Shifting Strategies: Multifamily Investors Adjust To Sector Slowdown, Mature Cycle

Investor confidence in the stability of the multifamily sector this year remains strong, despite robust new supply levels and concerns regarding rising inflation and aggressive interest rate hikes.

As the cycle continues to mature, investors are shifting their investment strategies to focus less on appreciation to generate crazy returns, and more on stability and betting on assets that will generate steady cash flow. 

"You’ve got a couple of challenges — [like] the perception that inflation will rise this year. But we really haven't seen that manifest yet," Marcus & Millichap First Vice President of Research Services John Chang said. "Inflation is still running at about 1.7%. We've seen upward movement in cap rates ... [but] it hasn't been egregious. If we were to see interest rates shoot upward, that could cause the market to pull back a bit." 

The slowdown in new apartment deliveries experienced last year has somewhat eased concerns about overbuilding in the sector, even though new supply will be robust. Marcus & Millichap anticipates 335,000 units will come online this year — down from 2017’s 380,000 completions. New deliveries will be largely concentrated in Dallas, New York City, Washington, D.C., and Atlanta.

The pace of completions this year will continue to moderate thanks to rising development costs and tighter construction financing. Average vacancy rates are expected to grow to 6.8% from last year’s 6.5%, and rent growth is expected to taper off to 3.8%. 

“Last year we saw a very significant wave of construction … the most completions on record and likely the most we’ve seen since the '80s,” Chang said. “[We] do anticipate it tapering a bit in 2018, coming down to 335,000 units, which is still a lot. We’re still looking at a very deep pipeline of construction that should continue to come to market."

Much of this year's deliveries will be high-end Class-A product due to headwinds in the construction industry such as expensive land costs, high-priced materials and a construction labor shortage that is forcing contractors to boost wages to attract employees. 

To earn a profit, most of the new product coming online is upscale. As a result, there remains a large disparity between the luxury apartments coming online and the working-class Americans who need units. This divide is driving renters from expensive core markets with inflated rents like San Francisco and New York to more financially manageable areas.

“While clearly there is a lot of new supply, almost all of that is luxury product and most of that is downtown center or urban product. Even in non-urban cities, they’re still creating their real downtown,” LEM Capital founding partner Jay Eisner said.

As a result, investment in Class-A assets in gateway markets is expected to taper off a bit as investors hunt for value-add opportunities in secondary and tertiary markets with stable upside potential. By purchasing these properties and giving them a face-lift, builders can pay less upfront, add a few amenities, boost rents and reap the profits — which tend to far outweigh the initial capital injection. 

“The difference between building Class-B and Class-A is not that different,” Eisner said. “The price of building the box is not that different, it’s really the finishes.”

Supply-Demand Imbalance

Construction levels will not stifle absorption in the sector as demand from millennials and those in search of affordable workforce housing is expected to drive absorption for years to come. 

“There are markets where there is a huge amount of construction coming online. Conversely, there are still markets were demand is exceeding supply. Even in metros with a lot of construction, there are parts of that market where supply isn’t keeping up with demand. Its becoming very localized — asset by asset, neighborhood by neighborhood [and] tactical in the valuation process,” Chang said. “If people aren’t fully up to speed on the nuances of the market — [they could face] more challenges or hurdles when coming to an agreement."

Pent-up demand from millennials still living with their parents and renting rooms with their peers to make ends meet is expected to continue driving multifamily absorption in years to come. U.S. census data reports 34.1% of millennials between the ages of 18 and 34 still lived in their childhood homes — this is largely the case in markets like Miami, New York City, Los Angeles, Washington, D.C., and Philadelphia, according to a report by Abodo. Yardi foresees millennials driving apartment demand for the next six years. 

Research reveals this generation, the largest cohort in the world, is putting off major life events like marriage and having kids longer than generations of the past, leading millennials to favor renting over homeownership for longer spans of time. In an economic outlook, Yardi Matrix reported the number of millennials within the prime renting ages of 20 to 34 would grow by 2 million in the coming years to reach 70 million by 2024.

Older millennials are transitioning into the homebuyers market. As of August, millennials accounted for nearly half of new homebuyers, according to a Zillow report. Despite their slow start, the Joint Center for Housing Studies for Harvard University predicts millennials will completely upend the homeowner market by 2035, when they will head roughly 49.8 million households. 

“The leading edge of millennials getting into their 30s are starting to buy homes, but later than the previous generation has bought their homes; that's a big factor keeping apartment demand where it is,” Eisner said.