Strong Wage Growth Fueling Apartment Demand

Demand for apartments remains strong nationwide, and renters remain economically strong as the U.S. economy continues to boast a tight labor market, the unemployment rate held steady at 3.8% in August, benefiting renters through strong wage growth. Wages are now rising faster than inflation, boosting households’ purchasing power and underpinning consumer spending as well as keeping the overall economy afloat.

Apartment unit absorption in the first half of 2023 surged to 98,429 units, with an increase of 83,449 units in the second quarter of 2023. This nearly quadruples the absorption seen in the first half of 2022. Demand is anticipated to continue accelerating in the second half of 2023 and the first half of 2024.

Significant New Apartment Deliveries Flattening Rental Growth

Simultaneously, apartment renters are also benefiting from the surge of luxury apartment deliveries. Apartment developers are rushing to complete projects that were green-lit during the pandemic-era surge in demand for rentals or left in limbo by delays in supplies of fixtures and building materials. With a record-breaking 198,806 units already delivered in the first half of 2023, total deliveries for full-year 2023 are expected to surge 51.1% year-over-year. Deliveries are also projected to increase in the second half of 2023 and continue through 2024.

The rent flattening resulting from new apartment supply is far more evident in the Class A luxury sector of the apartment market, as almost all new deliveries are high-end apartments targeting the upper quartile of U.S. households as segmented by annual income. There are virtually no additional middle income focused apartments being constructed because the cost of land, labor and navigating the government approval process incentivize developers to put up luxury apartments buildings. Additionally, more than 40% of the new rentals to be completed this year will be concentrated in about 10 high job growth metropolitan areas, including Austin, Nashville, Denver, Atlanta, and New York (Source: Marcus & Millichap). In many areas of the U.S., the boost to overall apartment inventory will be barely noticeable, especially for middle income renters seeking rents under $2,000 per month.

Despite the surge in recent multifamily deliveries, limited debt availability for new construction should normalize new units delivered in 2025-2028. The most recent multifamily starts have plummeted to their lowest point in three years, pressured by a difficult lending market with high borrowing costs, higher material costs, lack of labor and the growing amount of time required for permitting.

Rental Housing Becoming More Affordable to a Growing Pool of Apartment Renters

The sustained growth in renter wages, coupled with an increase in multifamily housing supply pushing down rental rates, has led to a scenario where wage growth has outpaced apartment rental rates for nine consecutive months. This trend bodes well for apartment affordability, and consequently, boosts rental housing demand. Enhanced affordability expands the pool of potential renters. According to a September 2023 survey by Harris Poll for Bloomberg, “About 45% of people ages 18 to 29 are living at home, which Bloomberg said is roughly the same level as it was in the 1940s.” The report continues, “The main reason for returning home was to save money, with many saying they can’t afford to live on their own.” These 18 to 29 year-olds are the types of potential renters that will likely re-enter the apartment markets as affordability improves and the renter pool expands.

Despite some media portrayals, the median rent-to-income ratio suggests that affordability is not an issue in the market-rate apartment sector, which operates on supply and demand without rent control or subsidies. Typically, housing is deemed “affordable” if it consumes no more than 30% of an individual’s total gross income. The rent-to-income ratio for market-rate apartments peaked at 23.1% earlier this year among actual lease signers and is expected to drop even lower (Source: RealPage). Should rent levels continue to flatten, or even fall a bit, inflation subsides, and if employment conditions stay robust, it’s likely that renters will benefit from greater spending power—a promising sign for sustained rental housing demand.

Furthermore, homeownership has become considerably more costly for households, with the average 30-year fixed mortgage recently reaching an 8% level not seen since 2000. Despite the increased mortgage rates, home prices have generally continued to rise, primarily due to low inventory levels, as existing homeowners are reluctant to sell given their favorable in-place mortgage rates of 3% or lower. According to the National Association of Realtors, year-to-date home purchases in the US have declined by 15.4%. The elevated cost of homeownership is likely to further boost the already strong demand for apartments, as more renters postpone buying homes until affordability improves.

