National Report: Multifamily 3Q / 23

Gateway Markets Demonstrate Resilience, but Rising Operating Expenses a Broad-Based Concern

Return of seasonal demand helped stabilize sector. The spring months of 2023 were once again a strong period for apartment demand, after the pandemic had disrupted normal seasonal patterns. From April through June, about 80,000 units were absorbed on net, the largest quarterly total since the opening three months of 2022. At the same time, net absorption fell short of the 107,400 rentals finalized during that span, keeping vacancy on the ascent. These dynamics foreshadow the remainder of 2023. Household creation is gradually improving, yet continues to be hamstrung by economic uncertainty and inflation. As a result, net absorption will remain in positive territory through year-end, but will trail record construction.

Development is historic, but very concentrated. The 200,000 units finalized during the first half of 2023 marked the largest total over a six-month span on record. An additional 200,000 units are expected to deliver during the second half, placing annual inventory growth at a historic 2.1 percent for 2023. Construction is clustered, however, with migration destinations in the Sun Belt receiving an outsized share of new supply. Austin, Charlotte, Jacksonville, Nashville, Raleigh, Reno and Salt Lake City are each on pace for 5-plus percent inventory growth this year. Conversely, some of the nation’s largest population hubs — Chicago, Los Angeles, New York City, Orange County and San Diego — will register sub-1.5 percent supply expansions

Dense coastal hubs stand out. Some markets are better weathering recent headwinds. As of 2023’s mid-point, just 10 major U.S. metros had both year-over-year vacancy increases below 200 basis points and sustained sub-5 percent rates entering July. That list included six of the nine major markets with average effective rents above $2,500 per month: Boston, Los Angeles, New York City, Orange County, San Diego and San Jose. Despite relatively high living costs, these cities remain attractive spots to work and reside. Extreme homeownership barriers, meanwhile, make renting a comparatively affordable option.

Class C rents realign with the market. The gap between an average Class B and Class C effective rent stretched from about $245 per month in 2019, to $400 per month in the third quarter of last year. Since that point, lower-tier rents have begun to catch up to the market. Class C rates grew by the fastest pace among segments over the past nine months, at 4.9 percent. Still, as of June 2023, they maintained a $340 monthly discount on average to Class B counterparts.

Higher Expenses a Top Consideration for Operators and Developers

Divergent rent and expense growth paths impact operations. After the average effective rent rose at nearly twice the pace of expenses during the yearlong period ending in June 2022, those trends inverted over the following 12 months. Operational costs grew by 8.6 percent on average year-over-year in the second quarter of 2023, as persistent inflationary pressures drove up expenses from multiple directions. Turnover, marketing and insurance costs each rose by more than 10 percent year-over-year, while administrative, taxes, management and payroll also grew more than 7 percent. The pace of expense growth has, however, begun to taper after peaking at the end of last year..

Insurance hikes prevalent across the country. Increasing by 33 percent year-over-year on average in the second quarter of 2023, insurance costs per unit have been the primary catalyst for expense growth. This is impacting operations at existing apartments, as well as influencing construction. Higher debt costs, coupled with rapid insurance hikes, have stalled a few project proposals and created delays at build sites. Some developers may shorten hold times upon completion to tap cash, after unexpected cost adjustments strained budgets.

Natural disaster-prone metros command costly insurance. Seasonal hurricane risk, susceptibility to floods and earthquakes among other natural disasters, have historically made apartments in certain markets more expensive to insure. This has become particularly visible over the past year. The six major Florida metros each saw insurance costs rise at a faster pace than the national mean over the past 12 months. Insurance rates per unit in these Florida markets exceeded the overall U.S. metric by $35 to $175 on average in the second quarter of 2023. Other locations with notable insurance hikes over the past year include Kansas City, Oakland, Orange County and Phoenix

Midwest and select Sun Belt markets enjoy lower premiums. Insurance costs per unit rose by less than 10 percent year-over-year on average in just five major U.S. markets as of the second quarter of 2023. This grouping included Columbus, Detroit, Milwaukee, Pittsburgh and St. Louis. Other metros like Charlotte, Las Vegas, Raleigh and Reno, meanwhile, had relatively mild adjustments and remained among the 10 lowest major markets for insurance costs per unit. Some developers and investors may shift their attention to these locations.

