Note from the CIO: Q2 Multifamily Numbers Indicate Potentially Strong Continued Performance

architecture-buildings-business-city-325185-2.jpg

By RealtyMogul Chief Investment Officer, Chris Fraley

As an investment professional, friends always ask me if now is a good time to invest in real estate. I am not qualified to give investment advice, but there are words of wisdom that I always like to follow (1) Warren Buffett advises that we should look at the fundamentals and not get swept up in the headlines, and (2) Peter Linneman, Professor at Wharton, advises that we should never underestimate the power of the US economy.

In the past few weeks, we have seen a dual hit of massive losses to both the equities market and bond markets. This has clearly impacted investor sentiment. In these times of volatility, it is important to focus on the fundamentals. Q2 data is now out and suggests that 2022 will continue to be a year of strong performance for the multifamily sector, potentially one of the strongest in the past 20 years. In fact, if CoStar’s current prediction is accurate, the absorption levels of 2021-2022 will be around one million apartments, roughly equivalent to that of the entire decade from 2000-2009.

Record-Breaking Performance Continues Through Q2

The US Multifamily market has the strongest fundamentals that I have seen in my career. CoStar estimates that the Q2 net absorption nationally is roughly 70,000 units with rent growth around 5% for the first half of the year. As of today, CoStar predicts net absorption of approximately 350,000 units with rent growth of 6.2% for 2022. Due to supply/demand characteristics, CoStar predicts that above-average rent growth will continue for the next three years as shown on the charts below.

Source: CoStar data feed June 30, 2022
Source: CoStar data feed June 30, 2022

Please note that this is on top of record absorption levels of 673,000 units in 2021. This was a surge of 127% according to data below from Newmark. To put that in perspective, the 2021 absorption levels could have almost populated the entire apartment inventory of the Dallas (735K units) or Chicago MSAs (706K units).

These charts indicate the number of units absorbed by year and market (in thousands) and give a sense of magnitude of the demand from 2021:

number of units absorbed by year and market

Inflation Concerns

You may have heard that multifamily may potentially be a good hedge to inflation. The chart below from Newmark provides a visual representation of historical multifamily returns versus inflation. Multifamily total returns have exceeded inflation in 38 of the past 42 years. In fact, according to the chart below, the year of highest multifamily total return was also the year that the US experienced the greatest inflation levels over the past 42 years (1979).

Total Returns by property type vs inflation rate

How Value Can Be Created in an Inflationary Environment

So how does inflation benefit multifamily? To illustrate this, I thought it might be helpful to provide an example of how abnormal rent growth and inflation can impact real estate valuations.

It is common in traditional underwriting to assign a 3% growth rate to rental revenues and a 2% growth rate to expenses. In the past 12 months, we have seen almost four years’ worth of rental revenue and expense growth.

Using the actual US national average growth rates from the trailing 12-months 14% and the trailing 12-month expense inflation of 8%, I applied this to a sample proforma with a 40% expense ratio and it resulted in an 18% increase to Net Operating Income and total value keeping all valuation metrics constant.

Assuming 75% leverage, the change in equity value results in a 72% increase to the leveraged return.

rent growth

I sensitized the above analysis to understand what would happen with the 6% rent growth that CoStar is predicting for 2022 along with abnormally high expense growth of 8%. This potentially more prudent scenario would still result in 19% increase in equity value. This may seem counterintuitive, but it is due to the fact that expenses typically represent 40% of the overall revenues of a project, and movement of expenses has less impact than revenue growth on overall net operating income.

Conclusion

So the question remains, is now the right time to invest in multifamily? Is there potential for future gains in this cycle? While we live in an era of high volatility and the rent growth and absorption projections are not certain, I personally continue to believe that multifamily remains a potentially good risk adjusted return. The Q2 data suggests that absorption levels remain strong and, according to CoStar, 2022 is on track to be one of the strongest years in the past two decades.

This CIO note is for informational purposes only and should not be regarded as a recommendation, an offer to sell, or a solicitation of an offer to buy any security. Information discussed herein include forward looking statements; forward-looking statements, hypothetical information, or calculations, financial estimates and targeted returns are inherently uncertain. All opinions expressed herein are solely those of the author and do not represent those of RealtyMogul or any of its affiliates. All expressions of opinion are subject to change without notice in reaction to shifting market, economic or political conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. This content was created as of the specific date indicated and reflects the author’s views as of that date.

RealtyMogul is not a registered broker-dealer, investment adviser or crowdfunding portal. We recommend that you consult with a financial advisor, attorney, accountant, and any other professional that can help you to understand and assess the risks associated with any investment opportunity.

Join RealtyMogul
Gain access to commercial real estate deals across the country
Easily review, compare and invest in deals that meet your criteria
Build the real estate portfolio that’s right for you
Potential benefits include diversification, growth and passive income
ARE YOU AN ACCREDITED INVESTOR?
Password should be at least 8 characters, contain an uppercase character, a lowercase character, a number and a symbol.
Sign In
Don’t have an account yet? Join RealtyMogul
Please enter your email and password below.

Forgot Password?

Forgot Password
Enter your email address to receive a code to reset your password.
Enter the code sent to your email address below and your new password.

Resend Code