Non-Controllable Expenses: Multifamily Insurance Costs Continue to Climb

As rents continue to cool off from their white-hot growth during the pandemic, insurance rates continue to heat up along with global temperatures. Natural disasters, inflation and a shrinking reinsurance market have pushed insurance premiums to record levels, echoing the surge in home insurance rates for much of the U.S. Multifamily insurance cost per unit have risen more than 20% year-over-year nationally, with wind exposed assets insurance costs almost doubling. Providence is working hand-in-hand with its insurance consultants to keep insurance costs down; however, the market for insurance, especially wind insurance for named tropical storms, is currently not cooperating with property owners, and dragging down NOIs.

The Continuing Rise of the Benchmark 10 Year Treasury Yield

Since 2020, the U.S. 10-Year Treasury Yield has soared ninefold from its August 2020 low of 0.52%. During the third quarter, the yield spiked 19%, rising from 3.86% to 4.58%. Though the current rate is still below the historical average of 5.87% (since 1962), the accelerated pace of this increase is unsettling the multifamily acquisition market. The rapid escalation in yields affects both the cost of financing and the valuation of multifamily real estate. This volatility, coupled with fluctuations in inflation, creates challenges for underwriters trying to produce reliable cash flow projections and valuation conclusions for multifamily properties. In addition, these higher interest rates are resulting in higher debt servicing costs to property owners, putting additional pressure on their current cashflows.

Multifamily Investment Sales Waiting to Reemerge

As the 10-Year U.S. Treasury rate rises, it’s driving up mortgage rates for multifamily loans. In response, lenders are reducing loan proceeds to borrowers to offset the higher interest burden on property cash flow. This change has led to a noticeable slowdown in multifamily transactions. For context, about 190,000 apartment units changed hands in Q2 2023, a sharp decline from the 425,000 units in Q2 2022 and an average quarterly volume of around 350,000 units (Source: Newmark).

While multifamily sellers have been hesitant to substantially lower prices to account for the increased cost of debt, market pressures are mounting. Many apartment owners are facing a cash flow squeeze due to flat rents and escalating non-controllable expenses like insurance and taxes, as well as interest costs. In light of these conditions, we foresee sellers becoming more flexible with pricing, although it remains difficult to determine the exact timing of this shift.

Window for Opportunistic Acquisition is Approaching

The persistent imbalance between supply and demand for apartments remains especially acute for middle-income renters. The rising housing needs of 72 million millennials (ages 28 to 42) and 68 million Gen Z’ers (ages 11 to 27) in the U.S., who are living with parents at unprecedented rates, exacerbate this imbalance. A National Multifamily Housing Council report forecasts a 4.3 million apartment shortfall by 2035.

Given these factors, we anticipate that the multifamily sales market will adjust to the prevailing environment of climbing interest rates and escalating non-controllable expenses. Once adjusted, the market should be ripe for opportunistic acquisitions to meet the unfulfilled demand from middle-income renters. While it’s difficult to predict exactly when this adjustment will happen, it appears inevitable—especially as property owners increasingly face financial pressures from rising non-controllable and interest expenses. Providence remains poised, ready to seize market opportunities as they emerge.

About Providence Real Estate

Since 1985, Providence and its affiliates have actively operated as owner-operators of multifamily residential communities. Its principals have acquired over 65,000 apartment units, worth over $7.5 billion. Providence comprises an experienced team of professionals dedicated to searching for, identifying, acquiring, renovating, and operating multifamily properties in select U.S. markets. As a fully integrated real estate organization, Providence includes divisions for Property, Asset, and Construction Management; Acquisitions; Accounting; Information Technology; Human Resources; and Business Development. To learn more please visit https://www.provre.com.

DISCLAIMER

The information contained in this letter is provided solely for informational and discussion purposes. It is not intended as an offer to sell, nor a solicitation of an offer to buy, any security. This document may not be relied upon in connection with the purchase or sale of any security. Any such offer or solicitation will be made exclusively through a confidential Private Placement Memorandum (PPM), subscription documents, and governing documents. These offering materials must be reviewed thoroughly before making any investment decision, as all information herein is qualified in its entirety by those documents.

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