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November 2, 2022

Why Multifamily Investments Are a Good Option When Inflation Runs Wild

With stubborn inflation, investment triggers feel harder to pull in 2022. Multifamily real estate is a strong option.

Kurt Houtkooper | Nov 01, 2022

Photo Courtesy of Andrii Yalanskyi/iStock/Getty Images

In an inflationary environment, many investors flounder as pulling the trigger on investments of any kind can feel like higher stakes. The questions are endless. With rising interest rates, falling returns and concerns about recession, where are our dollars best placed to serve our long-term financial goals? Will I need to keep this cash more liquid in case inflation gets out of hand? Or what investments are safer when economics are shifting so rapidly all around us?

One particular category of investment is especially daunting to many, and even more so during shifting economic times—commercial real estate investing. In countless financial advisory offices this year, the question has been posed ‘is now a smart time to invest in commercial real estate?’

Our analysis points to yes, particularly when it comes to multifamily. Unlike stocks and bonds, real estate provides a strong defensive strategy against market volatility, a hedge against inflation and a wide range of tax advantages (especially in 2022). Additionally, the sector is currently benefitting from a fundamental imbalance in supply and demand, which is generating higher income and cash flows not available with other asset classes. Let’s take a closer look at the many factors at play.

Recession

There are several advantages of investing in multifamily real estate in a recessionary environment. Supply of both rental and for-sale housing is constrained, as lenders and equity partners have moved to the sidelines and new housing deliveries are delayed. Demand is increased, as renters are priced out of homeownership by exorbitant home costs and rising interest rates, and new cohorts join the rental market. Apartment occupancy rates also tend to remain firm during economic downturns, as renters are disinclined to relocate and opt to stay in the rental housing longer than they otherwise would.

Interest rates

Apartments are likely to perform well in both stable and rising interest rate environments. Historically, financing rates for apartments have been lower than other commercial property types, as federal backing of multifamily mortgages from Fannie Mae and Freddie Mac results in a lower risk premium than privately sourced mortgages. In fact, according to Real Capital Analytics, apartments have benefitted from financing rates that averaged more than 48 basis points lower than commercial property over the last 10 years. Apartment investors may actually benefit from demand destruction caused by higher interest rates—especially if the increase in rates is due to rising inflation, as is underway now. As homes become more expensive to buy, and new product more expensive to build, the existing inventory of rental housing becomes more valuable and in-demand.

Inflation

Multifamily investment can serve as a hedge against inflation by offering the opportunity to reset lease rates as frequently as every 12 months, compared to three to 10 years for other property types. This provides managers with the flexibility to quickly reset pricing to meet demand or offset rising operational costs.

Historically, apartment rents have tended to outpace overall inflation rates. However, the potential for pushing rents upward will vary by how cost-constrained each market is, so strong local knowledge and acquisition selectivity is essential.

RealPage recently published a study that found the vast majority of renters were able and willing to pay their rent. While rents have soared due to a 40-year high in inflation, so too have renters’ incomes. This has kept rent-to-income ratios much lower than widely assumed, and not enough to meaningfully change apartment affordability.

The benefits to apartment investors go beyond the dramatic increase in rents. At Hamilton Zanze, operating expenses for the company’s national portfolio of multifamily properties represent approximately 40 percent of revenue. Even though rents are rising faster than inflation, if both revenue and expenses rose at the rate of inflation, our net operating income (NOI) and cash flow would still increase.

Liquidity

Liquidity is the biggest factor differentiating multifamily from other types of commercial real estate right now. As capital markets have largely frozen up, it has become incredibly difficult to get a loan for an office building, for example. We predict we will see a significant amount of distress in these properties, which may provide opportunities for savvy investors. By contrast, there is plenty of liquidity for apartments, with government-backed lenders like Fannie Mae and Freddie Mac doing exactly what they are supposed to do—step up to provide liquidity to the nation’s residential mortgage finance system. As a result, apartments have been spared the dramatic drop in asset values we are currently seeing with other types of commercial real estate.

Tax benefits (especially in 2022)

Total returns on real estate investment are enhanced with several tax advantages, including depreciation (particularly with bonus depreciation through cost segregation), capital gains deferral through 1031 exchanges, as well as the tax-efficient cash flow to investors considered a return of capital and reduction of basis before becoming taxable.

