In earlier research, we found that investors may find advantageous risk and reward tradeoffs during the pandemic in often overlooked Midwest secondary markets. For the most part, average rent and occupancy metrics in these markets continued to rise throughout the summer, recession notwithstanding. Together, their inviting cap rates, rising NOI and low historic income volatility form a fairly compelling investment predicate.
We also found that positive performance attributes were not limited to the region’s most robust economies. Even metropolitan markets that have experienced slow demographic growth — like Cincinnati and Detroit — posted surprisingly good revenue growth.
Can the same logic be extended to metropolitan areas experiencing actual demographic decline? A review of recent trends in three “high-yield” markets with negative population growth – Cleveland, Milwaukee and St. Louis – shed some light on the question.
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With respect to occupancy, the answer is yes. In fact, property level data published by Yardi suggest that market conditions in each of these metro areas has been constructive since February. Between February and October, average occupancy among stabilized same-store property samples increased by 14 basis points in Cleveland and 10 bps in St. Louis, in each case closely comparable to seasonal trends observed in 2019. Although occupancy fell 6 basis points to 96.24 percent in Milwaukee, the performance compared favorably to 2019, when occupancy declined 10 basis points in the same period.
Trends also were favorable in the Class B+/A quality segment that is of greatest interest to national investors. Segment occupancy advanced 40 basis points from February to October in Cleveland, in contrast to a 10 basis points decline in the same period during 2019, and gained 14 basis points in St. Louis, bettering a 2 basis-point decrease last year. In Milwaukee, Class B+/A occupancy increased 6 basis points to 95.57 percent, comprehensively stronger than the 38 basis points decline recorded from February to October 2019.
Investors seeking assets located near the CBD also may obtain better results in these demographically challenged markets. Pandemic period occupancy in Downtown and Downtown-adjacent submarkets dropped only 66 basis points in Cleveland, considerably less than declines observed in most primary markets, and improved 29 basis points in Milwaukee. Downtown St. Louis was a negative outlier overall, but Central West End properties reported a decline of only 57 basis points, comparable to the Cleveland experience.
Rent growth was encouraging, as well, particularly in suburban settings. Unit-weighted average rent increased in each market between February and October, rising 2.27, 1.50 and 2.21 percent in Cleveland, Milwaukee and St. Louis, respectively. Class B+/A rents, which are under considerable pressure in the primary markets, increased 0.47 percent in Milwaukee, 0.94 percent in Saint Louis and 0.96 percent in Cleveland.
It also is noteworthy that year-on-year rent growth in some low-density suburbs exceeded 5 percent in October; notably, Bay Village/Westlake and Medina County in Cleveland, and St. Charles County in St. Louis. Although Milwaukee suburbs generally lagged on this count, lately the metro is catching up — rents in its highest average rent suburban submarket, Brookfield, surged nearly 1 percent from August to October, and Greenfield rent advanced about 0.5 percent.
The foregoing demonstrates that performance in these slow growth markets is materially more stable under recessionary stress than most large U.S. markets. What is less certain is whether multifamily investments are likely to generate returns of sufficient magnitude to justify the attendant demographic, economic and ease-of-exit risks.
Capitalization rates — the measure of the relative cost of property cash flow — form the fulcrum that balances risk and returns. Are cap rates high enough to compensate for slower than average expected revenue growth?
Lument Research’s unbiased, historically specified metro rent forecasting models aren’t sanguine about the prospects. Although in each metro typical cap rates applicable to Class B/B+ suburban garden properties fall in the high-5 percent area, about 80 to 90 basis points above the large market average, only St. Louis is projected to produce compound annual rent growth of sufficient strength to produce meaningfully above average returns on an intermediate term holding period. In addition, although historical income volatility and model standard error are low in each case, prospective risk-adjusted returns determined in a Monte Carlo simulation again are only compelling in the Gateway to the West.
In spite of their demographic shortcomings, each of these markets merits consideration by investors seeking high current yield and predictable cash flows. But cap rates may have to rise to some degree in the manufacturing-centric economies before they represent compelling relative value.
— By Daniel J. Hogan, Lument (formerly, ORIX Real Estate Capital) Managing Director for Research. Lument is a content partner of REBusinessOnline. The views expressed herein are those of the author and do not necessarily reflect the views of Lument or of the author’s colleagues at Lument.
For Hogan’s insight into other markets, click here.