Is Multifamily Too Hot?

At the recent ULI and NMHC meetings, if there was one question on everyone’s mind it was whether the market is becoming overheated.

At the recent ULI and NMHC meetings, if there was one question on everyone’s mind it was whether the market is becoming overheated. There are several reasons for investor exuberance over multifamily—demand is up, valuations and rents are rising, and vacancy rates are falling. But is it sustainable? To get an insider perspective, I consulted a couple of experienced investors, Jeff Allen, CEO of Raintree Partners in Southern California, and Sam Goldstein, CFO at the Galman Group in the Philadelphia area.

The short-term outlook is selectively positive

Both Jeff and Sam are bullish on the market—and Jeff ticked off a number of specific factors that lead him to be optimistic, at least over the short term. He noted that Gen Y is entering the marketplace, and that for the large cohort of recent immigrants, renting is still the rule. But he also pointed to “steady population growth at a time when there seems to be a cultural shift in attitudes towards renting.” In other words, they see multifamily demand drivers as a whole remaining very strong.

At the same time, both professionals pointed to individual submarkets where valuations may not be sustainable. Sam sees Center City Philadelphia, with its abundance of “meds and eds,” as an example of a market that has attracted an influx of buyers. “There’s less risk in multifamily than in other CRE sectors,” he says. “The result is that equity is chasing multifamily, and there are a lot of competitors from outside the area entering the field. All it takes is one bidder to drive up valuations.” Jeff pointed to micro-markets where caution is indicated for another reason: increases in supply may ultimately have a chilling effect on valuations. He cites North San Jose as a market with a lot of multifamily housing slated for development.

Interest rates are the wild card

The question as everyone knows is not will interest rates go up—but when and by how much. Will increases in NOI be able to support pricing? Sam doesn’t think interest rates will rise faster than inflation, but Jeff is not so sure that NOI growth will compensate for increased cap rates caused by rising interest rates. He notes that stagnating and shrinking real wages may make it difficult to duplicate the steady increase in rents we’ve seen over the past few years.

Regardless, both investors are committed to making the most of the low rates while they last. But they are minimizing risk by taking a selective approach to the market, focusing on assets at attractive values in rising markets, optimizing operating performance through conscientious management, and adding value though redevelopment and renovation.

Adding the agencies to the mix

Another important factor to consider going forward is the state of the multifamily debt markets. The low coupon rates that are fueling aggressive evaluations are also keeping the agencies’ competitors on the sidelines. The result is that Fannie Mae and Freddie Mac have been dominating the market, and they have been measured in the way they underwrite. When rates increase, these other debt providers will come back in. The increased competition that results will tend to keep valuations healthy, despite the chilling effect of higher rates.