With a preference for low taxes and business-friendly regulation, Texas is America’s proving ground for free market economic theories — a crucible in which the benefits of economic liberty are tested. While the long-term impact of the Lone Star State’s experiment remains an open question, it is hard to gainsay its impressive accomplishments to date.
Daniel Hogan
Director of Research,
RED Capital Group
Texas recorded the fastest GDP growth among the 50 states (6.0 percent) in second quarter 2018, and the third-fastest compound annual GDP growth rate since the Great Recession (3.1 percent). By way of population growth, Texas ranked second among states since 2010, trailing only Utah. In terms of the 20- to 34-year-old “renter cohort” Texas was the leader, posting a robust 2.1 percent annual rate growth rate.
Powerful economic and population growth go hand in hand with multifamily performance. Indeed, the five Texas markets that we model econometrically — Austin, Dallas, Fort Worth, Houston and San Antonio — posted stronger fundamentals in the current decade than the balance of our RED 50 large market peer group in nearly every category. The “Texas 5” occupancy increased by an average of 564 basis points over the period (Reis), nearly three times as much as the non-Texas component. Effective rents increased at compound annual rate of 4.34 percent in the same period, surpassing the non-Texas group’s 4.19 percent gain. Investors reaped the benefits as unlevered returns averaged nearly 13 percent annually, edging out the non-Texas group by 0.1 percent.
Despite its many virtues, Texas hasn’t entirely shed its tendency to overdo construction at times. Currently, more than 250 market-rate projects with 60 or more units are under construction in the Texas 5, representing 4 percent of existing stock, and another 100 are undergoing renovation. Occupancy has begun to slide and rent growth to diminish. Market prospects remain encouraging but differ across metros.
Dallas / Fort Worth: Weaker Summer Absorption Contributes to Investor Caution
The Dallas Metropolitan Division remains an economic juggernaut. After a sluggish 2017 by local standards, the labor market roared back this year and is on pace to add more than 80,000 (3.1 percent) payrolls jobs, up 15 percent from the prior year. We forecast that Dallas will create close to 90,000 new positions in 2019, powered by exceptional hiring in construction and professional services.
Fort Worth is growing at a more measured pace. Metro employers will add 26,000 (2.5 percent) workers to payrolls this year, also a 15 percent improvement on 2017. Our models forecast a similar outcome for 2019, but events suggest Fort Worth may surprise on the high side. Accelerated defense procurement will boost aerospace headcounts and rapidly rising home prices should catalyze needed new home construction, potentially elevating growth to near Dallas levels.
Apartment space demand appeared to moderate over the summer. Absorption in Dallas and Fort Worth declined to the weakest third-quarter levels in years, causing occupancy to drift to 15-month lows. The allure of homeownership was in part responsible, but soft summer home sales data suggest a more complex explanation. Rents continued to rise at a brisk pace, however, as both metros posted 5 percent year-on-year gains.
Investors appeared to take a more cautious approach toward Dallas properties in recent months and sales volume declined accordingly, particularly late in the year. While interest in 1970s and 1980s value-adds remains strong, bidders were less aggressive and cap rates drifted from the mid-5 percent standard to the high-5s and even low-6s in the fall. Demand for Fort Worth assets was firmer, with particular interest evident in recently renovated Arlington and Fort Worth gardens. Cap rates were near recent Dallas observations, and included at least four trades – trophies and renovated gardens – priced to sub-5 percent levels.
Houston: Apartment Market Normalizes One Year after Harvey
Following a couple fallow years, higher oil prices and Harvey recovery efforts revived the Houston economy. Metro payrolls will increase by nearly 100,000 jobs in 2018, the largest vintage in four years. Job creation of a similar magnitude is the most probable outcome for 2019, although oil price weakness is a rising threat.
Spring and summer apartment demand normalized in the aftermath of the late-2017/early-2018 Harvey-related demand surge. Supply levels were moderate, however, as developers maintained a cautious posture following a period of high construction volume.
