Will the darling of the commercial real estate industry retain its charm next year?
The past few years have been extremely favorable to the multifamily market. Developers are building apartments to catch up on a lull of construction over previous years in a race to complete projects and capitalize on continuously rising rents. Investors are aggressively seeking opportunities to purchase multifamily properties, specifically core and value-add assets in top-tier markets, pushing cap rates as low as 4%.
Yet what remains to be seen is whether the “darling” of the commercial real estate industry will remain so, or whether the market will experience flattening or even a slight cooling in the coming year.
Concession Wars to Return
With rising construction costs and select markets at risk of overbuilding, projects that aren’t shovel-ready have begun to stall, potentially creating better absorption than expected next year as less new product will come on line. However, as new product is delivered, concession wars will take hold in top-tier markets as owners in select submarkets seek to justify the highest rents in history.
Renters, meanwhile, will begin to look for Class B properties as a way to save money, causing an above-average surge in rents. This effect will trickle down, and Class C assets will experience strong rent growth as well, although not as strong as Class B. Many traditionally affordable markets will likely see stronger rent growth than they have witnessed in more than a decade because of a lack of new deliveries in their particular submarkets. Construction costs prohibit new development beyond top-tier rental markets without outside incentives.
Entering the fourth quarter of this year, continued value-add purchases from institutional buyers are raising rents for entire submarkets. Properties that previously tested rental increases by a maximum of $100 a month now have justification for increasing rents by as much as $400 per month, as buyers spend upward of $10,000 per unit on upgrades.
Rent Growth Should Slow
Though rent growth is expected to continue next year, it won’t increase at the same levels it has during the past couple of years, as competing properties play catch-up on interior and amenity upgrades. Select submarkets will likely see rents flatten until absorption of new product lowers supply. Next year, we believe rent growth will be more traditional and modest, at 3% to 4%.
The success or failure of assets purchased in the second half of 2015 through 2016 will depend heavily on the amount of “homework” done during the due diligence process. Investors who overlooked deferred-maintenance issues and/or near-term capital needs in their haste to close deals will have a harder time withstanding the inevitable flattening of rents than investors who successfully negotiated price reductions or built the cost of these repairs into their models on the front end.
Along the same lines, existing owners who have intelligently reinvested recent profits into the physical asset will be much better off than those who took the profits and neglected these needs.
Value-Add Will Continue to Attract Interest
Core assets or light value-add assets in top-tier markets are likely to remain extremely costly, which will drive interest in previously overlooked markets that are currently experiencing strong rental growth because of economic barriers to entry. For many owners and investors, operational and moderate value-add deals will provide more yield than ground-up construction as labor costs continue to climb.
While investor interest remains very strong, there is increased concern about deals that will require heavy lifting to increase rents. The timing associated with the physical improvements made to reposition an asset could place an investor in a potentially less-favorable market contingent on supply.
With all of the factors affecting the multifamily market, we expect to see more thoughtful investor sentiment in 2017. As we enter the new year, it will likely become more difficult for investors to pencil in pricing that works assuming 6% to 8% rent growth. It is, however, unlikely that we’ll see major shifts in the cost of capital, which, in turn, will likely keep investor activity positive over the next 12 months.
We do expect to see a more-focused approach to achieving yield through operational expertise. Efficiencies gained by proactive management practices will control costs, including insurance, payroll, and contracted services and will be essential components in the success of assets.
About the Authors:
Jake Reid is senior director of Franklin Street Real Estate Services, focusing on multifamily sales for the firm’s Atlanta office. He can be reached at Jake.Reid@FranklinSt.com.
Chad Dewald is vice president, multifamily, at Franklin Street, a full-service commercial real estate firm. He is based in the company’s Tampa, Fla., office.
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