Smart investors will want to act quickly in the fourth quarter to take advantage of bonus depreciation, which allows purchasers to deduct 100 percent of eligible property through December 2022. Beginning with acquisitions in 2023, this benefit will gradually decrease each year until it is phased out in 2026.

Portfolio diversification

As the world slowly reemerges from COVID and investors prepare for whatever lies ahead, it is important to remember that portfolio diversification is essential in uncertain economic times. Apartment properties can provide a proven alternative asset class to a well-constructed portfolio, and to a growing number of investors, the category is increasingly recognized as a “fourth asset class” and a valuable alternative to traditional investments such as stocks and bonds.

Valuations

Another question on investors’ minds right now is what is happening with valuations.

Capitalization rates (and therefore asset values) are largely influenced by capital flows—more so than interest rate movements. According to Dr. Peter Linneman, “the connection between both multifamily and office cap rates and interest rates is weak, while the connection with flow of funds is the powerful driving force.”

Currently, cap rates have expanded by 10-20 percent, as interest rates have caused many funds and private equity groups to sit on the sidelines. However, there is a tremendous amount of equity that needs to be deployed for apartments and we expect transactional volume will pick back up in the first quarter of 2023. As the flow of capital returns to the market, cap rates should begin to stabilize.

According to a new report from Freddie Mac, multifamily is well positioned despite pressure on cap rates, and they expect every market they cover to experience gross income gains this year. The reason for this is that while cap rates are influenced by risk appetites, perceived uncertainty, cost of capital and market upside, net operating income (NOI) is generated through operations. Consequently, NOI growth is eroding the decrease in valuation from cap rate expansion.

Demographic trends

Homeownership rates remain well below levels witnessed in the last recession and today’s demographic trends continue to favor renting. The prime age group for renters—typically those 20-34 years old—is still increasing in size. In fact, more than half of the nation’s total population are now members of the millennial generation or younger.

While millennials are getting older, many continue to rent, whether as a lifestyle choice or due to rising home prices and burdensome student loan debt. Gen Z has also now entered the rental housing market, which will have a significant impact in the years ahead. Additionally, due to lifestyle changes and down-sizing, baby boomers also continue to be a significant source of apartment demand.

High demand, limited supply

Despite recent increases in multifamily starts, demand for rental housing still far exceeds current supply with a shortfall of 600,000 units, as reported by the National Multifamily Housing Council and the National Apartment Association.

In recent years, apartment construction has been concentrated on class-A, “renter by choice” product in downtown or central business district (CBD) areas of the major gateway markets. This has reflected demand from young workers who prioritized prime location and amenities over living space, a preference that will likely shift as millennials seek larger, more suburban properties to start families. Developers have largely overlooked prime suburban areas, where rent and occupancy performance have outperformed downtown areas. This presents an opportunity for investors to acquire suburban apartments at more favorable initial acquisition yields.

There continues to be limited new development for properties targeted toward the more moderate “renters by necessity,” who are a stable source of demand and less likely to shift toward homeownership regardless of changing market conditions.

It is worth noting that current inflation is also impacting the upcoming supply of new multifamily product. The rising price of construction materials and labor costs may cause some planned projects not to be built and limit the development of future projects. This will have the effect of making existing product more valuable, as replacement costs increase.

Affordability gap

While rents have been rising sharply, home prices have risen even faster. As a result, renting remains a far more affordable option than buying almost everywhere. According to recent Zillow data, mortgage payments are higher than rent in 45 of the 50 largest U.S. metros, up from 22 in 2019. Typical U.S. rents are now $2,031 per month, having crossed the $2,000 threshold for the first time this year, with an annual growth rate more than three times that of July 2019.

As barriers to homeownership remain high, which will likely hold true for some time, renting remains the most cost-effective option for many would-be-buyers.

Pandemic impact

Counter to the assumptions of many, rent collections have remained generally stable throughout the pandemic—consistently averaging between 95 percent and 96 percent since March 2020, according to RealPage.

