The drivers affecting multifamily growth in the next two to five years involve several issues that were discussed by leading experts from Yardi Matrix in a recent webinar.
The Yardi Matrix 2018 U.S. Multi-Family Market Update was presented by Jack Kern, Director of Research and Jeff Adler, Vice-President of Yardi Matrix, who discussed what they see upcoming in the multifamily market in the next few years.
“The apartment markets are not in bad shape but localized. If you are an asset manager, what is your key issue going to be? Adler said. Some of his key takeways about multifamily growth from the webinar which can be downloaded here.
- The domestic economy is strong and accelerating, as wages are rising steadily and the labor market is very tight.
- Inflation has shown signs of increasing, which will allow the Fed to increase short-term rates. It will also allow longer term rates to drift upward without an immediate inversion of the yield curve.
- Demand for multifamily units remains strong, although the strongest demand is emerging in secondary markets with lower costs of living. Job growth is faster in secondary markets than primary markets.
- Tech hubs are emerging in formerly non-tech metros, as well as often overlooked metros.
- A few markets may be on the brink of short-term over supply in the next 18-24 months.
“Where's the new supply coming? How shielded are you from new supply pressures? What are you going to do at the site level to get your costs down, your sites buttoned up to be able absorb this influx? If you're an operations manager you've got to be at the top of your game, particularly in places where a lot of the supply is coming because you're going to be challenged.
When it comes to multifamily growth the market "really faces an increasing set of crosswinds,” Adler said on the webinar. ”The demand picture in jobs and population is really good but it's shifting to lower cost cities and the home ownership rate I think is, and will continue, to gradually rise.”
7 Drivers Affecting Multifamily Growth Going Forward
The drivers affecting multifamily growth involve a lot of discussion on the analysis of overflow out of gateway cities and into secondary cities, Adler said.
- The economy is accelerating
- Tightening labor market
- Multifamily facing crosswinds
- Development capital is available
- Overflow from gateway cities to secondary and tertiary cities
- Development of intellectual capital hubs
- Lack of business culture and rent control
The economy is accelerating
“The U.S. economy is in very good shape,” Adler said. “Gross domestic product (GDP), employment is up, and growth is actually accelerating. You see that obviously, in pressures in the labor market as well as in the market for money, such as interest rates. Oil prices are up, $70 a barrel. I think they could even get to 80-ish, which is kind of a different call for me, but only for about 18-24 months, then there's a supply response, it kind of comes back down.”
Kern added, “The economy was pretty strong, and we were thinking oil prices were contributing to it, especially in the industrial base.Now, we're at $80 and the economy is really strong and getting stronger.”
Adler added, “You see it happening in Houston and in oil-related cities. Occupancies are up. Wages are rising 2.5%. The labor market is really tight and people are being pulled off the sidelines. Inflation is rising at 2-ish but I don't see it going the 2.5. Short-term rates are up. I would very much watch the yield curve, very much so,” Adler said.
Labor market is tightening
“Wage pressures are increasing. Unemployment is down at 3.9%. Pressures are increasing and I would tell you that in fact the wage improvements of the younger workforce is actually higher than what we're seeing in the headline numbers because we have retiring boomers,” Adler said.
“That's basically dampening the effect of what's actually occurring. We're able to have good times longer because if you were just looking at 4-5% wage growth, you'd throw a lot of alarm bells off. The demographics are actually helping us to keep this expansion going, so it's kind of good news.
“Then we see it all over the economy that there are labor shortages in certain places among certain trades, particularly at lower end less educated roles, which is actually helping that earning group get some wage growth back.
“Labor force participation has stopped declining,” Adler said.
“It has started somewhat rising and the same thing for productivity. This is a rolling six-year average so it's at 0.7% but again it's moving up, which is again, positive trends for overall economic growth and productivity growth at 1.3.
“The key issue we're going to have to watch here is the fact that population growth overall isn't increasing because of lack immigration. The labor force participation will see a somewhat positive. It's really going to come down to productivity.”
Multifamily growth facing crosswinds
“The multifamily market really faces an increasing set of crosswinds,” Adler said.
“The demand picture in jobs and population is really good but it's shifting to lower cost cities and the home ownership rate I think is and will continue to gradually rise.
“Our take on this is about 10 basis points a year in the secondary cities and that's a little bit of a headwind. Financing costs are up. Bottom line, if you're in the multifamily business, you've really got to focus where your NOI increase outruns the increased cost of debt,” he said.
