making some deal decisions in places like Austin at the wrong time.
What Does Rent Growth Mean to Investors’ Returns?
When investors buy a stock, they usually look at its price-to-earnings ratio, or P/E ratio, which measures a company’s current share price relative to its earnings per share. In real estate, the relationship between an asset’s value and its earnings is expressed as a capitalization rate, or the property’s net operating income (NOI) divided by its asset value. This percentage can be thought of as the rate of return an investment property is expected to yield over a year.
Typically, investors want to buy a property with a high cap rate, which means its purchase price is relatively low in comparison to its NOI. Lower cap rates mean lower risk but also less potential growth; higher cap rates mean more risk with more potential growth. Just as earnings growth for a stock reflects a healthy, well-managed company with carefully controlled costs, NOI growth reflects the same thing for a property. But what if you buy a property with a 6% cap rate, and deteriorating economic conditions slow rent and NOI growth? This can put upward pressure on cap rates and increase the property’s risk profile, and the investment may lose money. By predicting future rent growth and NOI more accurately, Multilytics helps us choose properties with lower risk profiles.
Measuring the Impact of Rent Growth on Returns
If higher rent growth signals lower risk, that results in downward pressure on cap rates due to greater investor demand (all else remaining equal). Let’s say we own a property that generates $1 million in NOI. In a 5.0% cap rate market, this asset would be worth $20 million ($1 million divided by 5.0%). In this example, if cap rates held steady and the property’s rents grew such that NOI doubled to $2 million, the asset value would equally double to $40 million ($2 million divided by 5.0%). But this type of rent growth is sure to bring additional investors into the market, putting downward pressure on cap rates. Let’s suppose this competitive buying environment drives cap rates from 5.0% to 4.5%. Now, our $2 million NOI asset is worth $44.4 million. Relative to an environment in which cap rates hold steady at 5.0%, that’s an 11% greater valuation.
Rent Growth in Today‘s Economy
We expect the Federal Reserve to keep interest rates higher than expected for the rest of this year. But multifamily fundamentals will remain strong because the price discrepancy between buying and renting is at its most extreme since 1996. Average monthly new mortgage payments were 52% higher than the average apartment rent in October 2023, and home prices remain high as supply remains constricted in almost all metro areas, according to Zillow’s January 2024 Market Report. So, despite higher rents, 23% of baby boomers, 48% of millennials and 74% of Gen Z adults living in their homes do rent, according to RentCafe data from spring 2023.
However, the multifamily investment market is still facing the impact of high interest rates, slowing but still high inflation, and the delivery of a near-record-breaking number of new units, some 672,000, in 2024. As the latter is absorbed, rent growth will remain stagnant throughout 2024 in most markets and lead to lower NOI and valuations. These fundamentals make rent-growth forecasts more significant than ever to our investing strategies and help us get a better handle on what risks to take—or not—with specific properties.
Rent growth forecasts can help us know when to sell assets we already own, or when to invest in an area—especially when we see outsized long-term rent growth. If our forecasts show strong rent growth in an area where we are building a new property or already own one, we may spend additional capital on amenities or improvements. Both are also likely to support rent growth and defend against the increased competitive supply engendered by that rent growth.
According to Multilytics, positive month-over-month rent growth will return slowly to normal in most of our target markets by January 2025, but the rent growth averages will be closer to the historic norm of 2% to 4%. Still, those are numbers we can work with to maximize the value of our assets, minimize risk and deliver the best possible multifamily investor returns.
Disclosure: This information may contain certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance, and actual results or developments may differ materially from those discussed. No investor should assume future performance will be profitable or equal the previous reflected performance. There is no guarantee that investors will or are likely to achieve their objectives or that any investor will or is likely to achieve results comparable to those shown or will avoid incurring substantial losses. Additionally, the performance results displayed herein may have been adversely or favorably impacted by events and economic conditions that will not prevail in the future.
