Real Estate Cash Flows Looking Better Given Equity Market Volatility; Asset Bubble Risks Remain

The Equity Markets are Real again! Observing the action in the equity markets the past few days has become exciting and real again. As a former 12-year long dedicated sell-side equities analyst (in what now seems like a past life), watching this multi-year meltup where stocks go up and up and up almost every single day has not felt like a real market to me. I'm not calling the end of the cycle, or that stocks will crash from here, but asset prices are very high (in equities and real estate) and the higher equities climb the riskier and riskier they get. It seems when everything is going swimmingly, investors feel invincible, and that is when complacency and thus risk become highest.

Multifamily workforce housing cash flows now feel 'safe'. Fortunately for my investors and I, we have focused on buying, owning, and renovating workforce housing oriented multifamily properties where cash flows are more or less predictable, and to some extent 'safe'. We own properties where rents are $600-$900 per month (average). Here, our Tenant Customers work regular jobs, earn regular incomes (median household income of $35,000-$60,000), and will not be as susceptible to an asset bubble correction as those renters paying $1,400-$2,000 per month in regular cities like Dallas, Houston, Orlando, or Charlotte might be. The opportunity to downgrade one's living situation from an $800 monthly rent bill is limited, and often times not worth the hassle of relocating, reconnecting utilities, and moving into a worse apartment unit just to save $100 per month in rent. That's a key reality of owning workforce housing multifamily apartments. With our multifamily properties we target Year 1, 2, 3, and 4 cash-on-cash yields to equity investors of 8%, 9%, 10%, and 11%, respectively, assuming 70%-75% loan-to-value mortgages and no interest-only payments. At our purchase prices, these investor yields are somewhat predictable. We may own for the long-term where yields will improve over time, or we may sell a property at a price that is attractive, and with appreciation and capital gains substantially improving our overall cash flow yield metrics.

VIX volatility index shows the markets are somewhat spooked, or at least jolted out of a slumber. Looking below we see the VIX volatility index (also knows as the Fear Index) has gapped up to multi-year highs, and jolted many out of their meltup-induced slumber. This suggests that, compared to 2015-2017, more volatility remains ahead. This is consistent with our view that the higher asset prices climb (into asset bubble territory) the more risks exist.

Figure 1. VIX Spike Shows Equity Investors Jolted out of Meltup-Induced Slumber

Source: Stockcharts.com

Figure 2. Cryptocurrency Selloff Suggests Asset Price Bubble May Have Popped (for Now)

Source: Coindesk.com

Underlying economic fundamentals still strong, but nothing lasts forever and self-fulfilling prophecies sometimes occur. We are not saying the US or world is immediately heading into a slowdown or a recession. Indeed, underlying fundamentals are strong with employment trends robust, wages beginning to slowly rise (though having lagged for years), higher home prices and the stock market driving a wealth effect, and now with Trump's tax cuts putting more money into the pockets of Blue Collar workers, and allowing US corporations to onshore significant amounts of cash. However, we would note that this has been a particularly long economic expansion by historical standards, and that no upcycle lasts forever. Furthermore, the Fed is raising interest rates somewhat aggressively at the same time as they are now pursuing Reverse Quantitative Easing and selling off their balance sheet assets (albeit very slowly). Finally, we would note that stock market action can become a self-fulfilling prophecy as corporations look at stock prices as a signal, and a steep selloff can cause C-Level executives to take actions like implementing a hiring freeze, limiting corporate travel, downsizing investment or capital expenditure plans, and so on...all of which serve to actually slow the economy. So, while fundamentals remain strong today, factors are at work that could reverse this, and no cycle lasts forever!

Lots of Multifamily Metrics are Available, So Let's Review

Multifamily data galore. Over the past few weeks seemingly every major brokerage firm has published their 2017 or 4Q17 multifamily market review. A lot of it is very helpful data helps us focus on key trends as we navigate our path forward. We did not create this research, and we tip our cap to the data driven people that did create this useful information from many sources including sales transaction data, Costar data, Axiometrics data, and other sources. Here is some of what we find most interesting:

Figure 3. The S&P 500 Has Appreciated Even More than Commercial Real Estate...Off of 2012 Levels (not 2009 Levels)

The S&P 500 has returned even more strongly than Commercial Real Estate since 2012, with both of these assets far outpacing Home Price Growth or inflation.

Source: Integra Realty Resources

Figure 4. Multifamily Cap-Rates vs. 10-Year Treasury has Compressed to Nearly Prior Peak Levels...Suggesting Apartment Properties are Priced Above Average

We look at this spread as a measure of how expensive multifamily apartment properties are as compared to their underlying cost of capital (10-year Treasuries). While not as compressed of a spread as during peak levels of 1992, or 2005-2006, clearly multifamily properties are more expensive than during most of the past 10 years, and even during most of the 1990s, on a relative basis.

Source: Marcus & Millichap

Figure 5. Multifamily Prices Per Door Have Grown Tremendously, Especially in Major Markets

Here we see that average multifamily prices per door have risen about 55% overall since the 2008-2009 trough, with a 75% rise for major markets, and a roughly 50% rise for non-major markets. This is substantial per door appreciation for an eight to nine year period and suggests future price appreciation will be limited.