“There are a handful of markets that are at risk of oversupply or the next two years, not so much in the next five. We've laid them out:
When it comes to multifamily growth, these cities are in for "a little bit of a rough ride,” he said.
Kern added, “I think on our last call we felt that the supply was coming but it wasn't fully evident just yet. Now, it seems like it's much more evident.”
“I kind of view this as this is an 18- to 24-month kind of thing. There's stuff that has to get absorbed, there's new stuff that's coming that has to get absorbed,” Adler said. “It has to get re-stabilized. You're talking about a good two years, a good two years of riding this stuff out. It is very localized in where it's coming. They're beautiful buildings. It is going to be great for the economy overall and the country overall. These are revitalized downtowns. But if you're owner of existing assets, you're going to struggle. You have to focus on cutting your costs.”
“Overall when you look at it on a market level, I think ‘Hey, with the exception of five of six cities, that's not so bad.’ However, I do expect the ride to be rocky and we're seeing this now and I think we'll continue that,” Adler said.
Development capital is available and sharpshooters game
“Multifamily capital is abundant, both equity and debt and the cap rates are steady, which means the spreads are compressing,” Adler said.
“The new supply deliveries are absolutely weighing down on the market and very tightly submarkets within those. The level of new supply is flattening.
“The discussions I've had with a lot of market participants and financiers is that development capital is there,” Adler said.
“It's now at the point of whether the developers themselves want to take on the squeeze of increasing construction costs and decreasing rents and whether they're going to build just for fees and keep themselves in business. My view is as long as the capital is there, stuff is going to continue to get built. It doesn't appear as if there's a drop off in 2019 but more of a leveling at 280,000 to 300,000 a unit. The key issue is it's new supply. This is with or without a mild recession. You just run it out and if you want to make money in this business, you're going be focusing on places where the supply isn't, that's pretty much it. That becomes a sharpshooter's game,” Adler said.
“As an investment officer, it's about being a sharpshooter, finding the places that there's a lot of capital to deploy. Everyone I have spoken to, almost bar none, has a lot of money to put out. The question is, how do they put the money out without shooting themselves in the foot?
“They don't want to come back with having these bad investment decisions. You've got to dig harder, you've got to dig deeper, and you've got to focus on where the supply isn't and where places have intellectual capital and where there's creative work going on,” Adler said.
Secondary cities and intellectual capital hubs
“We took the Amazon 20 as a jumping off point and we added a couple of other markets to round out this notion,” Adler said. “Then we began looking at that approach.
“You're trying to achieve very high quality at less cost. The question is how much less and how much you want to play? You can see that as an investor, this is an interesting way of thinking about this because it's based upon at what stage do you want to enter into a city in its development as a tech hub in terms of the quality of the labor and the cost of labor?
“Then as an investor, you can look and say aha, if I think about where I want to play, either high quality at moderate cost is Salt Lake, Orlando, Minneapolis, Sacramento, Phoenix or do I want to really throw the dice and go off of Indianapolis, Pittsburgh, or Detroit where it's very low cost, very high quality, but maybe perhaps underappreciated. It may take a little more of a longer timeframe to come to fruition.
“The longer an expansion runs out, the better the returns to secondary cities are. But, you do need to understand that if you're in a secondary city, you're going to see a sharper correction in values and you need to make sure you're not caught in a liquidity trap in that moment.
Development of intellectual capital hubs
“When I think about cities, you really think about it in four quadrants.
- Public and private partnerships that bring things together
- A business friendly environment
- A community and amenities that attract talent particularly creative, artistic and STEM (science, technology, engineering and math)
- An educated workforce.
“The tech hubs are emerging in both formerly non-tech metros and traditionally overlooked cities,” Adler said.
“ It's really about the development of intellectual capital hubs and the cost advantages associated with them as jobs and companies move those jobs to places that have a lower cost of living. The longer this expansion goes on, the more established that infrastructure becomes.
“I think the tax reform will only accelerate this. The good news for investors is that this is a slow pitch and you really have an opportunity to decide at what stage of development, with multiple points of entry, you want to play in one of these emerging hubs and so it does take some time.
“One thing we noticed in our 27-year study is that property values in the secondary markets are more volatile. No question about it. So your capital structure has to be prepared for that level of potential volatility in a downturn. But with that, actually returns are actually better in secondary cities than primary cities.
