Summary
- Supply unable to meet demand with high barriers to entry
- Yield spread and risk premium are attractive vs. other income paying alternatives
- Older inventory allows for value creation through forced appreciation
Inflation & Its Affect on Supply & Demand
With the recent dramatic increase in the money supply and The Fed telegraphing their intent to reach their target inflation level, many believe inflation is set to take-off. That may be what Wall Street is saying, but on Main Street, multifamily developers have seen in plain sight that inflation is already here. Building material and land have seen dramatic price increases over the last decade. Subsequently, construction costs have increased to a level where to remain profitable, building luxury, A-class property is the developer’s path of least resistance. According to the Wall Street Journal, 80% of multifamily supply coming to market are A-class properties. This increase in supply of luxury deliveries may struggle to be absorbed. That phenomena is already being seen in markets like Washington D.C., New York, and San Francisco, where rents have taken a hit in 2020. As the pandemic’s impact is felt, many renters have moved back home with relatives, bunked-up with friends, or found something cheaper to rent. This is producing downward pressure on rents among A-class properties and forcing leasing offices to get creative with concessions to attract tenants to vacant units.
Meanwhile, there is a different scenario playing out in the affordable, workforce housing space. Vacancy is historically low. The inability to profitably deliver new inventory leaves the existing supply for tenants to live, as the newer apartment stock is too expensive for much of the workforce. The stock of existing units is in need of capital upgrades (an opportunity we’ll address later in the article). Many midwest cities are in this situation. Further compounding the shortage in many markets is the migration of population away from the coasts.
U.S. Occupancy by Product:
A Class Property – 94.6%
B Class Property – 95.7%
C Class Property – 96.3%
source: RealPage, Inc.
Yield Spread and Risk Premium
It seems inflation is already here in housing. In anticipation of it hitting the broader market, treasury yields have been rising over the last six months, after hitting an all-time low. Rising interest rates present a headwind for real estate. However, if you dig a little deeper there’s more to the story.
First, even after rising for six months, rates still remain at their lowest level in decades. Second, low rates are likely to stay lower-for-longer. Our central banks have put us in tough spot and have little choice but to keep rates low in order to service our national debt. Higher rates would make that debt significantly more burdensome.
At the time of this writing, the 10-year treasury note is paying just below 1.6% and the inflation rate measured by the Consumer Price Index in January 2021 was 1.4%. If you purchase a 10 year bond from the federal government, your principal is almost certainly safe (risk free) unless our country collapses, but you are going to earn a .2% real rate of return on your investment. Just month ago, that would have been a negative number.
In a world where interest rates could be low-for-longer, investors have to compare the yield spreads between all income paying investments and compare risk in order to earn a return. Yield seeking investors are looking beyonds bonds. This reality forces income investors to put money into “riskier” assets – corporate/junk bonds, dividend paying value-stocks, real estate, etc.
Comparing these options, real estate, particularly workforce housing, offers a generous return. Passive investors can expect to make a 7-8% preferred return on their investment, while holding a real, tangible asset. This is quite a big difference when compared to the risk-free rate of return (10-year treasury) of 1.6%.
Income is important, but capital preservation is priority one. If you are getting paid an income stream, it doesn’t mean much if when the asset sells, its worth less than what was paid for it. Most real estate investors would like the opportunity for appreciation, along with steady income. Analyzing cap rates and looking at the economy as a whole offers useful data to underwrite risk. The national average cap rate for multifamily assets was 5.1% across all property classes. In the workforce housing stock, properties are trading at closer to 6-8% in the markets where we operate.
Multifamily property values have been rising steadily since the great recession. Much of this has been due to cap rate compression. It’s reasonable to predict that any additional upside in multifamily valuation will derive in the form of income growth or expense reduction, rather than cap rates continuing to fall, because interest rates are correlated and likely won’t fall much further. Although they certainly could, as they have in Europe and Japan – a scenario that would likely further compress cap rates, thereby increasing property valuations.
With these points in mind, there are few investment alternatives that offer a more attractive risk adjusted return than workforce housing, based on supply and demand and yield spreads. A solid distribution to provide steady income, with the opportunity for upside appreciation. Additionally, by investing in the right projects, you have a “value-add” component to protect your downside if rates rise.
Value-Add
Properties built 50 years ago can come with unique challenges. Deferred maintenance, capital expenses, and tougher management to name a few. But with challenges come opportunities. In the workforce housing stock, the cost to update units makes far more financial sense than the aforementioned acquisition of land to build new apartments. Once renovations are complete, the updated product allows the property owner to command higher rents that can still be below market rate, adding value to the property and helping the community.
In addition, many workforce apartments under 100 units are still owned by mom and pop operators, unlike the bigger communities that typically have competition from institutional money. These owners have been living off the cashflow, but have made few capital improvements and are likely missing some expense reduction opportunities.
This is just the type of property we look for to execute a reposition. Coming in with a business plan can lead to improvements not only in gross rents, but also the bottom line.
You can be less concerned about rising cap or interest rates after a value-add has been executed. Through renovation, the apartment is now attracting a different tenant at a higher rent. If cap rates rise and put pressure on the value of the property, the increase in gross rents will help offset any moderate correction, thereby protecting your principal.
These true deep-value opportunities are not available in newer product.
Wrap-Up
Workforce housing in growing markets offers the best risk reward opportunity for the income focused investor, with an opportunity for upside appreciation. By acquiring deeper value-add properties in low supply, high demand markets, investors have the opportunity to force significant appreciation through updates, collect income that is hard to derive from other investment vehicles, and help communities and the residents that live in them. This is where profit and progress meet.