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The Frontrunner Slows Down

By December 8, 2017No Comments

Multifamily is still the favored asset class in commercial real estate, but this year deal velocity and rent growth slowed. While multifamily core fundamentals remain strong—driven mostly by soaring demand that continues to grow—investors are making more thoughtful investment decisions. In October, the ALM Real Estate Media Group hosted RealShare Apartments, a national apartment conference in Los Angeles. Major players from across the country attended to discuss the market activity, and measured optimism was a driving theme in their commentary. 

“In 2017, we found less product available and a larger appetite to buy,” says Greg Campbell, senior managing director of acquisitions and dispositions at TruAmerica Multifamily. “We had this equilibrium of not enough supply and too much demand, which drove pricing up. Almost any group will tell you that they didn’t buy as much this year as they had planned to. Sales volume across the country is down about 20% to 30% on average. We will probably be off on our goal by 15% to 20% this year.”

The theme of softness in certain markets dominates the multifamily conversation. Gary Goodman, SVP of acquisitions at Passco Cos. agrees that there is some softening in the market, but says that it is concentrated in urban core environments. “The basic supply demand fundamentals are very strong, but there are certain cities, particularly in the urban cores, that are somewhat soft,” he explains. “There has been a lot of new development in those areas, partially due to the fact that cities have done a lot to stimulate revitalization in downtown cores. The capital community has really drunk the Kool-Aid of the idea that Millennials want to live in an urban core, so there is a lot of capital that has been built in those areas as a result.” 

While rental growth may be slowing, demand continues to be strong, and that detail is very important to players in this asset class. With Baby Boomers and Millennials entering the apartment market, there is growing demand for rental housing. Slowing rent growth and growing demand seems to be the current dichotomy. “The pace of rent increases has clearly slowed,” says Ella Shaw Neyland, president of Steadfast Apartment REIT III. “There is an ability to increase rents initially and then there is a stabilization. The pace of the rent increases has slowed, but the demand has not.”

Neyland says that there are 10,000 Baby Boomers turning 65 every day, 300,000 Millennials turning 22 each month and another 300,000 Millennials per month turning 23. These staggering numbers are ensuring a strong demand flow well into the future.

That demand, of course, has also created a dearth of supply. Goodman quotes a national study out of Florida that estimates there is an apartment supply shortage of 4.6 million units nationwide. “Because of the demand from Millennials and Baby Boomers, some studies estimate that we will need 4.6 million apartment homes by the year 2030, and it will take 385,000 apartment units built each year to meet that demand,” he says.

As a point of reference, the average number of units built between 2012 and 2016 was 244,000. This year will be a peak year with 350,000 new units, but beyond that it is expected to decline pretty dramatically because of the difficulty financ- ing new development. “That is why the fundamentals for rental housing are going to be very strong,” says Goodman. “It is very submarket specific and very market specific. On the demand side, it is well known that 18to 34-year olds are coming into their prime rental ages. Many of them are still underemployed and burdened with student debt.”

This combination of high demand and softening rents and deal volume has left investors searching for opportunities in niche multifamily classes. For Passco Cos., the best opportunities are in suburban markets just outside of an urban core. “Many of the suburban areas around various cities are not overbuilt,” explains Goodman. “There is a certain amount of NIMBYism in those areas, especially for multifamily development. We have seen that in a number of suburbs where there is a real restriction on new development, and that has created a lot of investment opportunities for owners. It is kind of counterintuitive. Historically, the focus has been on building in the urban core, but it has really gone the other way.”

TruAmerica has had a workforce housing strategy since its inception, and today, it sees a need for workforce housing more than ever before. “Early on in the cycle, we bought presale properties from the developer and we would take over the lease-up,” explains Campbell. “We haven’t been doing that lately because there are so many class-A properties delivering and the cap-rate discount isn’t as big as it used to be. We do try to be opportunistic. We are still focused primarily on workforce housing because we feel like there is a shortage of workforce housing. That is where we want to be.”

The shortage of workforce housing is only growing, and Campbell says the occupancy rates for this multifamily niche typically exceed class A housing by 8% or more. “The only way that something becomes workforce housing is if a property ages into it. That is not happening at a huge rate, and it doesn’t make sense financially for people to build brand new B product. We feel like because there is not much supply of workforce housing it is a space we can be in for a long time,” says Campbell. “The rent disparity between class-A and class-B is still pretty great in almost every market we look in. We feel like there is still opportunity for us to see strong rent growth on the class B product—and it stays occupied.”

Neyland agrees that the best opportunities are in what some are deeming the “urban suburban,” a market outside of the urban core but not in the deep suburbs. “If someone has a choice, they are going to choose to live in a cool city. I think that you are seeing migration out of some cities, because it is expensive to live there, but they still want a nice lifestyle,” she explains. “The concept that people used to have of the top 20 MSAs isn’t true anymore. Smart apartment owners are looking at cities where businesses are moving. Reno, NV is a great example of a small city where businesses are moving. Austin, TX is another good example. People today are saying that they don’t need to live down- town, but they can live in the loop downtown and Uber into the city core.”