“The development of a tech city takes time. Maybe, you could argue, that time will be compressed because the playbook is now quite well known and it is quite well known.
“But for Austin, it took a long time for the infrastructure, the tech infrastructure to coalesce before suddenly it went crazy right before the GFC and it has really taken off since then. That allows you as an investor to basically have multiple different entry points.
Some cities a suprise for multifamily growth
“Some cities that quite frankly surprised me when we were doing this work.
“I had never thought about Phoenix as a high tech city. And yet, Arizona has become, because of regulatory environment, a center of autonomous vehicles. Notwithstanding the tragedy that occurred with the fatality there, that is a step back, but it's a step back but not a knockout blow. It'll come back. I also found really interesting this whole notion of the autonomous trucks, which I think is really going to take off. All of that is happening in Phoenix as well as advanced manufacturing. There are clusters in Phoenix that you just never thought Phoenix was a high tech city and yet, around Tempe and other areas of technological talent, things are happening,” Adler said.
“Inside of our service, Yardi Matrix, you can drill into this and visualize the cities and drill further into micro markets,” he said.
Lack of business culture, rent control and whackadoodle responses
Adler said it is unfortunate that rent control has become an issue. “You're seeing this obviously in California with Costa Hawkins, the proposed repeal of a law that would enable localities to put local rent control in place – it's unfortunate.
“But you have pressures that have built, particularly in California where there has been job growth, there's been wealth creation because of intellectual capital, and there has been a very restrictive ability to build, both in northern California and in southern California.
“The political culture being what it is, rather than look at free market approaches to resolving these issues, it is ‘Let's go blame those dirty capitalists.’
It can for a short time benefit people in place. It is in the long run horrific from a creation and balancing of a functioning effective marketplace. I have spoken to a lot of people about Costa Hawkins and I've been in California and talked to a lot of people in and out of the industry. If there is a chance for it not to succeed, it's only because single family rentals are included. But I would say it's a 50-50 thing, I've heard people say 60-40 either way. It's even money. In the Wall Street Journal, there was an article by Laura Kusisto about a bunch of folks in Santa Monica, landlords just selling out and moving to Las Vegas.
“The question is, ‘How do localities respond to economic growth’ and the concentration of wealth. Unfortunately, if you don't have a positive business culture, a positive business climate, you get these whackadoodle responses,” Adler said. He cited the Seattle tax that was imposed on the top companies of $275 a person that they employ, “which again, was kind of whackadoodle. That's why business climate and long-term business climate is so important.”
“Seattle had been just rocking in terms of growth and a great tech hub. That change in business climate took a little bit of the bloom off the rose. No one is going to leave and the sky isn't falling but it's a chip away at what had been a very pro-growth environment and had been really rewarded in an expansion in their economy,” Adler said.
Summary multifamily growth
Adler said in his multifamily growth summary that if you are not in the right places “where NOI growth is outdistancing the movement in cost capital, you could be exposed to value headwinds, let's put it that way.”
He added 5 things to watch for that would indicate a recession is coming:
- Hourly earnings growth goes from 2.5% to 4%
- Cyclical sector share of GDP goes from 24% to 28% of GDP
- GDP deflator goes from less than 2% to 2.5%
- Operating capacity utilization rate goes from 76% to 80%
- The yield curve inverts – 10-year treasury less than fed funds rate
“I don't see any of things happening yet,” Adler said.
“We're at a stage of the real estate cycle where it truly is a sharpshooter's game. That we're looking for places where intellectual capital is developed or emerging, where you can have a good entry point, and where you're basically attempting in the short to medium term to be insulated from supply.
“If you're in the path of supply and you can't avoid it, just get prepared, get your cost structure under control, get your operations tight, particularly as an asset or property manager, and basically ride it through.
“I think if you were looking for lessons, you would probably go to the folks in Washington, DC who have been through this sort of cycle for a number of years and have worked on ways to survive through that cycle.
“I think the multifamily asset class is a great place to be. I think every market goes through challenges and evolutions and I think multifamily will continue to do it. It is a great market to be in but at this stage, you've got to know where to put your capital. That means you're going to have to dig harder and dig deeper in order to uncover opportunities,” he said.
Jeff Adler: Vice President & General Manager, YardiMatrix, Jeff.Adler@Yardi.com, 1-800-866-1124 x2403
Jack Kern: Director of Research and Publications, YardiMatrix, Jack.Kern@Yardi.com, 1-800-866-1124 x2444