Apartments have been a powerhouse investment in the current economic cycle. Nationally, the average price per unit across the United States increased from a low of under $70,000 per unit in 2009 to over $160,000 per unit today. The bulk of that increase in value has been captured by investors generating massive returns across the board. But despite increasing rents and net operating income, cap rates have also reached a cycle-low, reflecting extremely high pricing for new apartment acquisitions. Does that mean, however, that you can no longer make money investing in apartments? Not exactly.
Rental rates are still increasing in most major markets. In fact, rent growth over the last twelve months in many major markets is still above any figure a prudent investor should feel comfortable underwriting. To illustrate the point, the following are examples of rent growth over the past year in markets Arcan tracks closely: Raleigh – 4.9%, Atlanta – 4.4%, Austin – 4.4%, Birmingham – 4.2%. These are not outliers. Provided rents continue increasing at this pace, you can still make money investing in apartments. But you better be right about your pre-acquisition assumptions about the future performance of the property.
With rents continuing to increase, we expect prices to increase as well. So why are investors starting to worry about pricing? The answer is complicated. Much of the reason is that prices are increasing (and cap rates decreasing) faster than rents and cash flow can match. That means that not only are investors accepting lower returns, but they also end up paying for potential future rent increases before the property begins to generate them. When you start buying future assumed increases instead of today’s actual income, trouble can follow quickly – especially when assumptions do not pan out.
As the market continues to outperform, underwriting standards are continuing to get more and more lax. Buyer behavior is getting more aggressive as more buyers are offering non-refundable earnest money deposits to win deals and more are turning to higher leverage bridge loans to juice returns. This is similar behavior to what occurred over a decade ago, in the years just prior to the 2008-2009 financial crisis. We view the re-emergence of this behavior as a major warning sign.
Moreover, investors should keep in mind that July marked the longest economic expansion in U.S. history. We know that this expansion will not last forever, especially in light of the significant economic headwinds and geopolitical instability worldwide. If there is economic turmoil on the horizon, higher prices and aggressive behavior can result in lower rents, occupancy, returns and even foreclosures. These events will almost certainly be the catalyst to drive prices down across the multifamily market.
Despite the many risks in the market today, there remains a proven strategy to make money: buy for the long term. While any market can struggle in the short term, over a ten-year horizon, quality markets are given a better chance to perform. Interest rates remain historically low by almost any measure making loans particularly attractive. Moreover, many long-term trends favor apartment investment including, reduced homeownership rates and slower household formation, lack of single family home inventory and historically high home prices. We believe that these factors, among others, will continue to generate demand for apartment housing for years to come.
Ultimately, there are almost always good acquisitions available, they are simply getting more difficult to find. As the market cycle approaches its end, this trend should continue. If the U.S. economy experiences a serious slowdown or recession, we believe that many investors will struggle with performance. This is particularly true of the many overleveraged and underexperienced operators in the market today. Strategic buyers with a focus on long-term ownership, lower leverage and higher quality, will limit their downside risk while still benefiting if market growth continues. As the cycle reaches its end, we strongly believe that this style of investing will produce outstanding, risk-adjusted returns.
 “State of The US Apartment Market Update“. CoStar Q22019