RED Mortgage Capital: Strong Economy Boosts Boston Multifamily Performance, but Looming Supply Likely to Hinder Returns
The country’s largest commercial real estate services firm recently selected Boston as its choice for strongest U.S. gateway multifamily market performer for 2020, and with good reason. The Eastern Massachusetts economy gained momentum in 2019, propelled by its world class “Eds and Meds” cluster and resurgent high tech, R&D and financial management communities. Income growth and job creation ran ahead of national averages and apartment markets remained tight and rent growth robust regardless of elevated supply. Investor demand for metro apartment properties surged, especially after mid-year, while cap rates remained accessible by primary market standards, especially in the suburban Class B segment.
Metro job creation trends fell into a bit of a funk in the fall and winter of 2018-2019 but rebounded vigorously in the second half. Payrolls increased at a brisk 31,200-job, 1.7 percent year-on-year pace after mid-year, representing the fastest growth recorded in three years. Sector leadership was provided by Boston’s top knowledge industry sectors, headed by higher education (8.5 percent), research and development (9.8 percent), software and computer network design (4.9 percent) and financial management (2.6 percent). Only softness in the consumer-driven side of the labor market – construction, retail trade, personal services and government – held overall growth below 2 percent, a problem that may be remedied as the impact of rising wages and personal income filters through the market.
Job and income growth catalyzed constructive apartment demand. Tenants absorbed over 2,500 units in the second half last year, holding metro occupancy on 96.2 percent, according to Yardi surveys, 3,000 newly delivered units notwithstanding. Absorption was exceptional in city neighborhoods outside of core Back Bay and Financial District areas (“Boston City” submarket), as well as in Cambridge, raising submarket occupancy 1.2 percent and 0.8 percent, respectively, in the 12 months ended in December.
Rent increases were commensurate. Annual same-store effective rent growth averaged 3.7 percent in the second half of 2019, considerably stronger than the 3.0 percent U.S. major market average and faster than all U.S. primary market components with the exceptions of Orange County and Washington, D.C. Indeed, the largest public REIT reported that the Boston region delivered its fastest revenue growth (3.9 percent) in fourth quarter 2019, a table recently topped by Bay Area and Pacific Northwest metros. Submarket rent trends in Boston City (5.5 percent), Brookline/Brighton (4.3 percent) and Mystic River North (4.3 percent) were notably robust.
Investors responded accordingly. Multifamily property sales volume increased more than 80 percent in 2019 to nearly $3 billion, eclipsing the series record established four years before. This stack was not piled up through a few large dollar luxury high-rise trades, but rather by way of a significant number of middle-tier suburban garden acquisitions. Cap rates for Class B- and B gardens fell largely in the low- to mid-5 percent range, providing plenty of grist for attractive investment returns. Choice value-adds and institutional trophies largely traded to low- to mid-4 percent yields, but a Seaport District high-rise was priced to a generous 5 percent cap in August, suggesting that global institutional investors also may find attractive opportunities here.
RED Capital Research’s Reis-specified forecasting models suggest that prospective returns remain attractive. Heavy supply (we expect 15,000 new units to be completed by year-end 2021) will exert downward pressure on occupancy (see the graph above – view full size here) and hold rent growth to an average of about 3.3 percent over the next several years — middle of the U.S. pack numbers — and total returns, which we estimate were in the low-double digit vicinity in 2019, will moderate somewhat. But we calculate that investors can expect to earn annual total returns in the 8 percent neighborhood in 2020, and generate a 7.0 percent annual unlevered return over five years — pretty useful results in one of the world’s most liquid and recession-resistant property markets.
— 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.