Each of these investors are seeing better demand, returns and rent growth in markets just outside of downtown areas. “Our view is that buying in the secondary and tertiary markets throughout the country is a better risk-reward statistic than buying in the gateway cities,” says Goodman. “What is happening in many of the gateway markets is that a higher percentage of income is required to pay rent.” 

In the markets where his firm is active, most residents spend 30% of their income on rent, however some reports show that residents living in the urban core are spending as much as 50% of their income. Those rising rents are pushing renters out into more suburban markets. “The affordability challenge is quite pronounced in large urban cities,” says Goodman.

Neyland adds, “You are going to see some strata, but we’re moving into a more normalized increase in rents. It does have to be pegged to what people are making. Wage growth is the huge challenge for all of us. That is one of the reasons why you are not going to see double-digit rent growth.”

Another issue pushing renters out of the core markets is the abundance of luxury housing, which has helped to fuel the double-digit rent growth to which some developers have become accustomed. “There has been an overabundance of luxury high-end apartments post Great Recession, so there is a natural competition for residents,” says Neyland. “That resident pool is very small, so you really need to have someone that is making enough money and has no desire to live anywhere else to continue those rent increases.” She expects that the slowed rent growth will make development more difficult in the next year. “Apartment owners need to be realistic about rent growth,” she explains. “Builders have penciled in pretty significant rent increases, and it made the construction costs work. The price of construction has really gone up. However, that’s going to be really challenging based on where rent growth is going to be—it will be healthy, but it won’t be double-digit growth.” As a result, she adds, “New construction will have a hard time penciling rents that will justify the cost associated with building.”

Underwriting strong rent growth also helped to fuel increased pricing this year, at least for investors willing to take the risk. Many weren’t willing to estimate double-digit rent growth, and that contributed to the slowed deal velocity. “We remained disciplined this year. If there was an asset that we really liked, we would try to find a way to stretch a little bit more, but there were often other groups that were stretching a lot further,” says Campbell. “We found that the other groups that were winning the value-add deals, which is what we buy, were those that were willing to underwrite much higher rent premiums than the rest of the bidders. We tried to remain disciplined, and it might have lost us a few deals along the way—but we sleep well at night.”

As a result, TruAmerica leaned heavily on industry relationships to find and source deals. “We buy both market and offmarket deals this year. We buy about 50% of our deals off-market,” he says. “Even on the listed deals, we tend to have a good relationship with the seller that gives us a competitive advantage.”

In the next year, the firm will likely take on more bad-debt deals to secure acquisitions. “Over the next year or two, you’re going to need to be willing to assume debt, and it might not be as good as the debt that you could secure. Those are the deals that are available,” Campbell adds. “That is something that we are increasingly willing to do.”

Uncertainty caused by the new Administration fueled much of the slowed activity, according to these investors. “The day after the election, interest rates bounced up 40 or 50 basis points, and a lot of sellers wanted to wait to see if interest rates would come down—which, of course happened,” says Goodman. “Additionally, there were a lot of buyers, like us, sitting on the sidelines because there weren’t any deals available. That first quarter was really a wipeout in terms of deal volume.”

Taxation, especially, became an area of concern for potential sellers, and many accounting firms discouraged selling before the new tax plan was proposed. “The taxation issue was a big one this year,” adds Campbell. “I talked to a lot of owners that thought about selling this year but didn’t because they didn’t know how new tax policies would impact them. For a lot of private sellers, taxation is a driving force behind what they do, and I think it had a bigger impact than we can measure.”

In 2018, the multifamily market should improve compared to this year, and no one is expecting a recession or a black swan event to topple the market. “For 2017, I think we’ll see sales activity in the multifamily market drop off from where it has been for the past two years. Having said that, 2016 was a record year and 2015 was a record before that,” explains Neyland. “The interesting thing about 2017 is that one of the reasons activity is down is because there were more portfolio transactions in the previous years and now you’re not seeing as much of that. You are also seeing fewer higher-end deals. You are seeing more increased liquidity in the more moderate housing market. Looking ahead, we will see the normal volume of transactions and the activity is still going to be strong.”

Passco and TruAmerica predict that they will remain net buyers in the coming year, and are continuing to look for opportunities. Campbell, in fact, is hopeful that the firm will make up some of the acquisition activity it lost this year as a result of slowed growth. “We are selling selectively as well, and you will see us selling some assets every year going forward,” he says. “Next year, we are hoping that our portfolio will be back up to where we wanted it to be this year.”

While investors are remaining cautious and thoughtful about the multifamily market, they are also remaining overwhelmingly positive about the future. Strong demand continues to drive opportunities in the market—in many geographic areas and price points. In 2018, the confidence is high that multifamily will remain the darling of the commercial market. 

This article was originally published in Real Estate Forum’s November/December 2017 issue.

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