Multifamily has been the darling of the recovery and remains one of the most sought-after asset classes. And why wouldn’t it be? We’re constantly bombarded with the case for multifamily; there’s a secular shift toward renting, millennials are getting married and having kids later, baby boomers are downsizing and seeking an urban lifestyle, multifamily construction was well below historic norms coming out of the recession, many 18-34-year-old’s live at home and will eventually enter the renter pool etc. etc. It’s a compelling case.
Some of these are real, while others are overblown. In this post, I make the case against the multifamily sector as we look ahead.
Millennial’s are Leaving the Renter Pool
For years I’ve been hearing about a secular shift toward renting and that Millennials will opt to rent an apartment downtown, close to work and entertainment, as opposed to buying a house in the suburbs. This has proven to be untrue. Millennials don’t act any different than generations before them. Once they get married and have kids, they move out to the suburbs into a single-family house. In fact, 82% of couples between the ages of 25-39 married with 2 or more children live in a single-family home. That said, there are two major differences between Millennials and previous generations;
- Millennials are getting married and having kids later in life so they stay in the renter pool longer.
- The lack of affordable homes (due primarily to under-building at the entry level) and the burden of the $1.5T in student loans means more Millennial families will be renting single-family homes as opposed to buying.
The 73 million Americans aged 18 to 34 are beginning to cycle their way out of apartments and into homes. In fact, the net growth of 18-34-year-olds falls to zero by 2024.
New Supply Showing no Signs of Slowing (and may be increasing)
There’s no question that we underbuilt apartments coming out of the recession. According to Linneman Associates, there’s a significant shortfall in apartment development.
- 2009 and 2010, multifamily housing starts hit a low of about 100,000 per year.
- The 40-year historical average (1970-2010) is 355,000 starts per year.
- Multifamily housing starts gradually increased, peaking at 383,000 units in 2015. Production then declined modestly, to 381,000 in 2016 and 345,000 in 2017 but reverted to 354,000 in 2018.
- Annualized multifamily housing starts stood at 289,000 units in January 2019, up from 278,000 units in December 2018, but down from the one-month annualized peak of 435,000 in January 2018.
- Multifamily statistical models forecast about 401,000 average annualized starts in each of 2019 and 2020, 389,000 in 2021, and 390,000 in 2022, all of which are modestly above the 40-year historical average of 355,000 multifamily housing starts per year.
- The cumulative 17-year shortfall of multifamily housing starts (benchmarked against historical norms) peaked at over one million units in 2013 but is on a choppy decline, standing at 905,000 as of February 2019.
There’s no question apartments have been underbuilt over the past 10 years, but supply in many markets is beginning to catch up with and even outstrip demand. Zelman & Associates are forecasting multifamily starts to increase 3% year-over-year in 2019 and another 1% in 2020, as opposed to a decline which many researchers previously forecasted. Although a drop in multifamily supply has been projected by market observers for several years, robust capital availability, especially from debt, has mitigated construction costs increases and kept developer confidence elevated.
When attempting to forecast market conditions 2-5 years from now, it’s important to understand that predicting local space demand is hard, but predicting local supply is really hard. This is because employment growth is far easier to predict than development pipelines. Hence, while unexpected drops in economic growth will soften market fundamentals, it is excessive development activity that is always the real enemy of stable real estate markets.
This excessive development is evident in many downtowns. This glut of new supply will cause short-term pain in many markets.
Dry Powder will Lead to Overpaying for Assets and Lower Returns
There is more than $325 billion of global private equity dry powder, as reported by Prequin in February 2019, which will create competitive bidding for private assets even in the face of fear. The asset class that is likely to attract a large portion of that dry powder is multifamily. One thing that a lot of real estate professionals tend to overstate is the relationship between interest rates and cap rates. The relationship is tenuous, at best.
Cap rates are determined by the flow of funds rather than interest rates. This has proven to be true over the past three years, with interest rates rising and falling with no identifiable impact on cap rates. The flow of funds from both equity and debt will keep cap rates low and compress equity returns. According to Zelman & Associates in their latest Z Report, unlevered development yields averaged 6.3% in their latest survey, just 120 bps above prevailing class A cap rates in comparable markets.
No asset is so great that it can’t become a bad deal if you overpay for it.
Innovative Housing Models Will Lower Cost and Lead to more Development
New development today is being curtailed slightly by the high construction cost (cost of goods and labor). Due to the high development cost, any new multifamily being built today is in the luxury space, seeking top of the market rents. These communities target a small segment of the renter pool and raise the rent ceiling for the entire market.
The middle-market is underserved and as a result, we have an affordability crisis. Innovative models such as co-living, construction techniques such as modular/pre-fab, and design trends such as micro-units will make building rentals cheaper and increase supply.
If supply remains elevated, even in the face of high land and development costs and decreasing demand, the overbuilding could lead to higher concessions, lower rent growth (or declining rents), and low returns.
Despite the positive outlook for multifamily, there are many markets and segments of the multifamily space I’m concerned about. The combination of decreasing demand as Millennials leave the renter pool, increasing supply pipeline, significant dry powder chasing multifamily deals, and innovative housing models disrupting the industry, there are reasons for caution.
At Atlas, we remain bullish class B value-add multifamily, however, it’s critical to remain disciplined, buy at a great basis, control renovation costs, use conservative leverage, and asset manage closely.
What are your thoughts on the multifamily industry today?