After rents were frozen for two years, landlords are now playing catch-up. Despite sharp rental rate increases in many markets, residents are staying in their apartments longer. According to RealPage, apartment retention rates rose by 3.5 percentage points year-over-year in April to 57 percent. Notably, when renters renew their leases, they are also spending significantly more—10.7 percent more when compared to their previous lease. New renters, however, are paying even higher rates for the same units.

Demand for rental housing continues to outpace inventory in many areas. The 2022 Rental Housing Report from the Joint Center for Housing Studies (JCHS) of Harvard University reported the lowest rental vacancy rates since the mid-1980s.

Conclusion

In summary, there are many compelling reasons for why now is a particularly good time to invest in multifamily real estate. Historic demand across multiple generations, an anemic supply of new housing, demographic and lifestyle trends that favor renting, and economic advantages for both investors and renters will continue to provide tailwinds to the multifamily market. It is, quite frankly, a great time to be a landlord in whatever form or fashion that role can be held.

Kurt Houtkooper serves as CEO of real estate investment firm Hamilton Zanze. He joined the firm in 2003 and has more than 18 years of experience in real estate asset management, property management, leasing, acquisition and disposition of income-producing properties. At HZ, he oversees acquisitions, dispositions and capital markets activity. Justin Fossum, Hamilton Zanze’s director of asset management, also contributed to this article.


Hamilton Zanze in the News



August 11, 2022

Increased Cost of Capital Forces a Reset of Multifamily Valuations

Buyers are beginning to ask for discounts and some deals fall through. But experts say the disturbance in the sector is based on “short-term uncertainty.”

Jenn Elliot | Aug 11, 2022

In early June, two days before the Federal Open Market Committee increased the Federal Funds Rate by 75 basis points, Odyssey Properties Group struck a deal to buy a multifamily asset in Dallas at a 3.5 percent cap rate. The Los Angeles-based real estate investment firm was hoping to add the garden-style property to its existing portfolio, which consists of 44 properties comprising 7,217 multifamily units across 14 states with a total estimated value of more than $1.5 billion.

As Odyssey progressed toward a purchase and sale agreement (PSA), it struggled to obtain a float loan, so it put the purchase on hold, according to Derek Graham, president and principal at Odyssey. By late July, the firm had nailed down an agency loan and resumed discussions with the seller, who’d bought the property for $18 million in 2019.

For Odyssey to achieve the same returns it had projected just six weeks earlier, the firm needed the seller to reduce the price by $3 million, or roughly 10.5 percent off the original price of $28.5 million.

“Even with that decrease, the seller would have achieved an amazing return, given what he paid for it,” Graham notes.

The seller was willing to shave $1 million off the purchase price—a decrease of roughly 3.6 percent. To no one’s surprise, the deal ultimately fell apart.

“The seller’s question to us was: ‘Why should I sell for less?’,” Graham recalls. “I understand his position because I’m an owner too. The reality is that rents are increasing anywhere from 12 to 20 percent, and he’ll be able to increase his net operating income, probably by 15 percent or more. And if he decides to sell a year from now, he will have recouped the $3 million reduction that I needed to close the deal today.”

Shaking off the lost deal, Odyssey shifted its focus and locked down a multifamily property in Phoenix at a 4.4 percent cap rate. Unlike the Dallas owner, this one was “willing to meet the market,” according to Graham.

Odyssey’s experience certainly isn’t unique. In fact, it has become quite common in today’s uncertain investment sales climate. There has been a bit of a standoff between buyers trying to achieve a certain yield and sellers insisting on their original price, Graham notes. The sellers haven’t adjusted their expectations to an environment with higher interest rates.

“Just 90 days ago, their asset was worth a 3.5 cap rate, and they’re resistant to making needed adjustments. For us buyers, debt is now more expensive, so we need a 10 to 15 percent discount for a deal to generate the same kind of return potential.”

Diminished investor confidence

After the Fed’s initial rate hike in March, many multifamily sellers were willing to work with buyers and re-trade assets at 3 to 5 percent less than original agreements. The embedded gains that investors have achieved in recent years certainly helped by providing more flexibility to give some back to buyers so deals can get done, notes Brian McAuliffe, president of capital markets, who leads multifamily investment sales business at commercial real estate services firm CBRE.

