During the great multifamily bull market of this passing decade, investors became increasingly comfortable with exposure to highly volatile metropolitan markets. In an era when it was difficult to make a bad investment decision, the most lucrative were, in most cases, located in areas of the country known for their roller-coaster real estate cycles. Indeed, it seemed as though a purchase capitalization rate could never be too low if an asset was located in one of the primary markets. Volatility was an ally, not a foe — an investment feature, not a bug.
With the onset of the COVID-19 pandemic and its attendant recession, however, volatility appears to have switched allegiances. The winds now favor, perhaps, the stable, predictable tortoises over the high-flying hares.
In high-cost markets, the number of renters considering relocating to more affordable area codes has skyrocketed, and in the work-from-home era, this has become more of an achievable goal than an inchoate urge. For example, the San Francisco Apartment Association reported that 7.5 percent of tenants in the city — where rents increased at a 6.1 percent compound annual rate since 2010 — simply broke their leases in the three months that ended in May, moving out rather than continuing to make rent they could no longer afford or were unwilling to pay.
Moreover, rent levels in gateway cities exhibited some of the greatest vulnerability to COVID-19-related stress in April and May. According to Yardi Matrix, average rent dropped more in Boston (-1.5 percent), Los Angeles (-1.4 percent) and San Francisco (-1.0 percent) than in any other major market. By contrast, the best performances were observed in low-volatility markets, in many cases secondary and tertiary metros in the Midwest (e.g. Cleveland, Columbus, Omaha and Toledo).
Is it wise, therefore, for investors to increase geographic diversification by adding to their portfolios assets that are located in low-volatility markets? As you may expect, the answer is complicated.
To test the theory that low-volatility markets will generate better revenue performance under coronavirus stress we ranked markets on the basis of their standard deviation of quarterly revenue growth since 1999, using Reis data. The peer group was the 50 U.S. primary and secondary markets that we model econometrically (the “RED 50”). Markets with high revenue growth standard deviations are high-volatility markets and vice versa.
We compared these statistics to the gross revenue changes observed between February and May 2020. If the theory were correct, low volatility markets would, in general, perform better during the recessionary conditions observed during that period.
It’s still early, but we found that the correlation coefficient between historical revenue volatility and February-to-May revenue change was only about 2 percent, which is insignificantly different from zero (i.e. no evident correlation). In fact, wide performance variation was apparent even among similar geographically clustered low-volatility markets.
Neighboring Philadelphia and Baltimore are a good illustration. Each represents one of the lowest volatility markets in the RED 50 peer group: the former ranked least volatile, the latter fourth. But recent performance was starkly different. Baltimore revenue plunged -0.25 percent from February to May (44th best in the peer group), while Philadelphia charted down a 0.94 percent increase, the fourth largest peer group gain. Along similar lines, Nashville, a highly volatile market about which we have good things to say, recorded the largest winter/spring increase (1.46 percent), even as stable regional neighbor Louisville (RED 50’s seventh most stable) suffered the largest revenue decline (-0.90 percent) among the peers.
Over the long term, RED Capital Research’s team continues to believe that portfolio investors should seek to achieve geographic diversification and that the addition of assets in low-volatility markets generally enhances risk-adjusted returns. In the current environment, however, in which outcomes are under the influence of a powerful, non-economic exogenous force — the COVID-19 virus — this strategy may not yield portfolio risk improvement.
What does this say about San Antonio, a preternaturally low-volatility market (third lowest on the RED 50 league table) in the economically rising state of Texas? In fact, the metro’s historic stability didn’t translate to strong performance under recessionary pressure: revenues increased just 0.30 percent from February to May, only the 26th best outcome in the peer group, falling far short of more volatile Fort Worth (RED 50’s 12th most volatile), which posted a 0.74 percent revenue advance, sixth largest gain in the peer group.
Still, investors should not dismiss the River City. Our forecasting models project that San Antonio is likely to be one of the few major markets that will not experience a decrease in average rent this year, in large part because of its inherent stability. Plus, that rent growth may test series records (9 percent) when the U.S. economy roars back in 2021-2022. Although expected returns don’t quite stack up to nearby Austin, this metro area may prove to be an excellent substitute for investors seeking lower per-door prices and higher going-in yields than are on offer in the Texas capital or the energy capital of the world.
— By Daniel J. Hogan, 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.
For Hogan’s insight into other markets, click here.
