Multifamily Market Performance in the Late-Stage Real Estate Cycle

Multifamily Market Performance in the Late-Stage Real Estate Cycle

Sponsored by RED Capital Group

By Daniel Hogan

As the multifamily real estate cycle moves into its late expansion phase, what can be expected of market performance and investment returns? The answer is by no means obvious. The current cycle has proven unique in several respects and participants should assume that it will continue to deviate from the historical playbook in its later innings. 

Whether we stand in the “Late Expansion” or “Early Hyper-Supply” phase of the cycle is a matter of debate but it is clear that the classic characteristics of these stages are materializing. Supply is near record levels, occupancy is below cycle peak and rents are decelerating in nearly every market.

In the classic formulation, cracks soon will begin to form in the market’s foundation and a looming recession in Act V will end in tragedy. The drama is likely to play out differently this time.

Notably, no dramatic shift in tenancy preference toward homeownership is evident, and it is increasingly apparent that it will not unfold in this cycle. The two dominant age cohorts in the American demography—millennials and the baby boom—seem destined by design and necessity to rent at greater rates than before. Rapid home appreciation, tight for-sale home inventories, rising mortgage rates and renter-friendly tax reform will keep these apartment demand drivers intact.

At the same time, the economy exhibits evidence of neither overheating nor imminent collapse. Rather, the most probable intermediate outcome is for moderate growth, characterized by rising interest rate, inflation and resource scarcity headwinds; a recipe for useful demand and revenue growth in the near term. This recovery is more likely to set records for longevity and expire in its dotage than collapse in recession.

The implications for market performance are reassuringly dull. Occupancy among the 49 markets that we model econometrically (the “RED 49”) is likely to drift lower under supply pressure throughout 2018, bottoming out next winter about 40 basis points below the first quarter of 2018 level. West Coast primary markets, Southeast and Intermountain growth markets and some Midwest metros will experience the largest declines but from comfortably high current levels.

RED 49 rent trends will remain constructive, rising at about a 4 percent annual rate in the second half of 2018, using the Reis baseline, but variance between regions will rise.  The Northeast and Midwest are likely to underperform economically, hindered by slow population growth and skill shortages.  Rent trends will follow suit. By contrast, our models suggest that Southeast, Southwest, Mountain and Pacific markets are likely to sustain above average rent growth for the intermediate term. Contrary to the standard real estate-cycle narrative the longer-term outlook is constructive with possible moderate reacceleration in the offing when supply recedes next year.

The outlook for investment returns is weaker but apartments will continue to offer attractive relative value. Rising term interest rates will pressure cap rates higher, particularly in the pricy value-add segment. As a result, asset values will be flat this year, holding annualized second half total returns to 5 percent or less, perhaps lowest in seven years. Still, we estimate prospective total returns on a five-year hold to fall in the 6.4 percent to 6.6 percent range, modest by recent standards but compelling relative to investment alternatives.  n

Daniel Hogan is RED Capital Group’s Managing Director for Research. He directs Market Research and reporting activities, as well as performs research on the multifamily and senior housing industries.

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