Multifamily investors prefer to concentrate capital in the primary markets. Although prices are steep and cap rates low, the gateway cities offer private equity and institutional buyers the young, affluent tenants, economic diversification, deep trough of performance data and property market liquidity that can’t be found in smaller cities. Gateway cities offer these assets…until they don’t.
The pandemic recession has turned the usual way of looking at things upside down. At least for the moment, tenants are fleeing the high costs and perceived dangers of dense urban living for the relative safety and larger floor plans found in suburbs and, in some cases, secondary and tertiary markets.
The impact on property performance is significant. In the modern urban mid- and high-rise buildings favored by large portfolio investors, occupancy and rents are down materially, trimming forward-looking net operating income 15 percent or more in many Los Angeles, New York and San Francisco buildings.
Determining fair asset value is nearly impossible under the circumstances. Buyers still may be willing to bid at prices generating deeply sub-4 percent initial yields but only against conservatively underwritten NOI levels that discount an extended period of performance weakness. Few owners are willing to realize the resulting decrease in value, and sales are down commensurately. Third quarter volume fell 70 percent year on year in Los Angeles, 75 percent in New York and 67 percent in San Francisco. Participation by institutional, private equity and REIT buyers declined still more, plunging 80 percent or more in each market. So much for property market liquidity.
This raises the question of whether investors may find the primary market attributes they seek with less NOI risk in more predictable Midwest markets. Chicago’s near-primary market status makes it the natural test case for the proposition.
Chicago multifamily asset NOI growth historically falls in the middle of the pack among metropolitan areas. The RED Research Group calculates (using Reis quarterly average rent, occupancy and expense data) that Chicago apartment NOI increased on a 2.2 percent compound annual pace since 1999, 34th fastest among the 50 most actively traded metro markets in the country. Indeed, Second City growth was faster than only one of the primary markets — New York (1.7 percent). Annual NOI growth in the other primary markets ranged between 2.5 percent (Boston) and 4.1 percent (Seattle).
Did greater return stability (and therefore reduced risk) compensate Chicago investors for slower NOI growth? The answer is yes, but only to a degree. With respect to the standard deviation of quarterly four-quarter NOI growth rates, which we use as a proxy for NOI growth volatility, Chicago ranked 14th most stable among the 50 metro peer group, trailing Boston, Washington D.C. and Seattle among the primary markets.
Longer-term metrics don’t suggest that Chicago represents a particularly safe harbor in the recessionary storm, but what of recent performance? To test this theory, we reviewed the same-store gross rent revenue changes reported from February to August 2020 by urban mid- and high-rise buildings constructed since 2010 in the primary markets and Chicago using Yardi property level data.
The analysis confirmed that San Francisco and New York infill space is struggling. Respective monthly unit-weighted average GRR fell 10.1 and 12.4 percent, considerably worse than the 3.9 percent average decline recorded among the other primary markets. Seattle was the positive outlier in the group, posting a comparable decrease of only 1.6 percent.
The data indicate that Chicago hasn’t proven a particularly safe harbor in this cycle. Comparable GRR declined 6.2 percent among a group of 62 mid- and high-rise Chicago buildings (-7.6 percent in the Loop), worse than the -5.6 percent primary market average and roughly equivalent to East Bay and San Diego results.
Instead, rent and occupancy resilience during the 2020 recession emerged in some surprising places. As noted, Seattle has exhibited the most durable performance to date, regardless of the fact that it was the first metro area to feel the impact of the pandemic and has been no stranger to this year’s spate of social unrest. Likewise, property income in Miami (-3.3 percent) and Orange County (-3.8 percent) held up relatively well, in spite of the large exposure in these metro areas to the hard-hit leisure travel and entertainment industries wherein transitioning to a work-from-home environment is impractical.
Renter behavior in this recession so far suggests that to thrive in the post-pandemic environment total return-oriented buyers may be compelled to broaden their investment parameters a bit to include more suburban and secondary market assets. Age and the pandemic experience are leading the powerful millennial generation to reevaluate its housing priorities. Perhaps investors must tweak their asset preferences accordingly.
— Daniel J. Hogan is ORIX Real Estate Capital’s managing director for research. RED Mortgage Capital, a division of ORIX Real Estate Capital LLC, is a content partner of REBusinessOnline. The views expressed herein are those of the author and do not necessarily reflect the views for RED Capital Group or of the author’s colleagues at RED. For further analysis from RED Capital Group, click here
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For Hogan’s insight into other markets, click here.