September 11, 2014 - Thought Leaders
With an eye to real estate’s next opportunity, cyclical investors and their lending counterparts are shifting their attention away from the apartment sector in increasing numbers. In place of multifamily, they are expanding their portfolios with an array of commercial assets, both core and value-add. As confidence in the economic expansion has grown and the appetite for risk-taking has recovered its former vigor, the allure of relatively higher yields from retail and industrial properties, in particular, has attracted a rising share of mobile capital.
The latest numbers align with cyclical investors’ updated narrative. The second quarter’s year-over-year gains in transaction volume were dominated by retail property sales, weighted to sales of small- and mid-cap properties in primary and secondary markets. Apartment trades registered more modest increases, though they remained the most traded asset overall.
Broader Risk Taking
Supporting equity capital inflows to neighborhood and community shopping centers, strip malls, and other retail property types, conduit and balance sheet lenders have grown more accommodating. The most recent survey of commercial real estate lender sentiment, published by the Real Estate Lenders Association and Chandan Economics, evinces competitive pressures on lenders and an expectation of rising originations outside the multifamily space. In practice, very few markets are now characterized by the conservatism in underwriting that was a hallmark of the early recovery.
Without a single agreed-upon benchmark for loan quality, we cannot demonstrate definitively that underwriting standards have deteriorated over the last year or the last quarter. At least not in a way that everyone will find convincing. For now, few investors and lenders show an interest in being second-guessed. But we can sense a consistent migration to looser underwriting standards, however, with today’s borrowers finding credit more easily than a year, or even a quarter, earlier. For one, history suggests that the increasing prevalence of interest-only periods and interest-only loans is a canary in the coal mine for default probability.
Apartment Thesis Largely Intact
The shift in momentum is by no means an indictment of the apartment opportunity. Demand in the sector remains strong, reflecting structural as well as cyclical factors in households’ preferences and capacities for homeownership. For many younger households, renting is eminently desirable, not just the necessary result of rejecting ownership. That reflects a change in attitudes that is difficult to quantify this early into the housing recovery. And rising student debt loads are constraining some would-be homeowners, as are higher bars generally for residential mortgage qualification.
Though home prices are up dramatically in recent years, sales volumes have registered lackluster gains. For now, households are opting for rentals in numbers that approach the worst days of the housing crisis. Though it will not decline indefinitely, the homeownership rate in the United States slipped to a 19-year low during the second quarter, extending the longest period of decline in residential tenure in modern history. Instead, the marginal household has shown a propensity for urban living and is more willing to trade off personal space for common amenities and location.
Concerns About Supply and Prices
Demand for apartments should find a balance in the near- to medium-term that stanches the otherwise persistent decline in homeownership. Underwriting must reflect that more sustainable trend, including long-term rent increases that are better aligned with tenants’ unexceptional income trajectories.
Where current apartment fundamentals are imperiled, development is usually the culprit. As compared to softening demand, construction is the more immediate threat to the multifamily outlook. At the national level, new supply numbers are within historic tolerances, though several leading markets have taken more than their fair share of the development pipeline. Among the high-fliers, the deleterious impact of rampant construction is most easily observable in the Beltway, where recently financed properties have encountered slipping asking rents.
Stepping back from the weakest markets and submarkets, the second quarter was one of the strongest for apartment fundamentals since before the financial crisis. The lending data shows income gains on encumbered properties exceeding forecasts in most markets.
But it will not last; the challenge for investors in some markets is that
valuations are anticipating that it will.
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