Trends in the Sunbelt
The combination of strong migration and rapid economic recovery in the last year led to tight market conditions in the Sunbelt.
Occupancy levels climbed, in some cases reaching record highs, while annual rent growth accelerated into double-digit territory and surpassed 20% in several markets. This surge in demand helped fuel a development boom, and construction pipelines are at or near levels unseen in decades.
This rapid supply response began to outpace demand slightly, a sign of developer optimism more than a decline in renter demand. Occupancy levels ticked down in Sunbelt cities where development hurdles are relatively low, including Phoenix and Las Vegas. The increase in available units, particularly amenity-loaded apartments, led to a slowing of rent growth trends.
In California, particularly coastal metropolitan areas where development activity is more constrained, supply has yet to catch up to demand.
With a strengthening recovery from pandemic-related business restrictions and return of migration into urban centers, occupancy generally trended higher. The strong demand pushed rents higher, with tech-focused neighborhoods in the Bay Area outpacing rent growth of many suburban submarkets. Asking rent growth also accelerated in San Francisco and Silicon Valley after lagging the country thus far during the recovery period.
Notably, rent growth of luxury units, reflecting renters-by-choice, and multi-bedroom units led the market. Overall, the average asking rent nearly recovered to pre-pandemic levels in the Bay Area, though in-place rents remain lower in many communities.
Capital Markets Effect on Multifamily Housing
The Federal Reserve will likely play catch-up for not having normalized rates early by aggressively raising rates at each of its meetings in 2022. With the capital markets pricing in continued increases to the federal funds rate, expectations of potential real estate returns will likely adjust as well.
Though the cost of debt may increase further, complicating apartment acquisitions and refinancing activity, the primary risk of the Fed’s rapid tightening will be whether it can avoid a hard landing recession.
If the Federal Reserve, despite its track record, manages to tame inflation without causing more than a modest and short-lived recession, the multifamily segment would remain one of the stronger commercial real estate sectors.
Renter demand would be bolstered by higher mortgage rates with the decline in single family affordability leading to households renting for longer. Additionally, a rise in construction materials and financing costs may curtail development activity, supplementing the shortage of housing that persists throughout much of the country.
Apartment Cap Rates
Further cap rate compression is unlikely with cap rates for apartments in the 3% to 4% range, depending upon location and asset quality and while the 10-year Treasury yield approaches 3%.
If cap rates rise, assets need to produce strong rent growth for returns to remain positive.
Should cap rates normalize in the 5%–6% range, roughly a 100–200 base point increase from current levels yet still lower than long-term averages, renters would be unable to bear the level of rent growth needed, and investors would fall short of return targets.
The demand for higher quality housing is likely to remain elevated, particularly in coastal cities and growing secondary markets. Rental demand is relatively more resilient than other real estate sectors, as housing demand is somewhat inelastic.
Additionally, the ability of government sponsored enterprises to provide the apartment market with affordable capital options during all cycles leads to greater stability of asset values. The surge in apartment rents may slow in the coming months from the record levels, but continued job and wage gains should support rent growth higher than the long-term average.
Though pricing may be in flux, debt capital should remain available, with the Federal Home Mortgage Corporation projecting a 5%–10% increase in purchase originations in 2022.
Apartment market fundamentals will likely remain strong, and comparatively the sector has greater demand characteristics over the long term than other real estate sectors, but the realities of elevated inflation and higher interest rates shouldn’t be underestimated.
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