Current Economic Landscape

The general economic sentiment is bearish. Record high inflation drove the Federal Reserve to significantly raise interest rates, making the relative purchasing power of the average American lower. The war in Ukraine, supply ripples from the COVID Pandemic, and years of quantitative easing sent materials, labor, and just about everything else into volatile upward price swings. The stock market, which holds much of the nation’s collective retirement and investment savings is down. People across America fear recession and financial ruin, with memories of hardship from the 2008 Financial Crisis.

Unfortunately, I can’t reject these fears. They are valid. Trillions of dollars in cash and credit may disappear over the coming quarters and investors may lose life savings. It is a possibility.

We can’t know for sure what will happen to the stock market or property values in the coming months. What we do know for sure is that the basic human need for shelter will not go away.

Housing Shortage

In the most simple of words, people need housing and there are not enough homes. According to the National Association of Realtors, the United States is short 5.5 million homes and builders are only delivering 1.5 million housing units per year. If population and construction speed were held constant, this would be a 4 year problem. However, with the U.S. population expected to grow 23 million by 2030 per the U.S. Census Bureau, and with the cost of construction growing exponentially, we are really looking at a 5-10 year supply shortage.

Rent Growth

In addition to a supply-demand imbalance causing upward pressures in the housing market, the demand for hard assets with a built-in inflation hedge is growing. Private investors and institutions alike are sitting atop massive capital gains from over a decade of economic growth, and 40-year record high inflation is eroding this purchasing power. Investors are desperate to buy assets that will keep up with inflation, and multifamily real estate offers that due to the effects of rent growth.

Apartment investors are very good at closing supply-demand gaps by adjusting rental rates to create equilibrium. If the demand for housing units is high relative to the supply, landlords will increase rents. Given the housing shortage, rents are increasing at a rate higher than inflation (Zillow Housing Data). Some markets, such as New York, Tampa, Miami, Phoenix, and Tucson have experienced rent growth up to four times the rate of inflation.

When rents increase, so do property values. Multifamily property values are determined by Net Operating Income (NOI), which gets divided by a market and asset-specific capitalization rate (cap rate) to derive value:

Property Value (PV) = Net Operating Income (NOI) / Capitalization Rate (Cap Rate)

If both revenues and expenses are increasing at the same rate, which is unlikely because rents generally outpace inflation, NOI will increase because operating expenses for apartment buildings are typically 50%+ lower than revenues. A 5% growth on $1 million of rent is a $50k change. A 5% growth on $500k of expenses is only a $25k change. Thus, NOI increases and therefore value increases. The below table summarizes this point:

Most likely, rents will increase at a higher rate than expenses, resulting in property values growing at a higher rate than rent growth:

Cap Rate Compression

When there is high competition for multifamily properties, prices increase, which compresses capitalization rates, resulting in property values that grow at significantly higher rates than inflation:

This last scenario is optimistic, but possible given the opportunity cost. Investors have a choice:

1. Invest in equities, which are subject to high volatility and unlimited downside

2. Invest in fixed-income assets, which are currently returning negative real rates when adjusted for inflation

3. Hold cash, which devalues at a high rate

4. Buy real estate, which may experience near-term volatility, but has historically outperformed equities on a risk-adjusted basis, has a built-in inflation hedge via rent increases, allows the use of leverage, and provides an unparalleled tax shield.

Final Thoughts

The Fed is going to continue raising rates. However, this is a response to out of control inflation. While inflation is high, property values are likely to continue increasing. Combined with a massive shortage of housing, the search for yield, and a volatile stock market, multifamily real estate is very attractive and may weather a recessionary period the best.