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NREI Research Series

Exclusive Research: Defying Gravity

Exclusive research shows continued confidence in the apartment sector despite high levels of construction activity and rising interest rates.

Multifamily has enjoyed a long run as a favored commercial property type over the past decade. And despite a recent surge in new supply that has taken some of the edge off of enthusiasm, market participants are holding onto a positive outlook. 

Exclusive research conducted by NREI shows that a majority of survey respondents are predicting stable or improving fundamentals in the coming year, with a continued appetite to maintain or expand portfolios. The market remains optimistic even as concerns about high levels of construction move higher. Views on whether there is too much new construction occurring increased from 36.5 percent a year ago to 43 percent who now believe there is too much construction. Nearly one-third (35 percent) believe it is the right amount and 12 percent think it is too little, while 10 percent said they were unsure of the answer.

People often think there is a lot of development occurring just by looking at all of the construction cranes in their respective markets. However, once you dig into the supply and demand numbers, developers are building enough properties to meet the demand, says Richard Campo, chairman and CEO of Camden Property Trust. “Multifamily demand has outstripped supply in most markets. So, I think we’re pretty much in balance,” he says.

Survey results also appear to support the view that the market is maintaining a healthy balance, with a forecast for stable occupancies ahead. In all, 41 percent of respondents believe occupancy rates will rise over the next 12 months, while one-third say there will be no change and 26 percent think occupancies will fall. Although a sizable number are anticipating improvement in occupancies ahead, respondents are not expecting any big moves. Among those who do predict an increase, most believe occupancies will increase by fewer than 50 basis points, with a mean response among all respondents at a nominal increase of six basis points.

“What the statistics don’t really reveal is that we’re replacing obsolete or undesirable housing,” says Steven Fifield, founder and CEO of Fifield Companies and a principal at Century West Partners. “Our business has been so transformed over the last decade. What we are building today bears no resemblance to projects that were being delivered 10 to 15 years ago,” he says. For example, Fifield Companies is building transit-oriented  projects in Chicago and Southern California that feature modern amenities, such as bike storage rooms, lap pools and shared co-working and community spaces to accommodate the increase in people who are working from home. Occupancies for its stabilized projects range between 95 percent and 97 percent.

Respondents are also predicting that while rent growth will slow, it will still remain positive. Two-thirds of respondents expect rents to rise in the next 12 months, while 14 percent say there will be no change and 19 percent believe rents will fall. However, the amount of rent growth anticipated is lower than in past surveys, with a mean increase of 1.3 percent.

Survey results are consistent with what many operators are experiencing within their portfolios. “It depends on the individual market, but generally we’re seeing rent growth of 2.0 to 2.5 percent and occupancies that are stabilized,” says Matt Heslin, co-founder and managing partner of Los Angeles-based Oak Coast Properties, which has a portfolio of about 6,000 apartments across the United States. “I don’t see occupancies going up and I don’t see rent growth exceeding inflation” he adds.


Sentiment takes a step back

Survey results show respondents still have a bullish view of apartments compared to other sectors. When asked to rate the attractiveness for each property sector, multifamily and industrial both rate the highest, with a mean score of 7.7, followed by hotels at 6.1, office at 5.9 and retail at 4.8.

Although survey results show continued confidence in the sector, views are slightly less optimistic than in past surveys. In 2016 and 2017, half of respondents predicted that occupancies would rise, compared to the 41 percent in the current survey. Sentiment on rent growth has also been slowly cooling. Two-thirds of respondents say that rents will rise in the coming year, which is a decline from 74 percent who held that view a year ago and a bigger drop from the record high of 81 percent who thought rents would rise in the 2014 survey.

“This has been quite a long cycle and the fundamentals still look really good as far as rent growth and occupancies,” says Caitlin Walter, vice president for research at the National Multifamily Housing Council (NMHC). That being said, the NMHC’s third quarter survey of apartment market conditions also showed a further decline in its Market Tightness Index, which measures rents and vacancies. The index decreased from 46 to 41 in the latest survey, marking the 12th consecutive quarter of overall declining conditions.

The pullback in sentiment is not surprising considering that nearly two-thirds of respondents think that the commercial real estate cycle is at its peak as compared to a minority of 13 percent who believe it is still in recovery/expansion. Nine percent have a more negative view, including 5 percent who said the market is in recession and 4 percent a trough. Another 11 percent of respondents were unsure of the cycle phase.

