Main Takeaway: While remaining cautious, multifamily investors continue to enjoy strong fundamentals that will continue to attract investment activity in the medium-term despite economic headwinds such as reduced loan origination, inflation, and recessionary pressures. Strong rent growth will serve to pad the market during any forthcoming downturn.
Story: Freddie Mac released its 2022 Midyear Multifamily Outlook last month, outlining the status of this asset class amidst a backdrop of inflation, economic uncertainty, and rising interest rates. Here are the key findings from the report to situate our thinking:
- Rent, although moderating, is still “exceptionally high” with occupancy rates remaining well-above historical averages.
- Growth in multifamily is still strong, although will moderate in the coming 12 months as economic headwinds and rising rates put downward pressure on asset values.
- Multifamily gross income is projected to increase by 6.8%, and vacancy will remain unchanged at 4.8%.
- Tight market conditions will be able to absorb the increasing number of multifamily permits and completions over the coming years.
- Florida and the Southwest markets are expected to outperform while the smaller markets in the Midwest are projected to perform weaker.
Despite the perceived robustness of the multifamily sector, there are some headwinds to keep in mind as we consider an outlook over the coming year.
Multifamily Negative Leverage
With interest rates rising, multifamily returns can ultimately fall below the interest rate on the debt service. This is what is called negative leverage, and it means that landlords, who carry the most risk, are making less money than lenders.
Returns are indeed dropping, according to the WSJ. “Investors started buying apartment buildings at prices that have gone up so much so fast that their return rates are shrinking. Prices paid for apartment buildings rose 22.4% during this year’s first quarter from the same quarter a year ago…Then interest rates shot up quickly this year, so that some multifamily initial return rates have fallen a percentage point or more below the interest rate on their mortgage.”
Multifamily Rent Risk
Rents are at all-time highs, although growth is moderating according to the latest report from Apartment List. “This year rents have risen slightly faster than they did before the pandemic, but significantly slower than they did in 2021 when rent inflation was at its peak. So far in 2022 rents are up 7.2 percent, compared to 14.8 percent at this point in 2021. Year-over-year growth has slowed to 10 percent, down from a pearl of nearly 18 percent at the beginning of the year.”
Depending on how quickly and dramatically rents moderate, this will put downward pressure on NOIs and will increase uncertainty and debt risk. That said, rising rates are a double-edged sword for investors as they serve to generally keep folks out of the resale market and renting long. Further, given the strong demand for rental units, it is likely that we won’t see a dramatic drop in rents across the board.
Still, 13% of renters are still behind on rent according to Census Bureau data. If rent growth continues at record levels, expect more and more renters to get behind on payments.
Smaller Multifamily Markets Rise
Smaller and suburban markets are currently outperforming the larger markets generally across the U.S. According to Marcus & Millichap, vacancy rates in central business and primary markets rose in 2020, with smaller and suburban market vacancies contracting. Despite the end of the pandemic, this trend is continuing.
Multifamily Growth or Crash: Expert Take
“Multifamily vacancies now stand at 4.7% as of the first quarter of 2022, below the 4.8% vacancy level we recorded in 2019…Performance metrics remain tight, with asking and effective rents posting near-record highs in the first quarter of 2022. The new record is 8.1% effective rent growth in the third quarter of 2021—more than three times the prior record of 2.4% set in the third quarter of 2001.” — Victor Calanog, Head of CRE Economics at Moody’s Analytics
“We believe the multifamily industry is well positioned to weather the economic uncertainty and interest rate volatility impacting the broader economy throughout the rest of the year…While we expect total volume projections will be down in 2022, rent growth and occupancy will still remain above their long run averages.” — Steve Guggenmos, vice president of Multifamily Research & Modeling at Freddie Mac