Over the last several years, the term “workforce housing” has become a popular catchphrase in the multifamily investment community. Part of this is due to the strong financial performance of the asset class relative to other sectors of the multifamily housing market, and some is due to the perceived “recession proof” characteristics of workforce housing in an economic downturn.
In this article, we’ll discuss what workforce housing is, how investing in workforce housing may act as a defensive play in an economic downturn, the potential rewards and risks of investing in the workforce housing asset class, and how workforce housing is attracting capital from institutional investors.
What is Workforce Housing?
The term workforce housing can be traced back to the idea of high-end resort communities and ski areas – such as Aspen, Vail, and Park City – providing housing for workers who otherwise could not afford to live in the towns where they worked due to the wide disparity between income and the cost of housing.
Today, the definition of workforce housing has expanded. A recent article in Pensions & Investments notes that workforce housing is defined as Class B and Class C multifamily property with a few amenities catering to middle-income renters.¹ Middle-income renters are considered to be those who earn between 60% and 120% of the area median income. Residents who fall into this income range typically include teachers, firefighters, and law enforcement professionals.
In an interview with Multifamily Executive, Jason Robertson, vice president of development for American Land Ventures, observes that workforce housing is often misconstrued as “affordable housing”. Rather than being affordable housing, workforce housing is most accurately described as “housing that is affordable”.²
Investing in Workforce Housing in A Downturn Can Be A Defensive Play
In March 2019, Bisnow polled two dozen C-suite commercial real estate executives to learn how the next economic downturn could affect commercial real estate.³ While the majority of these CRE executives believe a downturn is coming in the next few years, most believe the industry is strong enough to withstand a down market – although some asset classes should do better than others.
Office, industrial, retail, and hospitality may underperform in an economic downturn. But the multifamily commercial real estate asset class may perform well due to multifamily’s countercyclical nature of affordability and demand in down markets, and to the sector’s access to capital via HUD, Freddie Mac, and Fannie Mae.
Fannie Mae’s February 2019 - Multifamily Market Commentary entitled “2019 Multifamily Affordable Outlook – An Overwhelming Need for Workforce Housing”, uses data from CoStar and Reis, Inc., to illustrate how vacancy rates for Class B and C multifamily property reached lows of 5.1% in 2015 and have remained low ever since. By comparison, vacancy rates at higher-rent and amenity-filled Class A apartment properties were three or more percentage points higher, coming in at a vacancy rate of 8.5% at the end of 2018.⁴
Other factors used by Fannie Mae to forecast the need for workforce housing in the upcoming years include:
Vacancy rates may not rise: according to CoStar, through 2020 vacancy levels at Class B multifamily property should rise to just 5.7% while Class C vacancies should fall to 4.8%. (Vacancy rates at Class A multifamily property could rise to 10.3% by the end of 2020 as the market struggles to absorb new units brought to market.)
Class B and C housing stock have declined: by 2018 the share of workforce housing units declined to about 52% of the total multifamily housing stock, down from 59% at the end of 2009. On average, about 120,000 Class B and C units are being lost each year due to obsolescence, gentrification, and conversion into Class A units.
Higher rent growth may continue: a decrease in the supply of Class B and C workforce housing units has helped rent growth to outstrip that of Class A units and to grow above the average 2.4% rate of inflation. In 2018 rent growth for the Class B segment was 3.4%, while the Class C segment grew an estimated 2.9%. CoStar projects 2019 rent growth to remain positive at 2.7% and 2.4% for Class B and C property respectively, with rent growth of Class A property coming in at 2.3%, just below the average rate of inflation.
How Might Workforce Housing Perform Financially in A Downturn?
If the above predictions from Fannie Mae and Co-Star are accurate, the future demand for this asset class appears to be strong. One of the key questions is, how might workforce housing perform financially in an economic downturn? To answer this question, we’ll look at two of the key measures of multifamily housing investment performance: cash flow and IRR.
Multifamily cash flow is calculated by subtracting (1) vacancy and credit loss, (2) repairs and other operating expenses, and (3) debt service from (4) gross rental income. What could be the effect on these four items – and the resulting net cash flow – in a downturn?
If the projections from Fannie Mae, CoStar, and Reis are correct then (1) vacancy levels and resulting credit loss could remain flat, if not decrease, due to the short supply and growing demand for workforce housing. In an economic downturn, where business can be hard to come by and jobs may be scarcer (2) repair and operating expenses may also remain level since experienced multifamily housing operators may have more leverage when negotiating with vendors.
