Multifamily properties have produced strong returns for commercial developers and investors over the past few years. But the apartment supply wave appears to have crested, suggesting 2019 will bring a slower pace of rent growth. Consequently, pricing levels should come down, cap rates should creep upward and returns on investment should cool.
According to a report from commercial real estate research firm Yardi Matrix, America’s multifamily market experienced 3.1 percent annual rent growth for the 12-month period ending November 2018, the latest data available at the time of this writing. The report also featured 2019 rent growth projections for America’s 30 largest multifamily markets, 19 of which are expected to see their paces of rent growth either decline or remain the same this year.
Brokers who participated in Texas Real Estate Business’ annual forecast survey indicated that investment activity for multifamily assets in Texas should be more modest in 2019. This group ranked multifamily second among property types likely to experience a high velocity of sales in 2019, suggesting the new year could see more properties brought to market in anticipation of future elevation of cap rates.
Numerical Context
Most recently, the story on multifamily in Texas has been demand, driven by the state’s exceptional job and population growth. But after several years of heavy supply additions in the Class A space and surging rents for Class B properties, pricing is likely to cool off as markets flirt with oversupply and flattening rent growth curves. This is especially applicable to Dallas-Fort Worth (DFW), the nation’s top market for new apartment deliveries in 2018.
According to CoStar Group, DFW added more than 20,000 units per year between 2016 and 2018, and is expected to post similar numbers this year. However, annual inventory growth between 2020 and 2022 is projected to be about 12,500 units.
CoStar also notes that in terms of sales, the average price per unit in 2018 in DFW was about $118,000. The company projects the average price per unit to fluctuate between $115,000 and $117,000 in the coming years, further hinting that cap rate elevation is nearing and the cyclical peak has passed.
Houston, which bolstered its multifamily inventory by about 15,000 units per year between 2014 and 2017, spent much of 2018 burning off excess supply. Last year purported to be a year of strong absorption and low volumes of new deliveries in the Bayou City. And while Houston is still expected to add about 70,000 jobs in 2019, tanking oil prices toward the end of 2018 have slowed hiring, keeping occupancy rates in check and limiting the degree to which landlords can raise rents.
The pace of annual rent growth in Austin, where supply tapered off in 2018, is expected to hold steady in 2019 but drop by 70 basis points in 2020, then again by 60 basis points in 2021, per CoStar. San Antonio is in a similar boat. The Alamo City’s annual rate of rent growth is projected to drop 60 points in 2019 and to be halved by 2020, relative to its current rate.
A separate survey among developers, owners and managers who are predominantly active in Texas revealed mixed feelings on whether 2019 is a year to buy or sell. About 39 percent of respondents said they expected to sell multifamily assets this year, making it the second-most popular property type to dispose of, trailing only retail.
All this is not to say that multifamily will be a bad bet in 2019 — far from it. Income-producing real estate can still be purchased in this capital-rich market at historically low interest rates in favor of volatile stocks or low-yield bonds. In addition, the United States needs to add about 4.6 million new units by 2030 to keep pace with demand and population growth, according to the National Apartment Association.
In today’s market, new development is synonymous with increasing construction and borrowing costs, which is typically covered by raising rents. And while developers could try to deliver smaller units or build in less-amenitized and vibrant markets, this runs the risk of alienating renters who can afford Class A residences.
But in the context of all these factors, the survey results indicate that multifamily investors and developers are due for a slowdown in 2019, at least when compared to the last several years. Furthermore, brokers who participated in the survey ranked industrial (unsurprisingly) and office (surprisingly) as sectors more likely to experience greater valuation increases in 2019 than multifamily.
“We are bumping along the top of the market,” said one anonymous developer. “Interest rates will likely push asset prices down. Strong growth in Texas will counterbalance that. Multifamily product in DFW will be in oversupply and rents will soften.”
Affordability Issues
The major markets in Texas are well stocked with Class A multifamily product. But with the metro areas of DFW, Houston, Austin and San Antonio all seeing tremendous population growth from a variety of age and income brackets, the shortage of affordable housing hitting states with dense populations — most famously California — may be approaching Texas.
“Meeting the demands of an undersupplied housing market at affordable rates will be both the greatest opportunity and challenge for the industry in 2019,” says survey respondent Pauline Thude-Speckman, owner of Houston-based Meridian Investment Realty. “Developers will have to sharpen their pencils and develop hybrid projects,” she adds. “Opportunities exist for those willing to go the extra mile for strong returns. But it’s a marathon, not a 5K.”
To address a potential dearth of affordable housing, local governments in some areas are introducing opportunity zone laws. There are currently about 630 census tracts in Texas across 145 counties that have been specifically designated by the U.S. Dept. of the Treasury for these developments.
These programs offer various incentives, usually in the form of deferments and reductions on capital gains taxes, for multifamily developers and investors who concentrate their business in economically distressed urban areas, or opportunity zones.
Ultimately, however, the supply of opportunity zones and the cost-saving incentives that accompany them is constrained, while the influx of new people to Texas is not. With so many factors working together to increase costs of new multifamily projects, the supply of affordable housing stands to be a major casualty of war.
“High land prices, high construction and materials cost, as well as higher [interest] rates and cap rates make new projects difficult to pencil,” says respondent Mac Jones, principal at Austin-based Hammond Jones Real Estate Development, which specializes in multifamily development and investment. “If rental rates cannot go higher, supply will be constrained.”
Financial Fretting
In its final meeting of 2018, the Federal Reserve followed its anticipated course and raised the federal funds rate by an additional 25 basis points. However, the nation’s central bank has signaled a willingness to slow its pace of rate hikes in 2019.
An overwhelming majority — 87 percent to be exact — of brokers who participated in our survey expect rates to rise significantly at some point(s) in 2019. Roughly 58 percent of developers who were polled indicated an expectation that the overall lending environment for new construction will be less favorable to borrowers in 2019. About 52 percent of respondents believe borrowers will have a more difficult time obtaining favorable loan terms on acquisitions and refinancings in 2019 versus the prior year.
“Being able to buy high-quality real estate and achieve a reasonable rate of return in a rising interest rate environment will be the greatest challenge of 2019,” says survey participant Rob Cohen, chief investment office of Hudson Capital Properties, a New York-based multifamily investment firm.
Participants William Doogan, CEO of Colorado-based Interurban Cos. and George Kondos, president of New York-based Ditmars Real Estate Consultants, both cited rising rates and by association, more stringent underwriting on loans, as the commercial real estate industry’s top challenge in 2019.
The results of the surveys also reflect a prevailing view that the 10-year Treasury yield, which stood at 2.85 percent at the time of this writing, is set to rise in 2019. Among those who took a stab at estimating where the benchmark rate will close in 2019, most brokers and developers ballparked the 10-year Treasury yield to settle between 3.5 and 4 percent at the end of 2019.
A rise in the 10-year Treasury yield could, in theory, steer capital sources toward treasury bonds and away from real estate investments, which are typically held for similarly long terms but carry greater risk. Combined with rising interest rates, this activity would conceivably cause some pullback in deal volume and velocity within the capital markets, regardless the property type and/or location.
Construction activity, long beset by a labor shortage that has driven overall building costs sky high, could be under further duress in 2019 via President Donald Trump’s tariffs. Among both brokers and developers, about half of all respondents see the protective taxes as having moderate impacts on materials pricing and project timelines for new developments.
— Taylor Williams