Occupancy trends were murky, complicated by the effects of storm-damaged units coming back on line and dislocated tenants vacating as their homes were repaired. Same-store data from Axiometrics were most telling, showing sharp October fill-rate declines, probably associated with terminating 12-month post-Harvey leases.
Rent trends also softened, particularly in suburban submarkets with significant numbers of dislocated owner-tenants. Overall gains remained robust but are likely to fall below 4 percent in 2019.
Property markets gathered momentum over the summer as investors appeared to gain confidence in metro value-add opportunities. More than 60 investment sales closed during the third quarter, with total proceeds in the vicinity of $2 billion. Investors concentrated on pre-2000 northern suburban and Montgomery County properties. Cap rates for larger assets were clustered in the 5.6 percent to 5.9 percent range, with a handful of value-adds located in prime suburban locations trading below 5.5 percent.
Austin and San Antonio: A Tale of Two Cities
The Austin economy showed no sign of fatigue after eight years of extraordinary growth. Payroll employment will increase by more than 3.5 percent again in 2018, and we expect a repeat performance next year.
San Antonio, by contrast, was a Texas anomaly, enduring the slowest growth in eight years, pulled down by declines in manufacturing and business and financial services headcounts. Although a few of its strong suits will continue to come under pressure, RED expects employment growth to rebound above 2 percent next year.
Austin apartment demand was steady over the summer, despite record home sales. Tenant interest in Class A and B space was surprisingly strong in seasonally soft October, raising same-store occupancy nearly 1 percent year on year to the mid-94 percent range. Nearly every submarket recorded positive results with South Austin and Hays County areas notching the largest gains.
On the other hand, the San Antonio market was soft, reflecting weak job creation and growing competition from the for-sale market. Above-average supply made matters worse, pushing occupancy to the lowest rate in two years.
Rent trends nearly stalled in San Antonio. Sequential rent growth was the slowest in eight years in third quarter 2018, and annual trends remained below the national average in early fall. Austin, on the other hand, exhibited excellent momentum led by strong pricing in the Class A sector, particularly in the previously soft mid- and high-rise segment.
RED projects slow but stable San Antonio rent growth, but risks lean toward the downside. The Austin outlook is constructive as rents are likely to maintain 4 percent growth rates into 2020, perhaps more if home prices continue to outpace national averages, before slower economics bend the rent curve lower.
San Antonio investors focused on West Side garden trophies and North and Northeast Side value-add plays, targeting mid- to high-5 percent IRRs in each case. Cap rates for the former ranged from 5.2 to 5.6 percent, and were mostly in the high-5s for the latter.
Renovations and value-add plays were the Austin trade du jour. Competition drove infill asset cap rates to the low- to mid-4s, and the mid- to high-4 percent range for well-located suburban gardens. Investors seemed resigned to modest near-term returns, targeting low-5 percent IRRs for mid-level stabilized assets and sub-5 percent returns for infill trophies.
Dallas and Fort Worth Offer Attractive Relative Value
When comparing geographic options multifamily investors must weigh the relative merits of metropolitan markets based on respective demographic and economic growth prospects, acquisition cap rate, property market liquidity fundamentals and historic return volatility characteristics. Typically, buyers must compromise on at least one of these primary performance drivers. For example, in most growth markets investors are compelled to accept high levels of performance volatility in exchange for the growth potential and moderate cap rate levels typically found there.
Texas is the exception to the rule. Texas markets offer investors unequaled economic and population growth prospects, moderate going-in cap rates by current standards and relatively low historic return volatility characteristics. Among the top state markets, Dallas and Fort Worth stand out as the most compelling overall values, melding above-average potential returns with attractive return stability. Austin, Houston and San Antonio also have strong return prospects but are less economically diversified and more volatile than the Metroplex, slightly diminishing their appeal.
— This article was contributed by Dan Hogan, Managing Director of Research with RED Capital Group, which is a content partner of REBusinessOnline.com. 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.