Now that the dust has settled on the first half of 2022, it is important to take a moment to consider the climate surrounding commercial real estate, specifically multifamily. The record-breaking transactions and high rates of returns of 2021 have given way to a much less steady investing environment, which resulted in a slower, but not stalled, rate of capital movement.
Attached is a report written by Greg Willet and published by Institutional Property Advisors (IPA) that outlines the six trends that will shape near-term apartment industry financials. This report provides a clear picture of the U.S. apartment sector’s first half of 2022 and gives reasonable expectations for how these trends will play out in the rest of the year. We understand that your investments with New Standard Equities are not your only holdings in commercial real estate. We are happy to share resources with our investors that we think will help paint an overall picture of the current apartment market, especially in relation to your investments with us.
The complete four-page report can be found here, but before you take a chance to look at it, we’d like to answer the following question: how do these trends affect NSE’s portfolio?
Six Key Trends Shaping Apartment Inusdtry Financials
Renter Demand is Returning to a More Normal Level:
2021’s surge of demand for apartments across asset classes has given way to a stabilizing market. The key drivers of apartment demand–monthly job additions, higher mortgage interest rates–certainly have their impact across the board, and the result will be a different renter profile overall. In the past two years, the average household income for renters has grown by nearly 20%. The young professionals of previous generations who would have been considering buying a house are renting for longer periods of time and renting has a different connotation now than before. It is this demographic that we specifically cater to in our value-add-centric strategy. IPA’s report touches on the dramatically lower apartment absorption rates nationwide, but most relevant to NSE’s portfolio is the emphasis on the limited supply of apartments at a non-luxury price point. This is a trend across the country, but one that is especially significant in West Coast markets where there is a notoriously low stock of housing entering the market every year, which was true even before the supply chain issues and labor shortages introduced by the pandemic.
Vacancy Uptick is Only Mildly Slowing Rent Growth so Far:
This report anticipates that rent growth will cool in the second half of 2022 compared to the rapid growth of previous quarters. While most eviction bans have expired, this is not the case in Alameda County, where four of NSE’s thirteen properties are located. In the nine properties where there is no moratorium, turning over units with non-paying residents will increase vacancy rates in the immediate future but does give property management the opportunity to fill those units with new residents–ideally resulting in less bad debt moving forward. This process does take some time even at properties outside of Alameda County, as the states of Washington and California are notorious for more stringent laws regarding tenant eviction.
As is the case nationwide, rent concessions at NSE properties are trending downwards. Concessions given in the first half of 2022 were approximately 65% lower year-over-year, which is an encouraging trend that will be further bolstered by a lifting of the eviction moratorium in Alameda County in the future.
Renewal Lease Revenue Helps Mitigate Spiking Expenses:
Retaining residents while increasing rents to cover expenses is a delicate balancing act. In the first half of 2022, the rental rates for new leases at NSE properties increased by 14.9%, while renewed leases increased by 6.1%. Renewal rates always skew lower than new leases in order to comply with rent control laws, save money and energy related to turning and leasing a new unit, and prevent a unit from sitting unoccupied for an uncertain period of time when it could be generating revenue. Expenses related to servicing debt have especially risen at properties with floating interest rates making rental increases imperative to keeping up with business plans. While we want to keep revenue in line with expenses, the ability to hang on to residents is an important one and rent increases have to be mitigated in order to do so.
Building Activity Trending Up, but Still Challenging Completing New Properties:
It’s impossible to paint multifamily development nationwide with a broad brush. Each region has different challenges when it comes to new development, and the West Coast is a notoriously difficult place to build new housing compared to the rest of the country. This is where NSE’s investment platform is able to really shine: in markets where high-quality housing is lacking but nearly impossible to build, our team can take an existing property and improve it to meet the needs of area residents at a price point that works for them.
According to page 3 of the report, national ongoing apartment construction at the beginning of the third quarter is up 20% on a year-over-year basis. Willett warns “construction activity can obviously get too aggressive in select metros and neighborhoods. Spots vulnerable to overheating construction include Phoenix, Austin and most metros in Florida.” Fortunately, the West Coast does not run this risk. The first half of 2022’s new apartment construction decreased in the East Bay and Inland Empire by 67 and 80% respectively year-over-year. Seattle-Tacoma added 6,145 new units in the first six months of 2022, which is up approximately 5% when compared to the same period last year but is still a much lower figure than the national average.
Living in Urban Cores Has Rebounded, Despite Slow Office Return:
On the neighborhood level, suburban multifamily properties like those operated by NSE continue to outperform the rest. Suburban markets were always strong, but the proliferation of hybrid working schedules ushered in by the pandemic made them more attractive to some young professionals working in the knowledge economy who did not want to contend with long commute times on a daily basis. But–will the hypothetical incoming “return to office” impact this demand for suburban housing? Whether or not we see a full return to working in-office, the report posits that any push to do so will not have a tangible impact on suburban housing, because apartment demand in downtown areas has recovered independently from downtown office usage. As of time of reporting, apartment vacancy rates in Los Angeles, Seattle, San Francisco, and Oakland are less than a percentage point higher than they were in the months pre-pandemic. Some renters simply prefer living downtown for reasons other than their commutes and any shift in the proliferation of hybrid work schedules shouldn’t be seen as a major threat to suburban multifamily housing.
Capital Markets Disruption to Investment Should Become More Apparent:
Our portfolio is not immune to the rising interest rates and institutional investor hesitation that are plaguing the rest of the industry. Our floating rate mortgages are feeling the pain of interest rate hikes and several deals have come across our path but did not entice institutional capital enough to close. Our acquisitions team is bringing the same diligence as in previous years and we continue to perfect our eight-factor decision model, but page 4 of this report illustrates that the misalignment of seller, buyer, and lender expectations is more pronounced than usual.
Though apartment trading activity across all asset classes in the first half of 2022 was up 15% year-over-year, this is not the case for NSE. Why is that? For one, many of these numbers include deals that began before the start of the new year, so the results are somewhat skewed by these transactions brokered in a much different market climate. NSE’s two most recent acquisitions, the Benson and the Brook on Center, closed just before the cutoff date of December 31st. Second, economic uncertainty has spawned another complication when acquiring new properties: many investors are no longer interested in core luxury products, so there is much more competition for the types of value-add deals that the firm seeks out. This flight-to-quality has yielded much stiffer competition for the same amount of product.