Why Rents in Some Markets Will be Heading Down!

The difference between success and failure in new multi-family deals will come down to how well the sponsors understand and can predict the supply/demand imbalance for housing in the surrounding area for the deal. When investing in particular markets, you must have a handle on the micro-economic factors in the zip code you are buying and not assume you will benefit from broader demographic trends. The pandemic created "herky-jerky" pressures on the housing market, and it continues today with supply in some areas being overrun by excess apartment construction as higher mortgage rates drive people toward apartments. It is critical that you identify and ride the positive momentum, and not get steamrolled by an oncoming wave.

Apartment supply in the US is currently increasing with a surge of post-pandemic building. From the chart below, you can see that developers have focused over 50% of new construction in 15 areas mostly in the Sunbelt, but also cities like DC, Philadelphia, Seattle and Los Angeles. As an apartment owner, you do not want to compete with a desperate developer in a stressed lease up phase. The impact of new development on asking rents will depend on demand, which is a function of net migration and new household formation. It is hard to imagine rents increasing in an area seeing net out migration (Los Angeles) while supply increases sharply. If you believe the demand for apartments outstrips the supply in your target area, then move forward with your investment; if not, run for the hills.

The good news, however, is that there is a silver lining! This current increase in new apartment development is a bubble, and new construction starts have already started to fall precipitously. Lenders have tightened standards for new development, and with rent growth softening and expenses rising, lower valuations can't support loan-to-value requirements on new builds. Constrained new supply is a very positive overall trend for future rent growth in late 2024 and into 2025. Again, this is a macro view, and any particular zip code could have very different economics.

Marcus & Millichap recently ranked their top growth markets for multi-family deals, factoring in net-migration offset by excess supply. The top five are: Ft. Lauderdale, Dallas, Orlando, Miami and Tampa. Interestingly, Charlotte, NC made the top 10 but they noted apartment deals in the urban center faced falling rents while the surrounding areas could have strong rent growth. Again, this points to the need for a very micro zip code view on rent potential; a shotgun approach to analysis could lead to disappointment.

From a macro perspective, the demand for new apartments continues to strengthen. The single-family home affordability gap between owning and renting remains elevated at $1,000 per month. The supply of starter homes available for purchase is at historical lows as homeowners are locked into 3% to 4% mortgages, so moving doesn't make financial sense. New household formation, statistically, is primed to push the demand for new housing higher. The millennial generation is now approaching the historical median age for first home purchase. And due to the unaffordability gap, millennials will most likely look for an apartment while they wait for an opportunity to buy a home.

When evaluating deals, it is important to understand the supply demand balance for the particular asset you are buying. You need to understand the threat of local new supply and what asset class is being built. Although most new construction is class A, President Biden's Housing Supply Action Plan is increasing incentives to build more class C assets, which could crush older class C properties. The diversity and strength of the local economy is also critical. Avoid areas with over-concentration in any one industry. Recently, the United Auto Workers announced a strike. If you invested in an area that was fully dependent on the auto industry, you could be in trouble. No investment is without risk. Identifying risk factors and taking measures to mitigate the impact is a proactive way to help ensure the deal is a success.