Source: NKF and Real Capital Analytics

Figure 6. Cap-Rates by Market are finally Bottoming as Interest Rates have Risen

Here we see that overall multifamily Cap-Rates are finally bottoming as interest rates have risen. By market, we see that Primary market Cap-Rates (Manhattan, San Francisco, LA, Miami), are averaging around 5%, while Secondary markets are trending closer to 6%, and Tertiary markets are closer to 6.5%. It seems Tertiary market yields have compressed meaningfully and may no longer offer an advantage versus Secondary markets.

Source: Marcus & Millichap

Figure 7. Multifamily Vacancy Rates and Rent Growth by Class Shows Class B Likely to Outperform in 2018

Here we see that overall multifamily Vacancy rates are better than the long-term average of 7%, with Class A Vacancies about 6.75%, while Class B & C Vacancies are about 5%, give or take. Regarding Rental Rate growth, while Class A has outperformed strongly over the last 15 years as affluence has risen and the wage/income gap have widened, we see that Class B Rental Rates are likely to grow most strongly in 2018. This is likely because Class A apartments are already very expensive and don't have much room to increase, while that is not true of Class B apartments as they close the fab somewhat.

Source: Marcus & Millichap

Figure 8. Multifamily Supply Growth Likely to Outpace Absorption, Suggesting Rental Rates Could be Pressured in 2018

Here we see Marcus & Millichap estimating that Multifamily supply growth in 2018 will outpace absorption (demand growth) for the second year in a row. While inflation in general is an offset, we think this could pressure rental rates somewhat, particularly in Class A apartments were rental rates are already very high. With lower Rental Rates, Class B & C apartments seem to be less at risk here (there is little new supply of these apartments).

Source: Marcus & Millichap

Figure 9. 2017 City-by-City Transaction Volume shows Dallas, Atlanta, LA, Denver Overtaking Manhattan

We knew Dallas was on fire, but 60% greater transaction volume versus Manhattan in 2017? This surprises us. We see that Atlanta, LA, and Denver also had transaction volume ahead of Manhattan in 2017. This data suggests that Primary Market buyers, and foreign buyers, are likely looking for yield and appreciation in some of these strongly growing markets (Dallas, Denver, Seattle, Austin, Phoenix, Orlando).

Source: Marcus & Millichap

Figure 10. Some Cities Expected to Have Greater Absorption than New Supply

Here we see a list of Cities where 2018 supply growth is expected to be less than absorption. The most observable under-supply situations (driving higher rental rates and lower concessions) are seen in Houston and the New York metro market. The third biggest spread is in Pittsburgh (what? I guess nobody has been building in Pittsburgh for a long time). Other growth oriented cities that we underwrite a lot like Phoenix, Orlando, Tampa, Jacksonville, Vegas, and Columbus also make the list.

Source: NKF and Axiometrics

Figure 11. Employment Growth Leaders Include Dallas, Raleigh, Orlando, San Antonio, Nashville, Vegas

Here we see a list of cities where that had the strongest employment growth in 2017 (top graph), including the standout performer Dallas, as well as Raleigh, Orlando, Riverside, San Antonio, Nashville, and Las Vegas.

In the second graph below, we see Cities that have the strongest employment growth and the lowest overall unemployment rates, with many of these same cities making the list, including Dallas, San Antonio, Orlando, and Nashville, among others.

Source: US Bureau of Labor Statistics and CBRE Research

Figure 12. Overall Data Suggests Houston is Early in its Recovery, while Washington DC is Seeing Hyper Supply Growth

Below, we see some conclusions from Integra Realty Resources that suggest that Houston is early in its recovery, relatively speaking, as oil prices rebound, supply is tighter post-Harvey, and new construction is limited. Washington DC, on the other hand, is seeing rapid supply growth, with other major cities in between.

Source: Integra Realty Resources

Net Conclusions: The Multifamily Apartment space is still reasonably healthy, though could see some pressure on rental rate growth in 2018, particularly in Class A apartments as new supply exceeds absorption. That said, predictable and stable cash-on-cash yields in Class B/C Apartments seem attractive versus equity markets that feel priced to the moon and now showing signs of extreme volatility.

Actively Fundraising on Two Attractive Deals

Avid Realty Partners is actively fundraising for what we think are two very attractive deals. One is a new construction Hotel project in a very fast growing suburb of Denver, Colorado. The second is an attractive class B value-add Multifamily property located in a major metro market in Texas.  We are always on the lookout for well-capitalized Equity partners to work with as Limited Partners, or even on a co-JV basis if it makes sense. We are focused on creating tremendous Customer Experiences, realizing robust cash-on-cash yields, and managing risk at all levels of the Project and throughout our organization. Please Contact Us Here if you are interested in discussing either of these opportunities further. 

About Avid Realty Partners

At Avid Realty Partners our passion is owning Multifamily Apartments and Hotels that deliver the best possible Customer Experience, while generating robust risk-managed returns to our Investors. In Multifamily apartments, we focus on Class B/C value-add properties in growth markets around the country where we proudly bring enhanced unit upgrades and property renovations to our Residents, improving their Quality of Life metrics. In Hotels, we build or buy properties that deliver everything that our Guests deserve, and more than they expect. We are proud of the hard work and results that our Team delivers everyday on behalf of our Customers and our Investors.