Now is the Time to Invest in Multifamily – Texas is the Place

In the face of the Covid-19 pandemic, storefronts shuttered, businesses failed, and investors waited for a historic buying opportunity, but the moment has seemingly passed. As the world reopens, the economic downfall thought to bring absolute destruction and distressed opportunities like those once found in 2008 are out of sight – especially for multifamily investments. While retail, hospitality, and office face an uncertain future, multifamily is poised for another banner run. Here we’ll explore why bargain hunters will need to turn to other vehicles, like retail or hospitality, to meet their sizable expectations and why now may be one of the best times to buy multifamily assets.

Multifamily investing in its most basic form is a function of price and the expected future income, or Net Operating Income (“NOI”), of an asset. Ideally, multifamily investors can minimize price and maximize expected future income from an asset. One simple way to estimate the ‘return’ of a multifamily asset is to take the net operating income of an asset and divide it by the price of the asset as expressed as a percentage. This resulting capitalization rate, or “cap rate”, provides one way to compare the expected returns of individual assets and the expected returns of multifamily asset classes compared across time to alternative investments. The most illustrative comparison to multifamily investment is alongside the “risk-free rate” of the 10-year U.S. Treasury Bond.

The spread between real estate cap rates and the 10-yr Treasury rate represents the return premium for real estate investments; the greater the spread, the greater the expected return when assuming ‘constant’ risk. Today, there are extremely favorable indicators for the current real estate investment climate. The cap rate spread has widened over 3.50%, which has only happened 3 times in the past 25 years and each time has led to above-average returns relative to long-term averages. Cap rates compressed to historic lows from 2018 through 2020, but as U.S. treasuries plummeted to record lows below 1.0%, the spread between real estate cap rates and treasuries has widened to near-record highs.

When compared to previous recessionary periods, today’s real estate cap rate spread is remarkably divergent. Heading into the recessions of 2001 and 2008, cap rate spreads were over 50% below their long-term average and primed for a correction: real estate assets were simply overvalued. Leading up to the Great Recession, commercial real estate cap rates compressed to historic lows and as the financial markets collapsed and liquidity evaporated seemingly overnight, cap rates had nowhere to go but up. Multifamily cap rates nationwide increased, on average, approximately 1.50% resulting in price adjustment of over 25%, varying by market. A similar pricing readjustment is not expected in today’s disparate environment. Going into the current market downturn, the real estate cap rate spread was at its long-term average and has since increased over 50% above that average.

While the cap rate spread provides a key measure, signaling an absence of wild price swings for multifamily real estate, other indicators only supplement this conclusion, notably the sheer volume of capital awaiting allocation and the outlook for multifamily relative to other commercial real estate classes. According to data from Preqin Ltd., private equity firms across the globe hold an estimated $328 billion in “dry powder” for real estate deployment. Data in early 2020 from Jones Lang LaSalle[1], one of the largest commercial real estate firms worldwide, showed that new capital raised in 2019 surpassed $100 Billion for the first time and in the U.S. alone “dry powder” is nearly $200B, close to the historic high set in 2018. With near-historically high spreads between the 10-yr Treasury rate and multifamily cap rates, the amount of “dry powder” sitting on the sidelines, and the unprecedented disruption in alternative CRE classes such as retail and hospitality, the yield for multifamily is expected to remain near historic lows and may see further compression heading into 2021 and 2022.

While the pricing outlook remains relatively stable for multifamily, so too does the income generated by these assets. While other commercial real estate classes like office and retail face rising delinquency and questionable long-term demand, multifamily fulfills the basic need for shelter without the subjection to social distancing measures. Throughout the COVID-19 crisis, this unfettered demand is illustrated in multifamily’s resilient rent collections relative to other real estate classes. According to the National Multifamily Housing Council, nearly 91% of apartment tenants made May rent payments, making multifamily’s collections almost double that of free-standing retail and even outperform the healthcare sector. Armed with a resilient track record through the pandemic’s most difficult period, investment decisions must be made by quantifying the risk to future income growth. Fortunately, the future, especially in states like Texas, shows resilience as well.

Across the U.S., initial unemployment claims continually decreased over the past 6 weeks; the worst economic damage is likely behind us. Consequently, estimates of future rents and occupancy reflect only a minor decline over the short-term. Current models[2] from data provider RealPage project the bottoming of rents in Q1 2021 with rent declines of only about 3% over that period for the U.S. overall. Additionally, occupancy is expected to decline 1% to 2.5% nationwide. Most markets, including the major Texas metros, are forecast to stabilize through the second half of 2021 with the strongest rent growth in late 2022, as new supply that would typically start construction today and deliver in 24 months will pull back substantially in light of the current uncertainty and lack of available construction financing. The forecasts for multifamily housing also demonstrate negligible declines relative to the past recession of 2008; the bloodbath some expected is nowhere in sight.

In addition, Americans are moving from the high-cost coasts and the withering Midwest to business-friendly and affordable southern states, where Texas is an undeniable leader. From 2010 to 2018, Texas had the second highest net migration of any state, accounting for over 1.7 million people and roughly 24 percent of the nation’s entire migration influx. [Don’t Mess with Texas]. The state’s very identity is forged by low taxes, attainable housing, warm weather, and clear political leadership. Today, such an environment is difficult to rival as is the strength of Texas. Once again, Texas is ready to prevail and lead, serving as a beacon and an added tailwind to our recovery as a nation.

When evaluating the current landscape of risk, multifamily investment becomes a clear choice. No, multifamily won’t see the bargain prices and the same distressed opportunities as other classes like retail or hospitality, but for good reason: the risk is simply greater for those classes. However, the intelligent investor, regardless of their appetite for risk, can distinguish an investment with outsize returns relative to its risk as a bargain. Historically, multifamily investments have proven their worth with outsize returns [Why CONTI is Certain About Multifamily in an Uncertain World], and we strongly believe investors can take advantage as the disrupted market and hesitant capital try to make sense of the current landscape.

While there are few active market listings in today’s environment, there are multiple off-market opportunities CONTI is evaluating. This is an extremely opportune time to buy strong assets, in great locations, with a solid and diversified economy such as Texas, before the institutional funds, pension funds, insurance companies, and investment banks reenter the market.

1 Jones Lang LaSalle Capital Markets Overview 2020 Industry. Retrieved from https://apps.bea.gov/iTable/iTable.cfm?reqid=70&step=1&isuri=1
2 RealPage Forecast Restatement, May 2020

Appendix:
With an estimated decline in rents and revenue, won’t prices decline?

The short answer is, in the short-term, yes. The longer answer is, not likely – let us explain: Without any adjustment in cap rates, every 1% reduction in income should result in a 1% reduction in value.

Net Income:$1,000,000$990,000
(1% reduction)
Cap Rate:5.0%5.0%
Value:$20,000,000$19,800,000
(1% reduction)