MULTIFAMILYINVESTORSENTIMENT REPORTAUGUST 2018

According to surveys and follow up interviews conducted by Real Capital Markets in July 2018, multifamily investments remain the darling of the investment community, largely based on the consistency of market fundamentals and the long-term positive outlook for the sector. Despite record construction activity in recent years and overheated pricing in certain markets, there remains considerable capital—both domestic and foreign—waiting to be deployed into this asset class.

According to statistics aggregated by the National Multifamily Housing Council, the trend line in four national categories—rental rates, sale price, cap rates and product completions—shows that each has improved in the last four years.

One key factor sustaining this record level of multifamily development and related investment activity is the shift in home ownership rates over the last 10 years. Many millennials, for example, have moved away from owning, partly because of the escalating costs involved, and are fueling significant demand for apartments, particularly in urban centers. This trend is also playing out with other demographic groups and is not expected to change significantly in the near future.

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“Overall, the market remains strong with significant capital, both domestic and foreign, looking to be placed. The challenge for many

investors is finding quality assets at reasonable prices.”Tina Lichens

COO, Real Capital Markets

• Most industry experts, and 69.7 percent of survey participants, ranked interest rates as a looming concern, as the market has already absorbed 12 to 18 months of increases and spreads are very thin.

• According to those interviewed, the multifamily market is thriving with much of $250 billion in CRE capital that is committed to the sector.

• Gateway and core coastal markets are back as the preferred place to be for many investors.

• Fierce competition and an upward tick in pricing remains for value-add properties.

• Steady employment, specifically from the tech sector in many core and secondary markets, is fueling growth in the multifamily sector.

Five Leading Multifamily Trends Impacting the Market:

Multifamily Investing: Fundamentally SoundOne of the underlying factors making the multifamily market so strong is its defensive position that people simply need a place to live. With fewer people that want or are able to afford home ownership, the demand for apartments remains high and as such, competition to invest in the market is equally as strong.

Additionally, the fundamentals of the market are sound and very consistent:*

• Rents per square foot: Rents have increased for the seventh consecutive year to $1.44 per square foot nationally. This represents more than a 16 percent increase since 2014 when the rate was $1.24 per square foot.

• Cap Rates: For the last four years the multifamily market has continued to see cap rate compression. While the rate of compression has slowed—year over year it declined by 10 basis points to 5.6 percent in 2017— the overall compression since 2014 is 70 basis points.

• Sale prices: In each of the last eight years, the average sale price per square foot has increased, reaching a peak of $196 per square foot at year end 2017. During the eight consecutive increases, prices have jumped 56.8 percent, from $125 per square foot in 2009.

• New product completions: Year-end completions in 2017 totaled 347,000 units, the sixth consecutive year that annual completions increased. During that run, a total of approximately 1.6 million units were completed.

• Vacancy rate: The only metric that is not altogether positive for the sector was the national vacancy rate. At year end of 2017 the national vacancy was 8.6 percent, a sizable increase from 2015’s rate of 7.4 percent, but still lower than the 2013 rate of 9.1 percent. The increase in vacancy can be attributed to the significant level of new construction that has taken place.

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*National Multifamily Statistics Source: NMHC, RCA, MPF Research

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The Market is Strong, Capital is Plentiful

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After several years of robust development and sales activity, the multifamily market remains strong, with record development and investment levels in many markets, and significant capital ready to be deployed by a growing number of investment sources.

According to Real Capital Analytics, multifamily sales volume for the U.S. was $69.8 billion for the first half of 2018, a 7.7 percent year-over-year increase. As previously noted, according to survey participants, there is significant investment capital designated for the multifamily sector, an estimated $250 billion or more from a wide variety of investment sources.

The market, however, is experiencing shifts in investor mindset and approach as participants adapt to market dynamics at this stage in the cycle.

Rent growth has been slow in many markets, for example, due to supply levels and other factors. Sixty-five percent of survey respondents

noted the outlook for rent growth as marginal. “Even in markets like Washington, D.C., you’ve had tremendous absorption, but not a lot of rent growth,” says Alan George, Executive Vice President and Chief Investment Officer at Equity Residential.

Investment pricing is also seeing significant swings from market to market.

“There is a vast spread in pricing. In New York it’s challenging for sellers to sell property because they won’t like where the assets will trade. Expense growth is outpacing rent growth and there is a supply issue.” David Schwartz CEO, Chairman and Co-founder of Waterton

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Great Interest in—and Concern for—Interest Rates

70%

30%

One of the greatest factors influencing and potentially threatening the strength of the market is the interest rate environment. Nearly 70 percent of survey respondents said that the prospect of further increases is having, and will have in the future, an impact on acquisition strategies.