Yet there are some indicators that suggest that this peak could, in fact, be a nice plateau. “With this cycle in particular, you have seen how the demographics are changing with people who view renting as a lifestyle choice,” says Walter. The NMHC forecasts that the U.S. needs about 328,000 new units per year to satisfy growing renter demand, and that demand is not coming from just millennials, but also Gen X and baby boomers, she says.

Vacancies have been rising slightly due to new supply coming on-line but remain at healthy levels. According to Reis, vacancies reached 4.8 percent in third quarter, which marks a 40 basis point increase compared to the same period a year ago. Reis data also shows that rent growth has accelerated this year. The firm is forecasting that effective rents will finish the year with a growth rate of 4.4 percent, which is slightly stronger than 2017.

One reason for that acceleration is that employment growth has been exceeding expectations this year, with estimates that the U.S. will add more than 2.5 million new jobs in 2018. “A lot of those jobs are going to our customers, the 20-year-old to 34-year-old cohort, and there is still a fair amount of pent-up demand from adults who are living at home or with roommates,” says Campo. On top of that is a behavioral shift with millennials who are delaying decisions for marriage, family and home ownership, which also bodes well for sustained renter demand.

Optimism also appears stronger where population and job growth is occurring. When asked to rate the strength of the multifamily market by region, respondents rated the West/Mountain/Pacific as the strongest area of the country at a 7.9 out of 10. That is not surprising as that region includes California and other top-performing metros such as Seattle and Denver. The South/Southeast/Southwest and East were both close behind, at 7.7 and 7.5 respectively. Meanwhile, the Midwest and Central regions lagged the rest of the country at 6.7.

Those results are not surprising given that most of the job growth has been in the smile states from Seattle and California through the southern states and up the Eastern Seaboard that tends to miss the Midwest. For example, Camden tracks the top 42 markets in the country. Midwestern cities tend to rank low on that list in terms of apartment revenue growth. For example, Chicago ranks 42nd for projected rent growth for 2018-2021 and St. Louis ranks 35th.

Buyers face stiff competition

Respondents continue to exhibit a strong appetite to buy more apartments, with 41 percent in the current survey who plan to expand holdings in the coming year. Another 44 percent are content to hold existing assets and a minority of 14 percent plan to sell assets. Once again, that sentiment is lower compared to the 47 percent who said they planned to buy more in the 2017 survey. The change in sentiment could be due to a combination of factors, including views that the market is at its peak, rising interest rates and a competitive investment market.

Oak Coast Properties has been very active for the past several years buying value-add assets in markets such as Atlanta, Denver, Seattle and Houston. However, aggressive pricing in the value-add space has pushed the firm largely to the sidelines. IRRs, cash-on-cash returns and multiples on the money have all dropped to the point where Oak Coast is not buying much of anything right now, says Heslin. “We would like to buy, we just can’t find deals that are priced appropriately for the risk-return that we’re looking for,” he says.

The investment climate is likely to get even more challenging as interest rates move higher. Deals are already getting repriced based on the interest rate moves that have take place. Since the start of 2018, the 10-year Treasury has increased by about 60 to 70 basis points. “I think there is going to be more repricing of deals going forward and there’s going to be an adjustment in buyer and seller expectations,” says Heslin. That shift in pricing could prompt more selling activity in the coming year as owners look to capitalize on value appreciation. For example, Oak Coast is currently evaluating about 2,000 units or about one-third of its portfolio for potential sale.

Sellers continue to be in a strong position. However, they are as concerned about the redeployment of capital and where to place capital after the sale as they are with the final pricing they achieve, adds Blake Okland, head of multifamily investment sales at Newmark Knight Frank. “Buyers are frustrated about the lack of available deals and the stubbornness of low cap rates amid rising interest rates,” he says.

Camden has dialed back its budget for acquisitions this year from $500 million to $300 million due to competition and aggressive pricing. The firm acquired one property in the third quarter with the $90 million purchase of a 299-unit property in Orlando and does not expect to close on any assets in the fourth quarter. “What’s basically happening is that there is a wall of institutional capital that is available for apartments,” says Campo. According to Real Capital Analytics, apartment sales during the first three quarters of the year were up 12 percent compared to the same period in 2017, with a transaction volume of $120.1 billion.

