It has been some time since our last special report. Each special report we have written highlights a pressing and urgent topic that is germane to real estate, and usually, the multifamily market in the United States.
It has been some time since our last special report. Each special report we have written highlights a pressing and urgent topic that is germane to real estate, and usually, the multifamily market in the United States. The COVID-19 pandemic that had consumed the World is now almost fully in the rearview mirror, however the scars and impact to the economy and financial system will leave their mark for far longer. We are now marked by headwinds of a different kind – crushing interest rates, increasing costs, the eroding affordability of daily life, and significant labor market challenges. We continue to evaluate our own portfolio for opportunities to exit investments, with a focus on capital preservation.
We are writing you today to provide you with a special report on the state of affairs, specifically the multifamily real estate market, from our point of view and opinion. We have built our reputation on stellar performance for our limited partners, transparency, and most of all, counsel and accessibility in the times most critical. As always, today is no different.
Multifamily Market – Pre 2022
When we last wrote to you, interest rates were likely still low, and the Federal Reserve had not yet embarked on the fastest tightening cycle in decades, and the highest Fed Funds rate since 2001. The current Fed Funds rate sits at a target range of 5.25-5.50%, and marks eleven (11) increases in twelve (12) meetings. The Fed, forced to reign in pesky inflation triggered by massive government spending during the COVID-19 pandemic, was late to the party, and mismanaged investor and market communication up until the very last moment of the first interest rate hike.
The COVID-19 environment led to significant population migration, bolstered by low interest rates, remote work (with portable wages), and rising opportunity in the new economic powerhouses of the Southeast and Southwest regions of the United States. In fact, Bloomberg recently reported that the GDP of Florida, Texas, Georgia, the Carolinas, and Tennessee has eclipsed the Northeast’s GDP for the first time since the regional records were kept in the 1990s. The Southeast accounted for more than 66% of all job growth in the US since early 2020, doubling its pre-pandemic share. With it, North Carolina, our highest conviction investment area since late 2016, exploded. Torrid rent growth, significant investor demand, and all the makings of a strong investment.
Increased Interest Rates
Unfortunately, the same factors were contributing to a double-edged sword effect, and multiple quiet storms were beginning to brew. In 2020 and 2021, government and Federal Reserve messaging was strong and supportive, of “lower for longer.” Even the best economists were not ready for the eleven (11) rate hikes that would follow, threatening to crush even the most robust economic activity. Interest rates heavily influence (and to a large degree) drive real estate investing. Specifically speaking, value-added investing relies on borrowing transitional financing with floating interest rates, and using this to improve asset valuation, exiting at a higher price. Even with the most conservative modeling, expecting the doubling or tripling of underlying interest rates was unheard of. Increasing interest rates severely compress the cash flow available from property operations to both service debt, and pay investor distributions.
Increased Operating Costs & Labor
Significant increases in costs, materials, and labor, began to permeate into the US businesses, especially the Southeast. Inflation ran hotter than most regions of the US, with levels accelerating at a faster rate, closing the gap and squeezing operational costs of businesses. Inflation at its peak in the Southeast almost touched 10%, while wages have accelerated at a pace 11% faster than the Northeast, overall increasing approximately 15% since the beginning of 2020 through 2Q23. Indexed wages in the Southeast are now only 2.2% behind Northeast wages. As a result of this growth, there has been a material change in turnover and re-training, making quality employee retention very difficult and expensive. Much like the restaurant and hospitality industries, although job recoveries are in order, seasoned and experienced tradespeople have transitioned to other fields, leaving large gaps of tenured experience in the wake. Anecdotally, we have also found its increasingly more difficult to push performance given the availability of jobs in the property management industry and escalating pay scales. Said another way, employer/employee leverage is extremely tenuous at the asset level.
RealPage Market Analytics, one of the largest data providers on multifamily in the US, published an article at the end of 2022 about apartment operating expenses climbing to greater than two times pre-COVID 19 norms. Pre-COVID expense growth oscillated between 2% and 4%, while expense growth through the second quarter of 2022 was greater than 8%, with the average at 7.6%. While we do not have access to similar data for 2023, costs have continued to accelerate and have worsened since the 2022 data (pictured below).
