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Multifamily real estate is a widely held and strategic commercial real estate asset class. At roughly 25% of the U.S commercial real estate stock, the multifamily sector now accounts for the second-largest share of institutional investors’ real estate holdings, lagging only the office sector. While previously considered a residential asset, multifamily is now firmly cemented as one of the four primary commercial real estate asset classes (the other primary three being office, industrial and retail).
In this article, we provide an overview of the multifamily asset class, discuss demand drivers, highlight changes in use and conclude with a synthesis of these factors to better equip investors with the knowledge to make informed investment decisions.
Asset Class Overview
As an asset class, multifamily spans a wide spectrum of residential properties that technically includes all buildings containing at least two housing units, which are adjacent vertically or horizontally. Multifamily is also characterized by shared physical systems whether it be walls, roofs, heating and cooling, utilities or amenities. While multifamily can include townhouse, condominium and apartment projects, for the purposes of this article, we will focus on apartments since they are most commonly acquired as an investment.
Classification: The industry “grades” multifamily properties as Class A, B or C based on criteria such as age, quality, amenities, rent, and location among other factors.
Class A multifamily properties, particularly in suburban locations, will almost always offer near resort-like settings complete with fountains, lavish pools, barbeque areas, and fitness centers. In general, Class A multifamily properties are best-in-class assets that usually command the highest possible rents in their respective submarkets.
Class B multifamily properties are a step down from Class A in terms of building quality, location, and amenities. This property class will often have the term “workforce housing” associated with it as it is often intended to offer a viable housing solution to median wage earners.
Class C multifamily properties are the lowest-rated tier of buildings. Spaces within Class C assets are barely functional and are cheap to rent. Often times, these are older assets that have outdated building systems, design or finishes, or they may be in desperate need of maintenance and renovations.
Property Types: Apartment properties also come in all shapes and sizes, ranging from dense, high-rise, urban apartment buildings to sprawling, resort-style complexes in the suburbs complete with swimming pools, fitness centers, and outdoor patios. In terms of size and type, multifamily buildings are often classified as follows:
Low Rise or Garden Style: 2-4 stories high and most typically found in suburban locations
Mid Rise: 5-9 stories
High Rise: 10 stories or higher
A good way to begin analyzing U.S. multifamily demand drivers is to consider that households are comprised of either owners or renters. According to the U.S. Census Bureau, homeownership, as of March 2016, currently stands at 62.9% (with renters at 37.1%), which is its lowest level in more than 25 years. There are roughly 117.4 million total households:
Demand drivers, for the most part, will 1) increase or decrease the total number of the U.S. households 2) change the percentage breakout of renters vs. owners or 3) both. While there are myriad factors that contribute to multifamily demand, the following comprise the key drivers:
Population Growth: As the population grows, so too will total households albeit at a lower rate. For example, if the U.S. population grew by 5%, which in turn, grew total households by 2.5%, from the 117.4 million noted above, we would now have 120.3 million households. Holding the 62.9% / 37.1% distribution constant would result in an increase in renter households of about 1 million:
Rental Household Growth: Following the great recession, we saw homeownership decline from its 2004 peak of 69% to its current level of 62.9%. In this kind of shift, if we hold total households constant, we have more renter households at the expense of fewer owner households. If we use our current U.S. household total of 117.4 million, an owner to renter shift of that magnitude would result in a loss of 7.2 million owner households and an equal gain of 7.2 million renter households. While we know that total households actually changed over this period, this example is designed to illustrate how swings in renters vs. owners affect demand holding total households constant:
Job Growth: Job growth correlates to household growth, as people can now afford their own residences (e.g. Millenials that moved out of their parents’ homes once they got jobs during the recovery). While job growth grows total U.S. households, it predominantly grows it via renters, since the people who primarily benefit from job growth are generally renters and not owners. Let’s consider the following exercise. According to the Bureau of Labor Statistics, the U.S. created 2.7 million jobs in 2015. Let’s assume that for every four jobs created one household was formed holding population constant. This assumption would yield 675,000 new households. Let’s further assume that 80% of these new households were renters, not owners. That would yield 540,000 new renter households and 135,000 new owner households. As a result, 2.7 million new jobs would both grow total households as well as slightly increase the percentage of renters in comparison to owners. If we started with our current 117.4 million U.S. households, it would look like this:
Cost of Ownership: Cost of ownership can be analyzed in two primary ways. First, high real estate prices serve as as a deterrent to ownership since it makes purchasing a residence difficult to afford. As a result, you will see higher percentages of renters in any market where housing stock is expensive. In fact, while the U.S. owner to renter ratio is 62.9% / 37.1% at the national level, it is nearly the inverse in metros such as New York, San Francisco, and Los Angeles. When the comparative cost of renting vs. owning changes, it induces demand for the option that just became a bit cheaper. For example, when we see rapid spikes in real estate values, particularly ones that dramatically outpace wage growth, we can expect to see the renter percentage in that location increase and the ownership percentage decrease. Such a change doesn’t grow the household number but, rather swings the percentage breakout:
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Demographic trends have made their own contribution to the growing popularity of renting. The behavior and choices of different demographics has direct effects on the multifamily trends, and now more than ever. According to a study published by the Joint Center for Housing Studies of Harvard University, the increase of 9 million renter households the U.S. has experienced since 2005 is the largest increase in any 10 year period on record.
