The volatility seen in equity markets during the last few trading sessions of 2018 made it clear that investors are beginning to contemplate a pullback. However, the real economy continues to exhibit strength by many accounts as we head into 2019. The labor market tightened throughout 2018, and the unemployment rate is at historical lows. Wage growth (registration required) reached 3% for the first time in a decade. Consumer confidence is at an all-time high, and private consumption expanded at its strongest pace since 2015. Against this backdrop, the Fed raised its target rate four times in 2018.
The multifamily business is in an unusual predicament. I’ve been working in the industry for over a decade, and have been following it for much longer. This current cycle is unique, as the economy shows neither signs of overheating nor imminent contraction. Multifamily real estate has been riding high for some time, and everyone is trying to figure out whether 2019 will be more of the same. The answer depends largely on the market segment and location: Real estate professionals tend to agree that there is no such thing as a national housing market. Each metro and underlying submarket is different.
The Elephant In The Room
Undoubtedly, interest rates significantly influence real estate profitability, and opinions vary widely on near-term projections. Several colleagues have even suggested the return of 1990s-era rates. I am not in that camp; I would argue that the Fed may raise its overnight lending rate another 25-50 basis points (0.25-0.50%). With strong competition among lenders continuing to support multifamily transactions, volume and stable NOI growth, I do not believe the Fed’s increases will weigh heavily on returns for the asset class.
For decades, interest rates have closely mirrored inflation, with the highest rates occurring during times of significant population growth that, in turn, stimulated consumption growth and drove up the price level. The result was a persistent cycle of high inflation and high-interest rates. The 1970s through 1990s were marked by geopolitical turmoil and soaring inflation. When the 9/11 attacks occurred in 2001, the Fed cut rates to unprecedented levels and did so again in 2007. These rate cuts began a downward trajectory that coincided with the aging of the baby boomers. With this 20% segment of the population producing, contributing and spending less, I believe it is unlikely that we will see interest rates rise to pre-2000 levels.
Demographics in the developed world greatly influence global interest rates. With much of the developed world struggling to keep population growth at replacement levels, economic growth has waned. Several institutions have conducted studies highlighting the inverse relationship between life expectancies and interest rates. One such study was performed by the San Francisco Federal Reserve, which found that the trend toward longer life spans and a decline in population growth rates has resulted in increased household saving at the expense of current consumption. These trends place downward pressure on interest rates, which I expect to continue. Therefore, I do not contend that rate increases pose a strong threat to commercial real estate profitability and cap rates.
What To Expect In Multifamily
That said, multifamily markets across the U.S. will vary in profitability during the next few years for several key reasons.
First, the national rental market is still benefitting from tight borrower guidelines for single-family homebuyers put in place after 2008. Appreciation in single-family home values has outpaced wage increases across most professions, and as the spread between the median mortgage payment and average monthly rent widens, many would-be homebuyers are poised to remain in the rental cohort. In 2018, sales of single-family homes slid by 5%, and the homeownership rate for people under age 35 fell from a peak of 43% in 2007 to 37% today. Millennials continue to rent in unprecedented numbers, placing greater value on mobility, flexibility and the community aspects afforded by renting than any preceding generation.
Rent growth, after remaining flat in many markets last year, has shown signs of rebound across the country. Average rent growth as of Q4 2018 inched up to 2.8%, while nationwide vacancy fell to a low of 4.5%, according to CBRE. Rental markets across the Sun Belt, in particular in places like Texas, Florida and Arizona, capitalized on outsized population and employment growth. Migration from the northern markets into the southern markets has fueled demand for apartments, which is a trend I expect to continue.
We’ve also seen compression in the spread between cap rates for suburban markets and the urban core, currently at 40 basis points, its lowest since 2010. Signs of overbuilding are evident in high-end multifamily projects in the urban core markets. Cap rates have hovered around 5% in the urban core for the past four years, while suburban rates have dropped to 5.4% as of mid-2018.
There was widespread speculation that vacancy rates would increase significantly after an influx of new supply last year, but absorption has been healthy. Occupancies have remained stable with vacancies in most metros below historical averages. The northern and coastal markets are the notable exception, however, as markets like Washington, D.C., and New York City continue to experience vacancies well above historical averages. According to Freddie Mac, Fort Lauderdale, Los Angeles and Orange County are all expected to fall in this category in 2019.
The reality is that multifamily remains a flight to safety for most real estate investors. While significant volatility plagued most asset classes throughout 2018, multifamily acquisitions actually increased by 12.1% to $173 billion, according to CBRE’s fourth-quarter report.
The real question for 2019 is whether the record rent growth and healthy absorption rates persist. According to Freddie Mac, the double-digit growth rates that multifamily investors have grown accustomed to will contract to single-digits, and I tend to agree. Ultimately, prospects for multifamily, as with any asset class, are predicated on the basic economic principles of supply and demand. While new housing starts have increased nationally, development of owner-occupied and rental housing has significantly lagged past cycles. My thesis for 2019 is that continuous rent growth and tight vacancies will endure across the Sun Belt, with some stagnation in the high-end coastal markets, save for San Francisco.