Vic Clark, Senior Managing Director in the commercial real estate sector for Hunt Real Estate Capital in Dallas, TX explains that interest rates have moved up about 60 basis points over the past year and are edging close to 5 percent. “In the last 12 to 18 months, lending agencies have found ways to reduce pricing to keep rates low despite interest rate hikes. So far, cap rates have held firm, but another 60 basis point rate hike will be difficult to absorb.”

“The biggest risk I see is interest rates – that is the cloud hovering above us.”

The impact of interest rate increases would likely be felt in different ways, depending on the type of investor, their acquisition parameters, individual market dynamics and other factors. Survey respondents agreed, however, that additional rate hikes would lead investors to either be more cautious in their underwriting and pro-forma approaches, or shift their strategies to shield against lower yields. For example, some investors may move into value-add properties, although that investment segment has become overpriced and saturated with investors in some markets.

Survey respondents noted that interest rates should be looked at in addition to sector fundamentals and overall asset performance. For example, some suggest that if rental rates increase at levels higher than expected (between 2 and 21/2 percent annually), the differential essentially would wash out further interest rate hikes. Conversely, if interest rates rise higher or if rents don’t increase as anticipated, some respondents said the “impact on returns could be problematic”.

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Survey responses regarding whether rate increases will have an impact on acquisition strategy:

Yes

No

“As interest rates go up, the case for renting is strengthened even further.”Alfonso MunkAmericas CIO - PGIM Real Estate

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Vic ClarkSenior Managing Director, Hunt Real Estate Capital

Name Your Threat

Market saturation and overbuilding each were noted by 30 percent of respondents, although there are markets across the country where the supply can’t meet the demand, despite strong construction activity. One of those market areas is the nine-county San Francisco Bay Area, which has had more development in the last five years than the previous 30 years combined.

“Multifamily fundamentals remain very strong in the Bay Area, in large part driven by high-wage employment growth in the tech and ancillary services sectors. As a result, we do not anticipate any meaningful shift or disruption that would alter the area’s housing supply-demand imbalance,” says Phillip Saglimbeni, Senior Managing Director, IPA, in the San Francisco Bay Area.

There were some survey participants who took a much broader view of factors that could threaten the multifamily market. Tyler Anderson, Vice Chairman, Institutional Properties with CBRE in Phoenix, believes the greatest threat to the market could be “a global type of event that would eliminate or severely limit liquidity in the market, a correction in the bond market or some type of volatile foreign event.”

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30%

30%

23%

9%

8%

Survey results of the greatest threats to the strength of the multifamily investment market:

Lack of quality product/increased competition

Overbuilding/oversupply

Diminished capacity for rent growth

More stringent lending criteria

Lack of quality product for acquisition

Munk offers contrarian perspectives on threats to the ongoing health of the market, primarily in the areas related to affordability and construction costs. “At the top of my mind is affordability; can people afford the rents being charged?” Munk asks. “Rent levels in some of the gateway markets—New York, San Francisco, Boston—make it very hard for some renters.”

He pointed to the age-old standard that people should spend no more than one third of their income on rent. In some of the top markets with new high-rise developments, the percentage can easily eclipse 50 percent.

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Value-Add is Hot, but Hard to FindDuring the past several years, as multifamily investment pricing rose in many markets, some investors shifted to buying value-add properties in order to achieve a higher yield through improving the property and/or its amenities.

This market segment remains strong but is experiencing intense competition and now a scarcity of supply in many markets. There is considerable demand for properties from the 1970s, 80s and 90s, where investments can be made to improve the aesthetics, the common areas and units.

“There is a lot of competition for value-add properties and you may have to look hard, but you can find them,” says Clark. “There is always somebody who bought the property 10 years ago and wants to sell. You can come in and spend $1 million to upgrade the units and get a lot of pop and return on that investment.”

Anderson notes a similar theme in the Phoenix area:

“With some 1,100 older properties that have 100 or more units, there are always properties well-suited for repositioning and a value-add approach.”

While there may be an abundance of value-add properties in Phoenix and other markets across the country, the influx of investors into this segment has created challenges in finding the right property at the right price.

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Tyler Anderson Vice Chairman, Institutional Properties - CBRE

Survey participants see balanced levels of supply and demand with more than half anticipating at least marginal improvements in occupancy rates. A slightly larger percentage predict marginal growth in rents across the country.

As with other fundamentals, the prospects for rent growth varies by market. Anderson believes the growth rate for rents will be strong, with rental rates in the Phoenix market growing at a pace that is stronger than the national average, as much as three to six percent. At the same time, he doesn’t predict any fall off in the pace of rental activity.

The Crystal Ball for Fundamentals

55%

26%

16%

3%

While survey respondents noted caution regarding interest rates and other factors, they generally are optimistic about the multifamily sector’s ability to weather these challenges. According to the survey, more than half consider themselves net buyers while another 26 percent are holding to absorb and manage the properties they’ve already acquired.