The aging of the millennial generation (born 1985–2004) is one key demographic trend that has lifted the number of adults in their 20s, the stage of life when renting is most common. Millennials, as a demographic, are delaying marriage, children and moving to the suburbs to buy a home until later in life. This effect has expanded the year-over-year renter pool nationwide. Millennials also are carrying a higher load of student debt in comparison to previous decades, which makes it more challenging to finance a first-time home purchase.
Millennials are not the only demographic making choices in favor of multifamily. Empty nesters are downsizing and opting for low-maintenance rental townhomes and apartments. In addition, both Millenials and empty nesters have been drawn to the urban renaissance movement that is seeing people move back to city centers to live, work and play. This movement is creating more demand for apartment and condo rentals in and around busy downtown and central business districts.
In combination, these trends have boosted the numbers of renters in all age, income, and household categories. Millennials have pushed up the number of renters under age 30 by nearly 1 million over the past decade, while members of generation X (born 1965–1984) added 3 million to the ranks of renters in their 30s and 40s, even though the population in this age range declined. The largest increase, however, was a 4.3 million jump in the number of renters in their 50s and 60s. This growth reflects the aging of baby-boomer renters (born 1946–1964) as well as declines in homeownership rates among this generation. While households in their 20s make up the single largest share, households aged 40 and over now account for a majority of all renters.
Changes in Multifamily Use
Many of the demographic trends, as mentioned above, have led to a number of shifts in multifamily use as the next generation of multifamily developments aims to provide a modern living experience. The following are highlights of the factors changing where apartments are located and what they look like:
Walkable / Bikeable locations: In conjunction with the urban renaissance, renters now desire their apartment to be located in close proximity to neighborhood grocery stores, cafes, pubs, and restaurants. In decades past, it was more common to see a multifamily property tucked away in a secure and private setting but that trend has given way to the walkable, bikeable property.
Transit-oriented developments: As commuting via public transportation has become increasingly popular amongst the renter sect, we are seeing more apartment buildings pop up along transit lines. Transit-oriented properties command higher rents and can expect to maintain higher occupancies all things being equal amongst its competitive set.
Modern amenities: With properties that are increasingly walkable and bikeable, renters now desire a host of modern amenities. According to a 2015 nationwide survey conducted by the NMHC, the following are highlights of what renters desired most:
Fast internet connections
In-unit washing machines and dryers
While not top ten in polling, the following are additional modern amenities that renters also seek out:
Dog washing stations
Bicycle mechanic stations
Interior storage units adjacent to dwelling units
As many new buildings contain most or even all of these types of amenities, the modern apartment building can almost feel like a hotel in the level of service and breadth of amenities offered. It’s a far cry from the standard walk-up apartment building of the past.
New Development vs. Existing Product
Due to recent changes in use, the amount of new apartment construction nationwide and the current disparity between the cost to build vs. the cost to acquire, many investors are seeking out opportunities to invest in multifamily development rather than multifamily acquisitions. Some of the key points to consider when weighing development vs. acquisition investment opportunities include:
Development risk premium: Investors should be compensated for taking on greater risk associated with development. One rule of thumb is to receive a The capitalization, or “cap”, rate is used in commercial real estate to indicate the rate of return that is expected to be generated on a real estate investment property. The calculation is based on the Net Operating Income the property generates divided by the Purchase Price. Lower cap rates (3-5%) generally point to safer / less risky investments and are... More premium of 150 basis points or greater on development over acquiring an existing property in order to make it worthwhile for taking on the extra risk (e.g. a brand new property that would currently trade a 4.5% cap rate at stabilization is developed to a 6% or greater operating cap rate at stabilization on cost). As that spread narrows or increases, it creates less or greater incentive to invest in development.
Construction type: Multifamily development can take many forms with varying levels of cost. Construction type and finish levels are the key determinants of price per square foot building costs, which in turn influences the rents a property needs to achieve to hit its target returns. That list ranging from low to high building cost includes:
Stick built: The least expensive building style uses primarily wood beams and stud walls. It is more common to find lower to medium finish levels in stick built product.
Podium: This style features a concrete base or “podium” on the first one or two stories with stick built construction on up to five floors over the podium. That base also may include digging down to create a basement or underground parking garage. It is common to find mid to high finish levels in podium product given the higher cost as well as the likelihood that will be developed in an urban location.
Concrete and steel: Urban high-rise buildings that need heavy-duty structural support to accommodate a very dense, vertical format will utilize a combination of concrete and steel. Given the high cost of land, cost of construction and density in this type of location and product, it is most common to find high-end finish levels in concrete and steel buildings.
Utilizing the Information
While multifamily real estate has its own unique complexities and risk factors, from an investment and risk analysis perspective, it is generally regarded as the safest of all commercial real estate asset classes (although I know many industrial operators that would challenge that statement, which we will discuss in an upcoming industrial-specific article). This is predominantly due to higher average occupancies with lower price volatility when compared to other asset classes.
For signs of evidence to support this argument, consider that apartments have a lower cost of capital and wider availability of debt capital. For example, government-backed agencies, Fannie Mae and Freddie Mac, will lend on multifamily assets but not on other commercial real estate asset classes. In addition, when looking back at the last recession, generally speaking, multifamily is the asset class that performed the best during the depths of the financial crisis and was the asset class to lead the recovery. There is something to be said for the notion that people still need a place to live no matter the phase of the economic cycle. During recessions, people can lose their homes and be forced into the renter pool, which you as now understand, increases rental demand through a shift in the owner vs. renter household breakout. Once a recovery begins, the shorter lease terms of multifamily allow owners to adjust more quickly to changing market environments.