Arcan Capital Multifamily Update: Strategic Value
As we approach the first anniversary of the COVID-19 pandemic, the apartment market has very much recovered from the lows of last spring. What began with a dramatic fall in rental rates in March of 2020 resulted in what most would consider a very successful year in nearly all of the markets Arcan tracks. Overall, rents are up, and transactions bounced back in spectacular fashion in the second half of 2020. While collections and employment are still a concern, the apartment market appears to be moving on from the pandemic and the data indicates more good news is on the horizon. On the surface, the story is nothing short of excellent, all things considered. If you dig deeper, however, some concerns about the market arise. While Arcan is very bullish on the sector long-term, we think much of today’s market is overvalued and believe a very targeted approach to value investing is the best way to move forward.
Transactions
Transaction volume across the country collapsed in the second quarter of 2020 but rebounded in spectacular fashion at the end of the year. As a point of comparison, the Atlanta market had $2.6 billion in transaction volume in the fourth quarter of 2019. In the fourth quarter of 2020, this number ballooned to almost $4.0 billion (1). This incredible volume growth was a bit anomalous, as there were very few transactions in the prior two quarters. For example, in the second quarter of 2020 Atlanta recorded its lowest transaction volume since the first quarter of 2012. On an annual basis, transactions were down in 2020 but not nearly as much as expected after a massive fourth quarter in which Atlanta set a record for transaction volume. Notably, cap rates in Atlanta fell to below the national average, as attention on the market continues to drive additional investment and more aggressive pricing. While still very reasonably priced for a market of its size and caliber, Atlanta is no longer an inexpensive multifamily market.
Performance
The rebound in transaction volume is likely tied to two forces in the market that have both been positive. The first is rent growth and the second is interest rates. Rent growth was down substantially from the beginning of the pandemic through May of 2020 but bounced back. In Atlanta, for instance, annual rent growth was 4.6%. Annual rent growth is positive in every major market we track in the Southeast except for Nashville (-1.0%) and Orlando (-0.5%). The common theme of those markets is their reliance on tourism, which we expect will begin to rebound soon (2). This rent growth is a welcome surprise given the turmoil of 2020.
Another major factor is interest rates. In 2020, as the Federal Reserve eased the Fed funds rate and embarked on additional quantitative easing measures, interest rates plunged accordingly, which is a favorable move for apartments. Moreover, financing remains abundant and is primarily driven by Fannie Mae and Freddie Mac. Interest rates are priced based on spreads over treasuries. Therefore, when the 10-year T fell to as low as 0.50% in 2020, interest rates for apartment loans were in the high 2% range. That is astoundingly low and provides great leverage for assets even if buying at cap rates below 5%. As the 10-year T rallies (now 1.48%) and interest rates rise, more pressure will be on apartment prices to lower in order to maintain returns for investors. We believe we may have seen the bottom as far as interest rates go and if interest rates rise too much, value must come down.
Collections
There is no denying that COVID-19 changed the way businesses operated in 2020 and apartments were no exception. Beyond common area closures and procedural changes, the largest shift was in rent collections. The federal and various local eviction moratoria combined with inefficiencies in local municipalities have made evictions rare, even if technically permitted. Many properties have multiple residents in occupancy for over 6 months without paying rent and with no sign of being able to remove them. The inability to remove tenants is just as harmful to collections as the pandemic, maybe even more.
Rent collections across the country fell but were closer to keeping pace with 2019 than expected. That started to change as we approached year end. January 2021 collections were over 2.6% behind 2020 at (93.2% versus 95.8%) and the delta is increasing (3). This may not sound like a massive increase but make no mistake, a 2.6% lower collection figure is a 62% increase in delinquent rent across the country. Moreover, Arcan’s data reveals that this reduction in collections is not evenly distributed. Class C assets and below are far more likely to suffer from collections issues than Class A and B properties, so even while rents increase, they are collecting disproportionately less than they were prior to the pandemic.
In Summary
The multifamily market in early 2021 is complicated to say the least. Rents are increasing at a solid pace, leading investors to believe that they can continue value add programs and revenue growth which will increase value. Conversely, delinquency increased by 62% and is getting worse with evictions still very difficult to process. Financing is abundant and interest rates are compelling, creating positive leverage even as prices increase. Having said that, prices are extremely high and cap rates are falling. In Atlanta, for instance, cap rates have now fallen by an average of 240 basis points since 2010. We are in the midst of, or at the end of a very long and powerful performance by multifamily. How long it will last in anyone’s guess. Arcan feels the market has been overpriced for nearly two years and expected the COVID-19 situation to be the reckoning. Instead, multifamily is the darling of investors because it outperformed office, retail and hotels in 2020. Given the pricing and duration of the current cycle, Arcan is focused on value. Major renovation projects are getting harder to execute as returns shrink. There is very little margin for error in apartment investments and for that reason, Arcan remains strategic about where we can identify value. We are attracted to secure, performing assets with an opportunity to improve. Arcan is now even more selective when it comes to the location, demographics and asset condition. While our return expectations have come down, there is still a good opportunity to make money if you are careful and diligent. Larger returns will be back, but 2021 is a good time to be patient, focus on quality, and avoid bad investments.
1 Multi-Family Capital Markets Report, Atlanta - GA - CoStar
2 CoStar Analytics, Multi-Family Markets
3 National Multifamily Housing Council, NMHC Rent Payment Tracker