Amidst rising interest rates, high inflation, and broader economic uncertainty – there is no shortage of doom and gloom headlines when it comes to CRE investment. Recent apartment vacancies piling up in certain geographies and sectors of the multifamily market have created a shift in media sentiment and headlines that multifamily has been immune to over the last few years. As headlines continue to simplify the narrative, our research continues to illustrate that the underlying demographic fundamentals and demand drivers remain compelling. Multifamily and related rental housing investment is a long game – and it’s critical to stay focused on the structural and secular factors that form the basis for a durable long-term investment program in the sector.
Focus on Fundamentals – Chronic Housing Shortage
What are these underlying fundamentals? Most importantly, the US housing market is chronically undersupplied – a shortfall that is now between 3.8 and 6.8 million units, as of 2020, according to Freddie Mac Housing Supply: A Growing Deficit May 2021 and National Association of Realtors Housing is Critical Infrastructure: Social and Economic Benefits of Building More Housing June 2021. Despite the more than 400,000 units completed during 2022 and another nearly half a million new apartment units that will be delivered by the end of 2023 (according to CoStar), it will hardly make a dent in this housing shortage.
It’s not just the shortage of units – it’s a shortage of the type of units that Americans need. Luxury housing alone isn’t meeting the rental market’s needs. The overwhelming portion of U.S. new developments are high end, high rent buildings. However, amidst stagnant wage growth, high inflation, and broader economic concerns –the luxury renter pool is already shrinking as rent increases have priced millions out of luxury buildings, contributing to new vacancies. There is an increasing need for workforce housing to capture those caught in the middle – both those now priced out of class A buildings, and those that have rented in the workforce housing category all along.
Historic Investment Opportunity in a Historic Housing Disconnect
We believe workforce housing is the most resilient asset class as higher income renters are trickling downward into less expensive housing, while lower income renters are being forced upward due to the lack of adequate supply at the lower end. In this way, the waterfall effect inhibits the ability of workforce renters to supplant those in lower-tier units and limits the supply of workforce units available to actual workforce income renters. In our analysis, workforce housing supply shortfall is worsened by builders’ recent preference for developing luxury product.
In a nutshell, demand for workforce housing is significantly outpacing supply.
Kingbird is already seeing evidence of this supply shortage in several of our target markets. In Austin, Samsung is building a new $17 Billion microchip plant with 4,500 new jobs within 30-40 minutes of two Kingbird apartment investments. In Columbus, Intel is developing a new $20 Billion microchip facility with 3,000 jobs also near several Kingbird apartment investments. Several other cities where Kingbird has apartment properties including Dallas, Huntsville, New York City and Los Angeles are also launching significant new job creating projects in fields such as technology, infrastructure, media, defense, and aerospace. We view this job-driven growth as providing additional downside protection against a “hard landing” market downturn; the projects also serve as ballast for accelerating important new growth channels.
Private real estate funds focused on workforce rental housing returned an average net IRR of 16.4% between 2009 to 2019, according to Preqin, versus luxury housing focused funds’ average net IRR of just 10.7%.
The unmet demand of the workforce rental sector is clear, the economy has failed to produce new supply at a level adequate to fill the workforce housing shortfall. As such, this supply gap has grown substantially and is poised to continue to do so, rendering the sector a sustainable target for investment.
Don’t Overlook NOI Growth – It Will Come Amidst Slower Rent Growth
Real estate asset values are generally driven by a multiple of Net Operating Income (“NOI”), just as the values of many companies are driven by multiples of earnings. Real estate assets trade as a function of capitalization rates, which are simply the reciprocal of a trading multiple (a 5% cap rate is equivalent to a 20x multiple). As the near-term outlook on revenues and trading multiples remains in flux, asset pricing is uncertain. We should expect this situation to linger until there is more clarity regarding the level and duration of the terminal rate that is required to stabilize inflation near its target level of 2-3%.
While real estate, including multifamily real estate, is not exempt from the current market volatility, it has historically declined less and recovered value faster than other real estate asset classes. The significant housing shortage occurring today has, in the long term, driven home prices out-of-reach for many households, pushing them to rent, thus driving multifamily rents higher and vacancies lower. This dynamic, in effect, puts a “stop loss” on multifamily real estate asset values, creating resiliency in the sector despite the current short term central bank-imposed volatility and market dislocation.
Nationally, apartment vacancies have been at historic lows and even though rent growth nationally is projected to decline to 3%, we have expected that rent growth will normalize to this level, the long-term historic average, as the rent growth of recent years was unsustainable. In 2021, the national average rent grew 11.1% on an annual basis, while home prices increased 18.9% per year. These outsized rent increases are well above historical averages. Amidst these changing averages, Kingbird Investment Management conservatively generally considers 3% rent growth (or even less), as our projected growth rate in our underwriting analysis.
It is important in today’s market to avoid looking at real estate through a “one size fits all” or “moment in time” lens that assumes all market segments and sectors are equal. Most cities will remain undersupplied with the kind of affordable units that see the highest demand. This will keep vacancies from rising and keep rents from going negative in most cities. At Kingbird, we carefully track all supply-demand dynamics throughout all US markets to inform investment strategy and bring NOI growth to our portfolios.
While we are being exceptionally cautious during this short-term period of volatility, the resilience and durability of the multifamily sector remains. Specifically, given the current housing shortfall and construction dynamics, we believe that demographic driven demand will continue to outstrip supply and create ongoing investment opportunities to capture compelling risk-adjusted returns.