2023 INVESTMENT OUTLOOK

• Mild buy-side competition helps some recently priced-out investors. Multifamily deal-making has been challenged for several quarters as many investors went to the sidelines amid financing hurdles and misaligned buyer/seller expectations. First half 2023 multifamily deal flow was down about 32 percent from the equivalent trailing-decade average. Some private investors, however, are seizing a window of opportunity amid reduced buyer-side competition. Assets priced between $1 and $10 million comprised roughly 76 percent of trades during this year’s first half, up from 71 percent last year

• Buyers and sellers are moving toward alignment. Cap rates have been rising as sale prices inch down, reflecting an investment market that is adjusting after a span of uncertainty. Apartments changed hands with a per-unit price of $196,100 on average during the 12-month period ending in June 2023, down about 5 percent from the full-year 2022 recording. The mean cap rate, meanwhile, rose to 5.4 percent, the highest mark since 2018.

• • Investors reassess, may look to diversify. Supply pressure, insurance hikes and localized economic headwinds could prompt some portfolio repositioning. Investors that enjoyed robust appreciation over the past decade, particularly in secondary and tertiary Sun Belt metros that performed exceptionally well during the pandemic, may opt to diversify into other markets as those locations face some near-term uncertainty. Prices held sturdier, or increased, during the first half of 2023 in several Midwest and mid-Atlantic metros.

Potential Soft Landing and Tempered Financing Costs Bode Well, but Broad Lending Challenges Persist

Federal Reserve resumes rate hikes after brief hiatus. The Federal Open Market Committee raised the benchmark lending rate by 25 basis points at its July meeting to a lower bound of 5.25 percent, marking the 11th increase since March 2022. This follows a pause in June, as the central bank took time to assess the cumulative economic impact of their monetary policy decisions so far. Although interest rates are at their highest level in over two decades, some encouraging signs may indicate that the Federal Reserve will take a more measured approach at its September meeting and beyond. Headline CPI inflation rose by 3.2 percent annually in July 2023, down from 8.5 percent growth in the same month of last year. The Fed’s preferred measure, Core PCE, recorded a 0.2 percent monthly gain in June and again in July, the smallest increase over a two-month stretch since late 2020. Meanwhile, the nation’s labor market has been resilient amid the Fed’s efforts to combat inflation, increasing the likelihood that the economy could be slowing to a soft landing. The U.S. added more than 1.8 million jobs through the first seven months of this year, keeping unemployment historically tight at 3.5 percent. As Core PCE inflation, at 4.2 percent year-over-year in July, moves closer to the central bank’s target rate of 2 percent, the need for future rate increases becomes less certain. The FOMC has committed to making data-dependent assessments at future meetings to determine if additional rate hikes will be necessary. This may provide greater rate stability moving forward, and could help lenders and investors become more closely aligned with the current state of capital markets. At the same time, the potential for U.S. banks’ credit rating to be downgraded could lead financiers to widen spreads near-term.

Financing remains choppy, but potential stability could help alleviate hurdles. The apartment sector’s comparatively low cap rates, in relation to other commercial real estate asset classes, have created pronounced challenges amid interest rate hikes. These obstacles were exacerbated by several bank seizures earlier this year and corresponding liquidity constraints, adding headwinds to an already conservative lending climate. Loan-to-value ratios have typically been in the 55 to 65 percent range early in the third quarter of 2023, occasionally nearing 70 percent in markets with higher cap rates. Agency financiers have been the most steadily active in recent months; while banks and credit unions are engaged, but often require significant recourse, as well as shorter amortization periods. Meanwhile, CMBS lenders are quoting rates about 100 basis points higher — in the mid-6 percent range — and have not been very competitive in recent months. Mezzanine debt and bridge financing options are starting to come into play for assets facing cash flow challenges, particularly for operators of value-add strategies that took on large debt and are falling short of NOI projections. As the market begins to absorb cap rate and valuation adjustments, these complications should subside. Interest rates are expected to be more stable in the second half of 2023 as well, although the Fed has indicated that rate cuts may not be on the near-term agenda.

Denver Office:

Adam Lewis Vice President, Regional Manager

Tel: (303) 328-2000 | adam.lewis@marcusmillichap.com

Prepared and Edited By:

Benjamin Kunde Research Analyst | Research Services

For Information on national multifamily trends, contact:

John Chang Senior Vice President, National Director | Research Services

Tel: (602) 707-9700 | john.chang@marcusmillichap.com

The information contained in this report was obtained from sources deemed to be reliable. Every effort was made to obtain accurate and complete information; however, no representation, warranty or guarantee, express or implied, may be made as to the accuracy or reliability of the information contained herein. Note: Metro-level employment growth is calculated based on the last month of the quarter/year. Sales data includes transactions sold for $1 million or greater unless otherwise noted. This is not intended to be a forecast of future events and this is not a guaranty regarding a future event. This is not intended to provide specific investment advice and should not be considered as investment advice. Sources: Marcus & Millichap Research Services; Bureau of Labor Statistics; CoStar Group, Inc.; Real Capital Analytics; RealPage, Inc. © Marcus & Millichap 2021 | www.MarcusMillichap.com