A report from the Federal Reserve Bank of St. Louis on “Bank Lending During Recessions” notes that loan growth at commercial banks decreased and remained negative for almost four years after the recession of 2007-2008. Refinancing a loan coming due in the middle of a downturn could increase (3) debt service due to higher interest rates and increased lender-required reserves. However, this negative impact on cash flow could be potentially mitigated with longer-term conventional loans or private equity financing. For the same reason, that vacancy rates could remain flat or decrease, (4) gross rental income on workforce housing might also remain flat or possibly increase.⁵
The net result is that cash flow from workforce housing investments may remain strong during a downturn due to short supply and growing demand.
Internal Rate of Return (IRR)
The IRR, or internal rate of return, of an investment considers the “time value of money” using a discounted cash flow analysis. An IRR calculation takes into consideration the periodic cash flows from an investment and the initial capital contribution made by an investor.
In general, the higher the IRR the more financially attractive an investment is. But if an investor’s money is tied up for too long, the lower the rate of return and the less attractive an investment is. How might IRR be affected during a downturn?
First, if Fannie Mae, CoStar, and Reis are incorrect in their forecasts for continued low vacancy levels and growing rents in workforce housing, then gross rental income and vacancy losses would be negatively affected. This could create lower levels of periodic cash flow and a reduced IRR. Periodic cash flows could also be negatively affected if the property needs to be refinanced during a period of high interest rates.
Secondly, it may be difficult to sell an investment during a downturn. If the exit strategy of disposing of the property needs to be delayed until the real estate market recovers, the investor’s money is tied up for a longer period of time, again resulting in a lower overall rate of return.
The net result is that the IRR from workforce housing might be lower than anticipated if there is a deep economic downturn, even though cash flow from investing in workforce housing could remain strong.
Other Potential Risks of Investing in Workforce Housing if The Economy Slows
In November of 2018, CBRE Research published a report entitled “The Case for Workforce Housing.”⁶ This market perspective covers many of the positives of investing in workforce house we’ve already discussed in this article.
But with any commercial real estate investment, there are risks as well as rewards. Here are some of the risks of investing in workforce housing in a downturn according to CBRE:
Renters may be unable to absorb rent increases during a downturn. Even in today’s growing economy, more than 33% of workforce renter households are considered to be “rent burdened”, with rent payments taking up more than 30% of their income. In an economic downturn, it may become increasingly difficult for workforce renters to pay higher rents.
Housing demand and household formation decline during downturns. During the last recession, household growth declined from 1.34 million new households in 2007 to just 286,000 in 2010. Class B vacancy topped 7% and Class C vacancy reached over 9%, the two asset classes targeted for workforce housing investment. If similar vacancy levels are reached during the next downturn, cash flows and IRRs could be reduced.
Increase in rent control policies. Although rent control is not that widespread in the U.S., high-rent areas such as California, Washington, Illinois, and Oregon are witnessing increased discussion and proposed legislation for rent control. Rent control limits how much a landlord can increase the rent when a lease is renewed, and when a unit is vacated and re-leased to a new tenant.
Each of these risk factors could have a negative impact on the cash flows and IRRs from workforce housing investments.
Institutional Investors Are Targeting Workforce Housing
Despite these potential risks, capital from institutional investors have been flowing into workforce housing investments over the last few years, according to a 2017 article in Pensions & Investments⁷:
- New York State Common Retirement Fund with $197.1 billion in assets recently committed $710 million to finance multifamily housing investments.
- CalSTRS, the $213.7 billion California State Teachers’ Retirement System, has already committed $200 million toward workforce housing with a total target of $500 million.
- Pennsylvania Public School Employees’ Retirement System and Philadelphia Board of Pensions and Retirement, with $52.7 billion and $4.8 billion of assets under management respectively, are investors in a $300 million fund focusing on Class B value-added and multifamily workforce housing.
- Allstate Corporation, an insurance company with $2 billion in real estate equity and $4.5 billion in commercial mortgages, recently acquired over 7,600 workforce housing units through a joint venture.
Mike Moran, managing director and head of commercial real estate investments for Allstate, believes workforce housing offers a “high degree of security on the downside” compared to other commercial real estate asset classes.
- Workforce housing is Class B and C product targeting renters earning 60% to 120% of the area median income.
- Investing in workforce housing can be a defensive play in a downturn due to low vacancy rates, short supply and high demand for workforce housing, and possible continued rent increases.
- While IRRs may be lower, cash flow from workforce housing investments may still be strong during a downturn.
- Risks of investing in workforce housing include the inability of renters to absorb rent increases, decline of new household formations reducing demand, and government intervention in the housing market via rent control policies.
- Despite these risks, institutional capital continues to flow into workforce housing investments.