Increased Delinquency due to Declining Affordability
While wage growth continues to weigh heavily on property operations, we have seen historic rent growth that has far exceeded wages. Increased household budget pressure, driven by generalized inflation (as well as shelter cost), have put workforce tenants in an increasingly more vulnerable position of deciding which “necessity buckets” their dollars should be put towards – food, shelter, transportation, etc. Coupled with a court system that has nationally grown more lenient with evictions and tenant displacement, tenants have increasingly turned to late pay cycles, or partial and full delinquency to buy time and balance their household budgets. More recently, a Clever Real Estate press release marked Charlotte as number three in the nation for metropolitan areas where rent has exceeded income growth by more than 50% since 2009, with the Charlotte MSA clocking in at 56%. National median rental rates have increased by 149% in the last 35 years, with rental inflation growing at four times the median wage. Anecdotally, these patterns are revving up lawmakers in DC to call for additional tenant protections, rent control, and other anti-landlord practices which will continue to add to market headwinds.
Increased Asset Protection Costs
The most recent additional burden to the multifamily space is the skyrocketing habitational insurance costs associated with multifamily investment products in the United States, specifically areas on the East and West coasts where climate events remain a growing and persistent concern. We have been lucky that climate events have not directly affected our assets, however we have been forced to bear the brunt of increasing premiums across our portfolio. Some of our insurance premiums have had extremely material impacts on our ability to produce cash flow, and as a spillover have impacted our out-sale valuations. One panelist more recently at the National Multifamily Housing Council (NMHC) webinar noted that owners and operators are now in the “risk-management and control business,” making uncomfortable choices about mitigating insurance costs by increasing deductible preferences or underinsuring property.
High level, climate events have generated the most significant impact to insurance premiums over the last three years, but additional stress in the marketplace has contributed – the exiting of larger insurance providers in certain markets, rising construction and replacement costs, inflation, and supply chain issues have all contributed. Additionally, density in locations benefiting from in-migration has also increased policy costs as a result cities and metros that are growing increasingly larger. Per a BisNow article that referenced NMHC’s Multifamily Risk Survey and Report, nationwide property insurance costs have risen 26% on average. When taking into account other sources directly referencing coastal states, some premiums have been as high as 200% from the prior year. At the same time, insurance companies have begun to increase exclusions and pare back wind thresholds, exposing property owners to additional risk.
Capital Preservation & Forward Outlook
Our main goal at Lucern Capital Partners has shifted from delivering returns for our limited partners, to capital preservation. Any individual deal shock previously outlined – perhaps even two, are able to be overcome by the strong economic strength of the markets we are involved in and the basis at which we are into each asset. Unfortunately we are facing an unprecedented confluence of events, driven by government policy, money creation, and the hangover of COVID-19. This confluence of events has altered the trajectory of population and migration patterns, triggered a vicious inflationary cycle, and has heavily impacted asset valuations through an interest rate shock. Even with a housing shortage and supply and demand imbalances, strong rent growth is not enough to grow out of the damage that has occurred. It is also our opinion that the next 18-24 months will be very challenged in the multifamily space as rent growth recedes (already happening), historical supply not seen since the early 1980’s is delivered, and government policy continues to grow more bellicose towards the multifamily space. We believe we will see capitalization rates widen, especially on the product where tenants are most vulnerable and compromised, and valuations will continue to be impacted as operational costs and insurance continue to eat away at the bottom line. We will continue to work extremely hard to preserve capital and return investor dollars. Moving forward, we are focusing new business on other asset classes that have room for performance in this environment. We will also keep a keen eye as multifamily opportunities present themselves, always ready to pivot to opportunities that serve our investor base.
Key Economic Takeaways
- Multifamily fundamentals in 2020-2021 provided an attractive, high-conviction opportunity
- Long-term multifamily fundamentals are sound, but in the next 18-24 months, the space will be challenged
- In the interim, we are seeking alternate opportunities that are better suited for the current economic climate
- The US South now contributes more to GDP than the Northeast
- Among a positive economic backdrop, several quiet storms were brewing, undercutting multifamily’s strength
- Increased interest rates have led to 11 FOMC hikes in ~ 1 year, leading to decreased valuations and cash flow
- Operational and labor costs have increased at run rates that are 2x+ historical run rates, compressing cash flow
- Rental affordability is an acute problem, leading to significant delinquency and bad debt
- Insurance costs are entirely out of control and have damaged asset valuation and cash flow