The survey results of investment positions are as follows:

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Net buyer

Holding - to manage what we already own

Net seller

Holding - to see how things progress in the industry, economy, politics

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“Demand for multifamily investment property has been very high and pricing is very strong. The market is awash in capital chasing deals.”Alan GeorgeExecutive Vice President, CIO - Equity Residential

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The Impact of Job MarketsIn major markets across the country, the employment base and further job growth drives the strength of the market. Munk said that PGIM Real Estate finds a number of multifamily products/opportunities attractive. One area of particular growth and intensity in the last year has been workforce housing or Class B product. The firm has acquired 33 projects totaling about $1.5 billion in the segment in the past year.

Reflecting back on his overarching concerns about affordability and the need for workforce housing, Munk says PGIM Real Estate is particularly attracted to Sun Belt area properties built in the 80s and 90s that require a minimal amount of value-add work. “This type of multifamily is attractive to tenants from the student and the working-class populations because of its affordability,” he says.

The intense competition for deals is a common theme in the multifamily sector, a sentiment echoed by 86.5 percent of survey participants. Competition is significant with prospective buyers using shorter due diligence periods and greater levels of non-refundable earnest money as a potential means for securing the deal.

Sources interviewed were mixed in terms of the amount of crossover they are seeing. Will Balthrope, a Senior Managing Director with IPA in Dallas, said that while the multifamily sector has a very focused and active pool of investors, others are looking at the multifamily sector because of its inherent defensive characteristics. “People need a place to live,” he added.

There is also an abundance of competition coming from investors trying to expand into what likely represents a new geographic area for them. Saglimbeni, for example, is seeing steady or often increased levels of competition for properties in gateway markets such as the Bay Area. One driver is the cap rate compression that has occurred between historically low yielding markets such as the Bay Area and evolving or secondary markets such as Denver, Portland, Phoenix and Las Vegas. As a result, many buyers are showing new or renewed interest in the Bay Area based on favorable risk-adjusted returns.

According to Balthrope, competition is driving investors to seek yield and opportunities in select secondary and tertiary markets, where there are strong demand drivers and no oversupply issues.

Competitive Forces at Play

“Those markets with a highly-skilled labor base—typically associated with the tech sector—see the highest paying jobs, which translates to strong performance for multifamily properties. No one is predicting a decrease in demand for these types of workers.”

Phillip SaglimbeniSenior Managing Director - IPA

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Generally speaking, multifamily investors and advisors have a positive outlook for the balance of 2018 and into 2019. Market fundamentals are strong, and while some talk about the industry reaching a plateau, the amount of capital chasing deals and the variety of buyers in the market will continue to drive healthy levels of activity.

Underscoring that line of thinking, Schwartz emphasized, “Closed end real estate funds have billions of dollars in callable capital—capital that has to be invested over the next three years. On top of that is a plethora of non-traded REITS, public REITS, private high net worth capital, foreign capital and other sources, each of which has some interest in multifamily investment. That’s what’s keeping these cap rates low.”

Balthrope is bullish on the market, saying the multifamily sector remains a robust segment. “Equity is abundant, debt is readily available and there are many properties for sale,” Balthrope said.

According to the findings of the survey, more than 38 percent line up with the assessments of Balthrope and Schwartz. Another 28 percent suggest the market may plateau, maintaining the strong level of activity the industry has experienced for at least the last five years and in some cases as many as the last eight to 10 years.

“At the end of the day, it’s all about liquidity,” says Anderson. “There is no lack of capital looking to buy multifamily complexes, in Arizona or anywhere, and we don’t expect that to change any time soon.”

In assessing the outlook for the sector, Steve Shanahan, RCM’s Executive Managing Director, notes the dynamic balance that exists in the market for products ranging from Class A, luxury complexes in gateway cities to suburban style garden apartments to workforce housing.

“Housing is one of the most fundamental needs, regardless of income level or socio-economic status,” he said. “Investors will continue to leverage those intrinsic needs, as well as strong market fundamentals, to create and take advantage of a steady stream of investment opportunities.”

Outlook Generally Strong

“The market will remain strong for the balance of 2018 and through 2019, but good transactions will be increasingly more difficult to find.”Will BalthropeSenior Managing Director - IPA

Thank you to the following individuals who gave further insight on the market:

• Tyler AndersonVice Chairman - Institutional Properties, CBRE

• Will BalthropeSenior Managing Director - IPA

• Vic ClarkSenior Managing Director - Hunt Real Estate Capital

• Alan GeorgeExecutive Vice President, CIO - Equity Residential

• Alfonso MunkAmericas CIO - PGIM Real Estate

• Philip SaglimbeniSenior Manging Director - IPA

• David SchwartzCEO, Chairman, Co-founder - Waterton

Acknowledgments

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Real Capital Markets regularly surveys industry professionals for insights on the current commercial real estate market.

Visit rcm1.com/reports to view a list of past studies.

For more information, please contact:info@rcm1.com | 888-440-7261 | www.rcm1.com

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