From Kevin Hampton and Andrew Felikian
Despite a wide array of headwinds currently facing the multifamily industry—including elevated interest rates, massive new construction deliveries and softening operating fundamentals—we maintain a positive long-term outlook for the sector.
In 2023, the U.S. added approximately 475,000 apartment units, with an expected increase to 550,000 units in 2024, marking the most rapid expansion in housing supply in over three decades. Despite this surge, apartment vacancy rates during the seasonally slow first quarter saw minimal change, edging up just 10 basis points to 94.1%. Fortunately, the high level of new supply coincided with the strongest first quarter demand in more than two decades, with 103,826 units absorbed as reported by RealPage. Additionally, same-store rents remained steady, posting a 0.2% year-over-year increase nationally.
As rent growth slows, higher expenses—particularly for insurance and labor—are making it more difficult to grow net operating income. A significant driver is the 35% year-over-year increase in insurance costs, now accounting for over 8% of a property owner’s expenses, nearly twice as much as five years earlier, per Yardi Matrix. High-risk areas like Florida, California, and Texas have seen the most significant increases, driven by the frequency of severe weather events and the significant increases in construction costs resulting in much larger insurance claims. Moreover, overall expense growth increased by nearly 7% year-over-year in the first quarter of 2024.
Despite facing challenges, the multifamily sector continues to experience strong demand. This is driven by strong wage growth and rising homeownership costs, making renting much more affordable than buying. Even with record levels of new constructions, projections indicate that housing will remain undersupplied over the long term, bolstering underlying fundamentals.
Notably, wage growth has exceeded rent growth for 16 consecutive months. This has led to renters dedicating a smaller portion of their income to rent, effectively making apartments more affordable. Nationally, the median rent-to-income ratio for new leases in market-rate apartments decreased by 120 basis points from its high in 2022 to 22.5%, according to RealPage data. This trend is resulting in higher-income renters transitioning from older, moderately priced units to newer, more expensive ones. In regions with abundant supply, these renters are upgrading from Class B and C properties, necessitating significant rent reductions in lower quality properties. Such dynamics are favorable for our portfolio, which is comprised of higher quality assets with an average construction year of 2015.
Additionally, home buying remains very unaffordable due to elevated interest rates and high home prices. High interest rates have made mortgages more expensive, significantly increasing mortgage payments and pricing out potential buyers. Meanwhile, homeowners with low fixed-rate mortgages are reluctant to sell, leading to minimal inventory and further driving up home prices. According to CBRE, it costs households on average 40% more to buy than to rent.
Despite short-term market disruptions, the long-term outlook for the housing market remains positive. Projections suggest that new apartment supply will begin to decline significantly by late 2025 and continue to do so into 2026. This trend is evidenced by the 40% decrease in construction starts in 2023 compared to 2022, as well as ongoing declines in building permit volumes through the initial months of 2024, as reported by RealPage data.
Furthermore, the multifamily sector significantly underproduced new units between 2009 and 2013, creating a peak shortage of 1.1 million units, around 2.5% of the national rental stock. Despite all the recent new supply, Linneman Associates projects a shortage of 767,000 units by year-end 2025, which is expected to increase through at least 2027. We believe these factors will lead to strong occupancy rates and rental growth in the coming years.
Multifamily capitalization rates remained relatively stable at 5.06% during the first quarter of 2024, after expanding by approximately 50% since their low in the first quarter of 2022, as reported by Green Street. This dramatic rise in cap rates has led to valuation declines of 30-50% for some properties, particularly impacting aggressive buyers who purchased at peak market pricing and have struggled to materially grow operating income. Some of these investors have lost 50-100% of their equity on these acquisitions. As a result, distressed sales should play a larger role in the coming quarters, creating an attractive environment for new investment opportunities.
Nevertheless, there are almost record levels of dry powder awaiting deployment in real estate, particularly in multifamily, which should limit the magnitude of further price declines. As highlighted in the Avison Young Q1 2024 Multifamily Insights Report, 35% of the total dry powder allocated for real estate investment is designated for multifamily properties. Multifamily assets continue to be the most sought-after acquisition target among all major real estate sectors in 2024, as highlighted in CBRE’s 2024 Global Multifamily Investor Intentions Survey.
While choppy market conditions are likely to continue in the short term, we believe that the long-term prospects for multifamily remain very positive. During the near zero interest rates of the pandemic, there were many exuberant investors that are just now beginning to face the music. This should result in near-term buying opportunities for disciplined investors. Our experience investing through multiple real estate cycles has shown that market illiquidity and disruptions are often correlated with exceptional investment opportunities. Our plan is to maintain our long-term strategy: investing in high-quality properties with strong growth potential utilizing conservative levels of leverage.