2019 Real Estate & Construction Trends: Which Classes & Markets Are Poised for Growth?

2019 Real Estate & Construction Trends: Which Classes & Markets Are Poised for Growth?

5 min read
Phil McAlister

Phil is the founder of The Macro Meets Real Estate Newsletter, a refreshing and entertaining take on real estate investing and financial markets.

A Chicago-area native and real estate investor, Phil’s career has spanned investment banking, commercial lending, and real estate, with extensive transaction experience from multiple sides of a deal.

Experience

Working for a large national sponsor, Phil has been in charge of the underwriting, financial modeling, and valuation of over $6 billion in commercial real estate, including multifamily, medical office, self-storage, hospitality, and senior housing assets. Phil leads a team in evaluating commercial real estate deals nationwide and across multiple strategies including core, core-plus, and value-add, with an occasional ground-up development sprinkled in.

Phil is also involved in evaluating and negotiating multi-million dollar joint ventures with various strategic partners. In addition, Phil has been tasked with evaluating projects in Qualified Opportunity Zones, a new and exciting frontier in commercial real estate.

Phil’s passions include family, football, American history, and real estate investing, in that order. Phil resides in Naperville, Ill., with his wife Kristin and three (sometimes) perfect children, Anna, Ryan and Charlie.

Phil holds a bachelor’s degree in finance and economics from Elmhurst College.

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I’ve been spending increasing amounts of time lately learning about new asset classes. I’ve had the opportunity to work on some exciting new deals, ranging from joint venture hotel developments in opportunity zones to independent living, assisted living, and memory care senior housing assets.

We’ve also done some massive storage portfolios. Still, multifamily investing is the core of the business. But it’s been a while since I’ve put some serious thought into what really butters the bread.

Observations on the Market

As I survey the current landscape and look back at my notes and research reports from the past several years, several themes start to emerge. It has been a few years running now that some very smart, real estate-focused economists have been predicting that the new supply hitting the apartment market would overwhelm demand. They thought we’d start to see slowing rent growth and an uptick in vacancy.

So, why haven’t we seen this yet?

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Multifamily Real Estate New Construction: Trends in Supply vs. Demand

Starting on the supply side, it’s true that there’s been a wave of new units coming online. That looks to continue in the near future. Certain markets like Boston, Charlotte, and Jacksonville have pipelines representing a pretty hefty fraction of the overall inventory. But there are a few factors limiting the impact of this new supply.

Builders are experiencing high land costs and exploding construction costs, both on materials and labor inputs. This means that they have to build to a very high spec and attract high-income renters. They’ve also got to deal with land use restrictions and municipalities that can gum up the works.

Related: Is Airbnb Really Ruining Rental Markets?

Single Family New Construction: Trends in Supply vs. Demand

On the single family construction front, we are still running far below historical levels. Homes that are being built are again at very high price points and in expensive locations. You’ve got almost nothing being built that is targeting renters or buyers with incomes below a fairly high threshold. Existing homes aren’t hitting the market either, because the current owners don’t have the means to move into bigger and better locations.

This leads us to the demand side of the equation. I’m not a believer in the theory that there’s been a long-term paradigm shift in people’s living preferences. People want to own homes; they just can’t.

I believe there is a significant amount of pent-up demand for home ownership that isn’t being expressed due to lack of product at the appropriate price point. This is why we continue to see absorption of new multifamily units rising to meet or exceed the growing supply.

So, what we have is continued rental demand from people who’d prefer to buy. If (and that is a big IF) they get the opportunity, that rental demand will evaporate in favor of for-sale housing.

Current State of the Economy

On the macroeconomic front, job growth is slowing and manufacturing and auto sales are weakening. In addition, there are potential headwinds to economic growth from a geopolitical perspective, including a reduction in immigration and worsening trade wars.

As building high-end apartments becomes less and less economical and it gets harder to justify sky high rents, developers may shift to the neglected for-sale development sector. We should keep a close eye on single family housing starts and condo developments as the natural threats to capture the pent-up demand. I don’t see class B apartment development as a real threat, as these deals won’t pencil out for the developer given the costs.

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A Multifamily Investing Strategy Tailored to Today’s Economy

Looking forward at how to continue succeeding in the multifamily space, the word that comes to mind is “surgical.” Over the next 10 or even 20 years, which markets, sub-markets, and asset types are poised to hold up best? I truly believe winners and losers will be selected on a deal-by-deal basis. Who can do all of the small things right?

One long-term trend that I don’t see reversing is the domestic migration patterns we are seeing. People are generally moving away from the West Coast, Northeast, and Chicago in favor of markets in the Southeast and Southwest.

If you’ve got a home in San Jose that you bought for $400K and is now worth $800K, you could sell, take your $400K in equity, and buy a huge and beautiful home in Las Vegas or Phoenix, free and clear. And you’d probably have a nice little chunk of change left in the bank. Your cost of living would be reduced drastically, while your income and property tax burden is slashed. It’s a no-brainer.

Chicago is mired in debt from which there is no escape; taxes are going up and they’ll continue to get worse. Anecdotally, a large percentage of the young and fairly successful people I know here in the Chicago area are at least considering the idea of leaving for greener pastures. Maybe Nashville will finally start to get some good pizza!

And pretty soon, North Carolina will just be called New York South.

We need to be in cities where this long-term trend is in place. Places like Charlotte, Austin, Dallas, Las Vegas, Phoenix, Atlanta, Orlando, Tampa, and Nashville should continue to benefit disproportionately.

Related: Why Demand for Rentals Will Likely Rise in 2019

Which Is Best: Class A, B, or C?

My first instinct would be to think that we want to be in the assets where the disappearance of high-income renter demand won’t be felt—workforce housing, class B/C value-add, etc.

However, cap rates for B and C product have compressed drastically. The spread between class A and B cap rates has historically been much wider than it is today. We see a lot of value-add deals that are trading below a 5 percent cap on T12. In other words, buyers are putting most of the value creation into the purchase price.

On a risk-adjusted basis, buying a class A deal at a 5 percent cap may be better than a class B deal on a pro forma cap rate of 5.25 percent or 5.5 percent. There is a lot of execution risk in achieving that cap rate, and you’ve given a big chunk of the value to the seller up front.

But we certainly can’t buy class A at these exorbitant rents! So, we have to be surgical. We need to find ways to add more value than the other guy. Try to find specific assets in specific locations where you feel like you can create an edge. There will still be good deals available in class B and C value-add assets.

One intriguing idea is to buy what we call “A deals.” These are deals that are only four or five years old, but all of the new development has quickly surpassed them in terms of amenities, finishes, and price point. These deals could benefit from some updates but still rent well below the new product. They look like a great value option for renters who don’t want to pay up but also want a better product than class B.

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What are you seeing in the multifamily market?

Let’s discuss in the comment section below!

The multifamily real estate market continues to evolve and change. Investors who want to make money in the space will need to evolve with it, or go extinct. As I survey the current landscape and look back at my notes and research reports from the past several years, here are several themes that have emerged.