The US is the world’s best-established rented multifamily housing market, and the asset class has proved highly attractive to institutional capital in recent years. Dodge Carter, head of multifamily and student housing investment strategies at Texas-based private equity funds management firm Crow Holdings Capital, and Ken Valach chief executive officer of related company, Trammell Crow Residential, which develops multifamily communities across the US, discuss how investors can access the right assets in the sector.
PERE: What factors are driving demand for the multifamily housing sector in the US?
Ken Valach: At the moment single family completions are around one million a year and multifamily completions are around 350,000. Add in some condos and that equates to 1.4 million housing units we are producing in the US. Household formation should be in the 1.4 to 1.7 million range before you take into account the obsolete stock that is torn down, so if anything the housing market is undersupplied. Prior to the global financial crisis, the country was producing well over two million housing units a year.
Dodge Carter: The financial crisis was caused by abnormally high home ownership percentages and over-leverage, and since then about 10 million people have left single family homes to go into the rented apartment sector. Meanwhile demographics are changing with people putting off getting married and having kids until later in life, and the millennial generation has a propensity to rent because they want flexibility and they like the sense of community that living in a multifamily development gives them. Those factors have produced a tremendous focus on developing in-town, high amenity apartment communities in recent years.
PERE: How has that impacted investor appetite for the asset class?
DC: Both domestic and overseas investors have focused their capital on multifamily investment because it produces a very predictable income stream. If you lose a major tenant in an office building you could easily be losing a large chunk of your income, but in an apartment community you might have 350 leases, so losing a few of those is not going to affect the bottom line. Since the crisis weighting to multifamily in our own diversified funds has been around 50 percent, compared with 20 to 30 percent before. As an institutional investment class, the sector has experienced a paradigm shift and together with where we are in the real estate cycle that has led to a market that is practically “priced to perfection”. It is very difficult to find an investment opportunity that is not priced as it should be, and so it is challenging to find opportunistic deals. You have to create your own value. Yields across the
risk spectrum have compressed about 200 basis points since the financial crisis. Cap rates for core assets are around 4 to 5.5 percent in major markets, maybe below 4 percent for new product in hot markets like Seattle. With some debt core returns have come in to 5.5 to 6.5 percent.
PERE: So how can institutional investors maximize their returns in the sector?
KV: The answer is to develop. By developing you are getting another 150, and maybe even 200 to 250 basis point of yield, but you have timing risk. Even in the sun belt markets it will take two to three years to complete a development, so the risk is what the rents will be when the development is stabilized. and you cannot know what rents will be then. Meanwhile construction prices are rising so replacement costs are increasing.
DC: You can still manufacture income growth and create value-add returns by buying a well-located older property next to a new development where rents are $500 a month cheaper, then refurbishing it to make it like new, but still at a discount to its newer neighbor. However, today any multifamily asset that is five years old or newer in the majority of markets is selling at or above replacement cost, so development provides the greatest opportunity for value growth. Investors are most likely to access the market through a commingled or separate account fund working directly with a developer, or through investing in a public vehicle like a residential REIT. To deliver successfully in today’s market developers need a strong track record though, because pricing is high, and it is difficult to get entitlements [planning permissions]. As an investor you need to find the right sponsor with which to invest. When I am looking to partner with a developer I am looking for best in class in a particular locality with boots on the ground.
KV: As a developer you can’t be in all markets being all things to all people. You need to make a substantial investment in a market to operate in it. You need to know the entitlements process, the building officials, the best architects and the subcontractor base. Accessing development finance is a little bit easier this year than it was over the preceding two years. The banks are now actively lending if you are a solid developer. The equity is also there for well-located, well-conceived multifamily products, although it isn’t like 2006-7, thank goodness. People are doing their underwriting prudently.
DC: The asset type and geography you invest in will be dependent upon your return expectations. In the US there are 25 major markets. If you are looking for core returns you are going to be in the top 5 markets: New York, San Francisco, Boston, Chicago, and Los Angeles. As you go up the return spectrum into core plus and value-add you are going to be investing more in markets six through 25 on that list because you cannot generate the returns you need in the core markets. That is what we do in our value-add commingled fund. When deciding which of those markets to invest in, we focus on whether they have good job and population growth, good transport links, and are favored by institutional capital, both debt and equity.
PERE: Can investors still expect rental and cap rate growth?
KV: Rental growth overall has slowed, but starts and permits are trending down, and if you look at the demographics and the pricing of single family ownership housing it looks pretty good for rental increases in most markets. Rental growth is 3 percent now, but if the economy stays strong then looking out to 2020-22 it could easily be back to 5 to 7 percent in a lot of markets.
DC: I am not expecting any decline in values, but I do see capital growth opportunities becoming thinner.
KV: Barring a recession, we think the market will be about the same in a year’s time, probably marginally better. Over five to seven years we fully expect the market to go through some form of cycle, but overall the prospects for multifamily are pretty darn positive. It gives you steady income and solid appreciation while playing almost all the demographic trends. We have an expression: “heads on beds.” Going into the financial crisis we had 100 multifamily properties but even through that period almost all of them were full and generating a good yield.
DC: We are having more conversations with new international investors than we have ever had, and a lot of that has to do with their appetite for multifamily investments. It used to be a very domestic market, but going forward over the next five years we are going to experience increased investor appetite for domestic US multifamily investment.
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This overview is designed to introduce Crow Holdings and its various operating companies. Crow Holdings Capital is a U.S. SEC registered investment adviser and is the manager to the Crow Holdings Capital Funds. Maple Capital Management, L.L.C. is a U.S. SEC registered investment adviser and is the manager of the Crow Holdings Industrial Build-to-Hold Fund. Crow Holdings Capital, Trammell Crow Residential, Crow Holdings Industrial and Crow Holdings Office are operated separately and independently from one another with separate senior leadership and investment committees. SEC registration does not imply a certain level of skill or training.