Twin Cities Multifamily: A Look Back, What’s Next for the Resilient Market
By Ted Bickel and Jeff Budish, Colliers MSP
At the start of the pandemic last spring, conversations with developers, investors and operators varied from discouraging to catastrophic. Everyone expected the worst.
Luckily for the industry, that is not what happened. Amid a year of great uncertainty across the economic spectrum, the Twin Cities multifamily market showed a great deal of resilience, overcoming many challenges in 2020.
Considering that the marketplace was nearly frozen for the second quarter of 2020, overall transaction volume for 2020 was surprisingly strong. Minnesota saw a considerable uptick in activity toward the end of the year, driving annual totals up to just short of $1.3 billion. A strong bounce-back in the second half of the year speaks to strong demand drivers and generally solid operating performance — even during the economic shutdown.
However, while vacancies did not run up, as many had feared, collections and bad debt suffered. Understandably, many tenants struggled to pay rent as stimulus waned later in the year. This had a notable effect on net operating income. Overall, pricing did not change, while cap rates lowered to some extent. Inexpensive debt, particularly from the agencies, was a large factor in keeping pricing afloat.
Refinancings helped to stabilize the entire multifamily industry during this critical time by lowering debt service at many properties, and this is expected to continue. Agencies and GSEs (Fannie Mae, Freddie Mac, HUD/FHA) have continued to provide liquidity and financing to the market (while being more selective with borrowers, product types and locations) and interest rates are historically low.
That being said, underwriting standards have tightened to require larger debt-service reserves and lower loan-to-value ratios, which will extend in 2021 as the market stabilizes post-pandemic.
Newer construction (built in 2016 or later) drove nearly 40 percent of total sales volume in 2020, with some trading for the second time since they were built. Construction costs rose in 2020, largely due to the 6.7 percent increase in construction materials pricing from the previous year. Effects from the increase in costs will likely be a determinant of future renovation and new construction projects, as total development costs and tight renter budgets are driving projects to require more efficient floor plans, fewer amenities and lower-finish product.
The increase in construction costs will continue to be a factor in 2021 and beyond. Interest rates will need to remain at historic lows to keep the construction pipeline open, and new construction will have smaller floor plans and fewer amenities. To keep up with workforce demand, construction projects are expected to spring up in communities that offer lower price-per-square-foot rent to budget-conscious renters. State-of-the-art complexes will still find renters though, given the increase in population in the Twin Cities and more millennials electing to rent than past generations.
Another trend to track is recent suburban development, as there has been a notable shift to new construction in the suburbs over the past four years. The west and south metro areas are seeing especially high interest, with less focus on the east and north. As renters search for units with more space due to the pandemic, this trend of suburban growth may accelerate.
While the south and west areas have been dominant, successful projects with faster than anticipated lease-ups in the east and north Twin Cities metro areas should spawn increased development activity in these underdeveloped submarkets. In some cases, cities have been more aggressive in helping get projects financed and approved to offer more housing. New construction projects may well constitute a larger portion of overall sales volume in 2021 versus older construction.
The general sentiment from investors is that the current depressed state of revenue will recover in the second half of 2021. To many, locking in favorable debt now and riding out this rough patch is an acceptable risk.
With many unknowns due to the pandemic’s fluctuating economic impacts, it is difficult to forecast renter-side inputs. Collections, vacancy, rent growth and retention figures are not as static as in the past. However, investors will continue to favor multifamily as a safe haven compared with other asset classes, such as retail and hospitality. Downward pressure on cap rates will persist and boost pricing.
Investor sentiment is cautiously optimistic both in the Twin Cities and nationally, with an eye more toward the mid- and long-term prospects than in past years. As yields compress in a low interest rate environment, the cap rates found in the Twin Cities market are looked upon favorably by out-of-state investors.
To maintain its status as a prime market for investment, Minnesota will have to see continued population and job growth to keep inputs sufficient for continued development. As a comparatively affordable major urban area that is home to several Fortune 500 companies, the Twin Cities market is on track to maintain its dominance.
Ted Bickel is senior executive vice president and Jeff Budish is executive vice president, both with Colliers MSP. This article originally appeared in the March 2021 issue of Heartland Real Estate Business magazine.