December 31, 2020
Multifamily properties are an important part of the real estate landscape. Any institutional investor with private real estate exposure should have multifamily assets in its portfolio to have prudent diversification. One need only look at the property weightings of the NCREIF (National Council of Real Estate Investment Fiduciaries) Property Index, NPI, to get the point: multifamily properties now account for 25% of the NPI (the second largest only behind office at 35%). Household formation growth since the early 80s has driven strong demand for rental apartments. In turn, multifamily properties have offered investors reliable income and solid appreciation potential. As a result, over the past 30 years, institutional investors have continuously increased their allocations to the property type. This, in turn, has created greater levels of liquidity and transaction efficiencies that lower its perceived risks and investor return requirements.
Trends Fueled by the Pandemic Prior to the COVID-19 pandemic, multifamily fundamentals were exceptionally strong: vacancy was near all-time lows at 4.2%, absorption was in-line with new supply, and rents were at all-time highs (28% higher than the previous market peak in 2008 prior to the Great Financial Crisis). However, over the past nine months the pandemic has caused cities across the U.S. to “shutdown” in an attempt to slow the spread of the virus. As a result, many of the country’s largest and most densely populated cities have lost their appeal due to the closure of “urban amenities” such as restaurants, bars, fitness centers, entertainment venues, cultural attractions, and local retailers. This coupled with the flexibility from working from home has resulted in a large exodus of millennials from urban cores to the suburbs and beyond.
As a result of this episodic exodus, urban-centric markets such as San Francisco, New York, and Los Angeles have seen a dramatic increase in apartment vacancies. According to CBRE Econometric Advisors (EA), the average vacancy rate for San Francisco, New York, and Los Angeles increased 110 basis points (1) to 4.6% from pre-pandemic levels in Q1, 2020. Less dense cities such as Phoenix, Dallas/Fort Worth, and Atlanta were less impacted as the average vacancy rate for those three markets actually declined 30 bps to 4.8% during the same period. In addition, suburban sub-markets have held-up quite well compared to urban markets. The average vacancy rate for garden-style apartments, which are a fixture in most suburban markets across the country, witnessed a 40 bps decline from pre-pandemic levels in Q1 2020 to 3.9%, while the vacancy rate for high-rise apartments, which are largely developed in urban cores, increased by 170 bps to 6.4% during the same period.
The appeal of suburban locations rested on a combination of factors: cost competitiveness (i.e., larger living space for the money) vis-à-vis apartments in expensive urban locations; the desire for more space (both inside and outside the apartment); and a greater sense of security than in some urban landscapes. With the help of record low mortgage rates, many millennials looked to trade being a renter for being a homeowner... and here again, the suburbs beckoned. The pandemic has ignited demand for single-family homes. The home- ownership rate has surged 210 bps (to 67.4%) since the start of 2020, and the homeownership rate for millennials has hit an all-time high at 40.2% at the close of the year.
Post-Pandemic World: Will the Pandemic Trends Shift Back? Looking ahead to the post-pandemic world, the lasting effect of some of these trends on the multifamily sector hinges entirely on whether and how quickly pre-pandemic habits and patterns of behavior return. As restrictions are lifted across the country and offices reopen, there will undoubtedly be a pull back to certain pre-pandemic norms. The appeal of urban living will draw renters seeking all the things vibrant urban centers have to offer, along with easier com- mutes. However, the trend of millennials moving to the suburbs is here to stay because it was a secular trend driven by demographics and family formations well before the pandemic. Prior to the pandemic, markets such as Phoenix, Dallas/Fort Worth, and Atlanta were already seeing large in-migration trends from millennials. According to the U.S. Census Bureau, the population of people between the ages of 20 and 34 in Phoenix, Dallas/Fort Worth, and Atlanta increased 7.0% from 2015 to 2019. During the same period, the population of the same age cohort in urban-centric markets of San Francisco, New York, and Los Angeles decreased 4.0%.
If suburban migration tapers-off, homeownership rates will likely head back to historical norms (average of 20 years: 66.5%) or plateau due to the shortage of for-sale supply. For-sale inventory currently averages 2.7 months on the market, which is considerably below the long-term average of 6.2 months, indicating that demand is significantly outpacing supply. In addition, current housing starts which totaled at 1.5 million in 2020 was 31.9% below the previous peak achieved in 2006. A limited supply of for-sale housing, exacerbated by the recent demand for single-family homes, led housing prices to rise 11.0% during 2020, outpacing personal income growth of 7.7%. A shortage of for-sale properties could crimp home sales activity and exacerbate affordability issues for the foreseeable future.
Over the next ten years, millennials (currently 24 to 39 years old) will age into their 30s and 40s and aspire to “settling down” and homeownership. “Gen Zers” are right behind the millennials and will help maintain apartment demand momentum. At roughly 68 million, the Gen Z cohort is comparable in size to both baby boomers and millennials. Gen Zers are just beginning to enter the workforce in substantial numbers and, by extension, forming households. According to the Pew Research Center, there are roughly 24 million Gen Zers between the age of 18 and 23. This means there remains an additional 44 million Gen Zers who will be entering the workforce over the next decade providing demand for millions of new apartments.
Investor Demand: Is Multifamily Still A Good Investment? As the pandemic subsides and the economy enjoys a more broad-based expansion, job growth and household formations from the growing tide of Gen Zers will trigger a renewed wave of renter demand. While a portion of the millennial demographic may elect for home ownership when the opportunity presents itself, those who leave will be replaced by the next generation of renters.
Population trends, along with the supply/demand and affordability dynamics of single family homes, all point towards continued robust demand for multifamily. This, in turn, will keep apartments at or near the top of investors’ preferred property types. In the midst of the pandemic, multifamily investment volume in 2020 totaled over $107 billion, significantly more than the previous recession volume of $29 billion during the Great Financial Crisis, according to CoStar. Better supply and demand fundamentals compared to previous recessions were key to why pricing and transaction volume held-up. The 10-Year U.S. Treasury rate dropped below 1% by early March and has remained there. Debt and equity capital is cheap and plentiful. The low interest rate environment is expected to persist for the foreseeable future. This, coupled with healthy supply/ demand fundamentals, will continue to drive strong investor interest in multifamily properties.
The multifamily sector seems to have exceptionally favorable tailwinds from demographic trends, tenant demand, for-sale supply dynamics, and capital markets support. With that said, less expensive and less dense suburban markets, which proved more resilient in 2020, are primed to continue to benefit from longer term secular trends and more flexible work strategies. Urban cores, on the other hand, will likely see a bounce back to some degree, but will face hurdles both near and long-term related to millennial out-migration and potential supply challenges for the more expensive, high-rise residential alternatives.
(1) A basis point (“bp”) is 0.01%.