Is It Time to Weigh the Scales and Take Stock?
The U.S. Census and others report that the supply of naturally affordable residential housing is approximately 4 million units short of demand for such units. New construction cannot be delivered to meaningfully reduce this gap. And, this gap is actually increasing in suburban markets as tenants exit urban markets to escape crime, high cost of living, poor schools in favor of a remote working life-style. These facts suggest that allocating investment capital to the suburban multifamily real estate (“MFR”) segment has long term, strong and sustainable valuation tailwinds. But, the question is this: are currently negative market factors adversely impacting MFR transaction volume mitigated by counter-veiling factors that suggest now, after a decade, we have entered a buyers’ market that has significant opportunity for appreciation over the coming 3-5 years?
| Reasons to Sit on the Sidelines | Mitigating Factors |
|---|---|
| The spike in interest rates has outpaced the decompression in multifamily cap rates, thereby creating “negative leverage” where borrowing costs are higher than cap rates. | Deep value-add, older vintage, suburban garden-style multifamily properties have significant NOI growth potential driven in part by the well-acknowledged urban exodus to suburbia. |
| Rent growth rates are slowing to even negative. | Negative renewal and trade-out rents is largely occurring in urban markets. Prospect’s 48 property MFR portfolio generated ‘same store’ LTM rent growth of 8.8% for June 2023. |
| The economy is poised for a downturn which will surely hammer rental properties. | Prospect’s MFR portfolio has average rent of $1,374 per month and targets the largest worker demographic in the US—those with AMI in the range of $40K-65K. During Covid, a most severe downturn when unemployment spiked from 3.5% to 14.7%, Prospect generated 4.3% ‘same store’ NOI growth from 2019 to 2020. |
| Until recently, many market pundits thought interest rates would start to trend down in Q1 2024; there is now emerging concern that we may be in for a longer period of higher rates. | Unless one believes that high interest rates will persist beyond a 3-5 year holding period for MFR value-add properties acquired now, while some may try to time the market, the fact is that, today, workforce housing properties can be acquired for 150-200 bps higher cap rates than they could be acquired 18 months ago. |
| These market uncertainties make it almost impossible to underwrite exit cap rates. | Those that believe stabilization in the capital markets will occur over the next 5 years underwrite (i) a base case exit at a cap rate flat to the entry cap rate and (ii) an upside case assuming partial snapback to pre-Fed tightening June 2022 values. |
Not all multifamily real estate is created equal: Our conviction is that, over the next five years, the capital markets will stabilize and supply/demand factors will cause cap rates on older vintage, suburban, value-add MFR workforce housing to compress from where they are today with a corresponding valuation impact.
Disclosures
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