Plenty of capital available

A majority of respondents do expect interest rates to continue rising (90 percent), while 8 percent think they will remain the same and only 2 percent said they will decrease over the next 12 months. Despite expectations for higher interest rates, views on availability of capital for multifamily properties remain optimistic—and consistent with past surveys. Most respondents (43 percent) believe the amount of equity available for multifamily over the next year will remain the same, while 28 percent think it could be more widely available and 22 percent say it will be less available. Seven percent were unsure.

Views on availability of debt are very similar. In all, 46 percent believe availability of debt will be the same as it was 12 months ago, while 28 percent predict that it will be less available, 21 percent said it will be more available and 4 percent were unsure of the answer.

“The capital markets, both debt and equity, are flooded with cash,” says Fifield. Last year, Fifield Companies refinanced several of its apartment projects through life insurance company lenders and the agencies. However, the firm recently refinanced its recently completed NEXT on Sixth development in L.A.’s Koreatown with a new $125 million bank loan with a five-year term. The project features 398 units on top of a lower level Target store. Banks are more competitive with the insurance companies and the agencies and are getting into the interim financing business, notes Fifield. However, financing for new construction is more selective, he adds.

Respondents are accessing debt from a variety of sources. When asked to rate their use of sources of capital on a scale of 1 to 10, with 1 being no use and 10 being a significant source, most are likely to seek loans from Fannie/Freddie, with a mean score of 7.3. Local/regional banks, national banks and institutional lenders all rated next highest, with a mean score of 6.6.

When asked about anticipated changes to financing for multifamily over the next 12 months, more than half of respondents expect LTVs and debt service coverage ratios to remain the same, at 58 percent and 59 percent respectively. Twenty-three percent said that LTVs could decrease and 19 percent predict an increase in LTVs. Along those same lines, 30 percent think debt service coverage ratios could increase compared to 11 percent who anticipate a decrease, suggesting that respondents are more likely to believe lending availability could tighten in the coming year.

Rising Cap Rates

Investors are keeping a close eye on the impact of rising interest rates on cap rates. Nearly half of respondents (49 percent) said that the risk premium will rise over the next year, meaning that the spread between the 10-year and cap rates will increase. Given expectations for rising interest rates, that suggests that people think that a rise in interest rates will outpace an increase in cap rates. However, another 37 percent do not believe the risk premium will change, and only 14 percent predict a decrease in that spread.

“The general market sentiment right now among buyers and sellers is one of concern, because interest rate increases have two effects,” says Josh Goldfarb, vice chair, Southeast multifamily advisory group at Cushman & Wakefield. First, higher interest rates impact underwriting by undermining leverage returns. Second, clients are concerned about the impact of rising interest rates on the cost of capital, which may lead to a tempering of pricing and activity, he says. “There is a tension between having a sense of urgency to sell now versus taking a wait-and-see approach for next year,” adds Goldfarb. And of late, more clients have been taking the latter wait-and-see approach, he adds.

More than two thirds of respondents (69 percent) expect cap rates for multifamily properties to rise over the next 12 months as compared to 17 percent who said there will be no change and 14 percent who predict a decline in cap rates. However, respondents are anticipating only modest increases. Thirty-one percent believe cap rates will rise by less than 40 basis points; 25 percent think the increase could be between 40 and 50 basis points; and 12 percent said that rates will rise by more than 50 basis points.

“Regarding the pricing gap, we’ve been able to achieve higher pricing than anticipated through third quarter because there is an abundance of capital facing a finite number of deals,” says Goldfarb. According to Real Capital Analytics, cap rates averaged 5.4 percent in the third quarter, which reflects a slight year-over-year drop of 12 basis points.

However, the dynamic could shift more towards a buyers’ market as rising interest rates create pressure and cause the gap to widen the spread between the bid and the ask, notes Susan Tjarksen, managing director, Midwest multifamily advisory group at Cushman & Wakefield. “We have seen that there are still strong offers out there, but buyers are being much more conservative and therefore pickier due to their underwriting,” she says. Assets with a solid and proven track record certainly have an advantage among these buyers, she adds.

Download the report HERE

Survey methodology: The NREI research report on the multifamily sector was conducted via an online survey distributed to NREI readers in October. The 2018 survey results are based on responses from 416 participants. The majority of respondents hold executive-level titles at firms.

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