As printed in CREJ>>

It’s no surprise that people are getting spooked with terms like uncertainty, risk, crash, and crisis swirling around the industry at rapid speeds. In fact, the top trending search term on Google last month was “real estate market crash.” But when you block out the noise and dig into the data, signs continue to point to multifamily investments remaining strong nationwide, and even more so in secondary, high-growth markets.

It’s been predicted for several years that a market correction was imminent given the unsustainable increase in home values. After seven months of the Fed raising rates to cool the economy, we’re seeing the first signs of actual impact on the real estate sector with home values finally slowing down, albeit still growing at pre-pandemic levels. Although this was a necessary and forecasted course for the industry, it’s human nature to react to change with the fight or flight mentality. Either have conviction that housing will be more valuable in the long term or remove funds from real estate and invest in bonds or other “risk-free” options that likely won’t keep up with inflation. Our trajectory aligns with the fight response as our thesis continues to prove out and point us toward multifamily in secondary markets as the most advantageous long-term investment. Some of the biggest areas of focus by economists reinforce advantages for multifamily investors seeking value-add and core-plus assets with holds exceeding five years.

Interest Rates

With interest rates hitting a 20-year high and inflation continuing to soar, many would-be homebuyers are in a holding pattern until they see how everything shakes out. Regardless of recent softening in home values, interest rates are pushing monthly mortgage payments into an unattainable range for many despite incomes being higher than ever.

A shift from rates at 3% to nearly 7% adjusts monthly mortgage payments significantly. Using the national median home price as an example, monthly payments could increase from $1,400 up to $2,200. This factor alone would be enough to make people put home ownership on pause, but with cost-of-living also at a 40-year high, the financial pressures are pushing more people to stay in rentals.

The price-to-rent ratio is close to 30% nationally and that number continues to grow in secondary markets in the mountain west seeing outsized population shifts from areas with higher household incomes. Recent Brinkman acquisitions in the Intermountain West region show discounts upwards of 50 percent to rent versus buy. Topping the list are Missoula (54%), Salem (51%), Billings (49%), and Ogden (45%). With such a significant gap, there’s room to add resident-centric upgrades and adjust rents while remaining the most affordable option in the market.

In addition to a healthier renter population due to the inability to buy in this capital markets environment, we predict some multifamily investors will be more motivated to sell over the next 12 months due to a variety of factors. Some will need to refinance a construction loan or attempt to lock in a fixed rate loan, and higher interest rates will lead to many loans being debt service coverage ratio-constrained resulting in lower loan amounts. Cap rates will rise from historical lows resulting in lower appraisal and loan amounts. Additionally, many owners over-levered their assets, relying on high-priced capital events, such as refinancing or recaps, that are no longer available. This may threaten diminished returns relative to their contemplated underwriting causing business plans to adjust to meet investor return thresholds. This distress in the marketplace may force some multifamily owners to sell at a discount as they won’t have satisfactory financing alternatives.

Household Formation

While data shows household formation is declining and weakening demand, the recent metrics of new lease signers in market-rate apartments also show incomes that are substantively higher (20%+) than pre-pandemic levels. This paints the picture that people are staying in rentals not due to affordability, but likely because of uneasiness around the pending recession and inflating consumer costs. Through this phase of the market cycle, demand for rentals will remain strong. While we are seeing a slight slowdown in traffic in the larger secondary markets like Salt Lake City, retention rates remain high, further evidence that existing households are staying put. As uncertainty clears, we could be expecting another housing boom with the pent-up demand, contributing once again to the need for quality rental product.

Supply

Rental supply remains at record lows in secondary markets in the Intermountain West region. The inventory per population in markets like Missoula, Flathead County, Ogden, and Payson are all sub-six percent compared to larger MSAs which typically feature per capita rental inventory well above 10 percent. Inventory will continue to dwindle as populations shift from dense, urban markets to smaller communities. With remote work becoming the norm and opening opportunities to live anywhere, people are searching for more space and access to the outdoors, less traffic, less crime, less political polarization, better schools, and overall higher quality-of-life combined with lower cost-of-living. New products will continue to be priced at a premium with construction costs in smaller markets just as expensive, if not more, than larger markets. In the secondary markets, skilled labor is tighter, there’s less affordable land availability, and materials are scarcer, among other factors. This all contributes to the continued and systemic undersupply in these already chronically undersupplied markets.

Incomes tend to be higher with the households migrating to these smaller communities. Recent data from Montana, for example, shows that between 2019 and 2021, the number of households earning $200,000 or more increased by more than 60 percent and the people working from home nearly tripled in some areas. This contributes further to the need for quality rental housing, particularly for the locals, in these desirable, high-growth markets.

Real estate is generally considered a strong investment through all phases of the economic cycle. In today’s unprecedented landscape, multifamily is still weathering the market shifts with muscle. The growth of the renter pool due to increasing rates, economic uncertainty, and undersupply continues to build confidence that multifamily acquisitions are reliably strong investments. Those choosing the “flight” response to the looming recession may miss out on discounted assets that will prove to be strong long-term investments.