However, with each successive rate hike, the buy-sell gap has widened. Experts estimate that valuations have decreased from 8.0 percent to 15.0 percent, with core assets in growing markets landing near the low end of the range and value-add opportunities hitting double-digits.

Because data detailing recently closed deals is not yet available, it’s difficult to pinpoint exactly how much valuations have reset. Furthermore, investment activity has slowed significantly over the second quarter, making it even more difficult for investors to confidently value properties.

“Right now, it seems like market participants—buyers, sellers, and lenders—are all looking for data for confidence,” says Martha Peyton, global head of real assets research at Aegon Asset Management.

No motivation or desperation to sell

Many owners are paralyzed by indecision, unsure whether they really want to sell off their multifamily assets, according to Kurt Houtkooper, CEO of Hamilton Zanze (HZ), a San Francisco-based real estate investment company that owns and operates 132 properties totaling 22,821 units across 17 states and 30 markets.

“Owners know valuations have changed, so they don’t feel very motivated to sell, and fundamentals are so strong, there aren’t a lot of desperate sellers either,” Houtkooper notes.

Since its founding in 2001, HZ has acquired more than $5.9 billion in multifamily assets. The firm’s strategy is to buy an asset that it thinks is broken, fix it and sell it once it’s stable. Then, the firm will do a 1031 exchange, investing the proceeds into another property.

“We’re a value-add shop, and we’re going to buy and sell through the cycles,” Houtkooper says, adding that earlier this year, the firm decided to dispose of several properties and has no desire to deviate from that plan. “We’re still selling the properties that we planned to sell, and we’re still making a profit, just not as much as we would have if we’d sold in January 2022.”

Beyond valuations, owners might be hesitant to sell because there are fewer properties on the market. Odyssey’s Graham likens the current environment to a game of musical chairs, where if an investor sells a property, it might be a challenge to find a replacement asset.

Shallow pool of quality buyers

Many buyers who have been active over the past few years are now on the sidelines, closely watching the action in the “field.” Houtkooper estimates that the buyer pool has decreased in terms of size and quality. He notes that four months ago, the firm was getting 30 offers and today it’s getting about 10, and those 10 offers may not be as high quality as they were previously.

He also adds that buyers have returned to the traditional due diligence period after three years of offering non-refundable money from day one.

That’s a bummer when you’re a seller, but a boon when you’re a buyer. “We like it when there’s less competition,” Houtkooper says. “Our thought is that we might sell at a discount, but we’ll also be buying at discount.”

HZ’s strategy to combat higher interest rates and increased cost of capital is to seek out properties with existing assumable debt. Currently, the firm is in the middle of acquisition process for two apartment communities in Tennessee totaling roughly $150 million. It will assume agency loans for both properties and expects to achieve a positive arbitrage on cap rates, according to Houtkooper.

“By assuming a loan, we know the loan constant, and we’re taking out market volatility,” he says.

Aegon’s Peyton says well-capitalized and respected buyers have increased leverage in this market. “As a function of changes and uncertainty in the capital markets, buyer credibility has certainly become of increased focus during seller due diligence,” she notes. “Operators with less reliable capital sources are being scrutinized much more heavily.”

Of course, all-cash buyers continue to hold the power position over buyers who use debt to acquire assets, even those like HZ, which boasts a balance sheet that is strong enough to assume loans.

How much will valuations continue to shift?

Industry players predict that investors will have a much better handle on the market by the fourth quarter, which should help stabilize valuations.

“If multifamily properties continue to perform well and rents continue to increase, I would be very surprised if there was another large shift in values,” says John Sebree, senior vice president and national director of Marcus & Millichap’s multi housing division. “They might slide up and down a little, but I think the big shift has already taken place.”

Sebree expects that once valuations stabilize, investment activity will pick up as well. He notes that here is little concern in the industry about multifamily investment levels and property fundamentals in the sector in the next five to seven years. The current market hesitancy is about short-term uncertainty, he notes.

Graham says his firm will continue to pursue multifamily acquisition opportunities even if interest rates continue to increase (as the Fed has indicated). “Our industry got intoxicated on cheap debt in 2020 and 2021, but interest rates are pretty much exactly where they were in 2019,” he notes. “With realistic buyers and sellers, cap rates will also return to 2019 levels, and I think we were all pretty happy with the returns we were getting back then.”