Affordable Strategies Make Even More Sense Now

Angela Kelcher

The ongoing economic uncertainty caused by rising interest rates, inflation and looming recessionary fears have caused volatility and disruption in the overall real estate market. But maintaining perspective is essential. The short-term dislocation will resolve and provides an opportunity to assess long-term strategies. Challenging macroeconomic conditions and the pervasive supply-demand imbalance are factors causing CRE investors to pivot towards workforce and affordable housing.

The current market is difficult to navigate. In an effort to tame inflation, the Fed has increased interest rates rapidly over the past year. The good news is that historically we see that the faster rates go up, the faster they will go down, which suggests rate cuts in late-2023. But the bad news is that these actions increase the potential of a recession, further disrupting debt markets.

Interest rate volatility, in particular, is proving to be the most challenging factor today. While the debt markets remain liquid, many capital providers are underwriting more conservatively and factoring in recessionary and interest rate risks, which ultimately increases debt rates and reduces proceeds.

As the market digests the rate increases, the relationship between the cost of debt and cap rates are affecting overall valuations. Buyers must factor in these higher costs and lower leverage, as well as lower projections of future rent growth. In this period of price discovery, uncertainty breeds caution where some buyers have moved to the sidelines, and unless driven by a capital event, sellers are generally holding tight.

In the long-term, the market will adjust to higher rates. Most agree that the low-rate environment we experienced in 2020 and 2021 is an anomaly that we are unlikely to see again. As stability returns, deal flow will pick up. But with limited new construction in the pipeline, the supply/demand imbalance for affordable and workforce housing will continue for many years to come.

Housing affordability in the U.S. is at a new national low. Affordable rental options are extremely limited and home ownership is increasingly unattainable. The high-cost coastal markets like Los Angeles, San Francisco, New York City and Miami have been facing affordability issues for a very long time. But accelerated migration trends are playing an increasing role in causing affordable housing to be out of reach in markets that have historically been more affordable, such as Dallas-Ft. Worth, Phoenix, Salt Lake City and Orlando.

Getting supply on the ground is not easy. In fact, since the early 2010s, housing production has slowed. Construction activity had been picking up but delays in active construction projects have increased and new deliveries are expected to drop further in the coming years. Project feasibility is harder to achieve as inflation has caused construction costs to accelerate in 2022 alongside rising labor and land prices, cumbersome entitlement processes and escalating operating costs. The liquidity compression has also hit the development sector with market rate units drying up, causing continued strain on all income levels for housing supply. As development of conventional assets slows, any future “trickle down” supply is in danger.

Preserving existing supply is equally challenging as steady rent growth has made pushing rents and realizing gains a solid strategy. Older properties are either replaced with new ground up Class A product, or value-add upgrades are made. Federal programs and state and local incentives are available but aren’t sufficient to meet the demand.

But there is a silver lining. Despite the short-term disruption and volatility, the long-term outlook for investors and owners is bright and remains quite strong because of the supply-demand imbalance in the industry.

The affordable segment performs well. Even through the pandemic, we saw strong collections at affordable properties. Tenants generally prioritized rent, knowing that options for quality affordable housing were limited.

Rent growth trends also remain strong and affordable properties experience greater resiliency in downturns. This is especially true in markets where there is a significant rent advantage or discount to comparable market rents.

State and local programs to incentivize or require affordability components in projects are increasingly making public-private partnerships worth pursuing to fill a budget gap. This can be done through land banks, tax abatements or with socially motivated capital.

The Federal Housing Finance Agency has expanded the requirements of the GSEs to support the affordable housing market. In 2023, FHFA will require 50 percent of production be mission-driven, with a new category to support preservation of affordable rents at workforce housing properties. So the agencies will continue to be an ever-present source of debt liquidity in this segment.

The potential upside of the shifting economic environment and declining construction starts is an easing of labor supply constraints, and the trend may even have an impact on construction costs as the year goes on.

As we enter the second quarter of 2023, the economy will continue to present a mixed picture with rising interest rates, albeit slower than 2022, and the potential for a recession. Outsized demand, robust rental rate growth and limited supply are an ongoing and long-term opportunity for investors.

Angela Kelcher is a senior managing director in the Dallas office of JLL Capital Markets, Americas, focusing on affordable multi-housing.