What Makes Workforce Housing Such a Resilient Investment?
OneWall Communities' Nate Kline discusses supply and demand dynamics and the impacts of rising interest rates on this housing segment.
Workforce housing investments have been growing in popularity as the demand for more affordable housing options increases. These properties tend to be more resilient across market cycles, with lower default rates, more stable cash flows and less cap rate volatility when compared to other sectors, according to OneWall Communities CIO & Partner Nate Kline.
OneWall is an investor focused on transit-oriented workforce housing in the Northeast and Mid-Atlantic. Multi-Housing News interviewed Kline about the challenges and opportunities in the sector in light of the current lending environment.
How much have the Northeast and Mid-Atlantic workforce housing markets changed lately?
Kline: The biggest changes in these markets, and other housing markets around the country, are how COVID-19 changed demand patterns, driving people to the suburbs and different locations, and how COVID-19 policies and spending artificially inflated asset prices and rents at an even greater multiple of income growth than had been occurring prior to that.
On one hand, single-family home prices inflating faster than rents drove more demand to rentals and reinforced the inflation that was already happening in rentals because of the embedded supply-demand imbalance in the market. Now, with the sustained inflation and dramatic interest rate rising to combat it, spending power is eroding at the same time as financing costs are making inflated home prices even less affordable, either driving more people to rent or rent for longer.
We are now reaching the limit on rent affordability and, as a result, rents in some places will fall. Certainly, they cannot grow enough going forward to cover increased financing costs and without asset prices falling before they can rise again.
What can you tell us about the supply-demand dynamic in these regions when it comes to workforce housing?
Kline: It is unbridgeable. By that, I mean the current cost of new construction and time required for entitlements in high-demand locations makes it essentially impossible for developers to keep pace with the growing demand for naturally affordable rental housing. This is happening because capital isn’t available due to the economics not working and, even if they did, the pace of construction would not be able to supply the demand.
What markets in the Northeast and Mid-Atlantic regions stand out in terms of workforce housing investment potential? Are there any markets where you see limited potential in?
Kline: We like to be in or near densely populated employment centers with diverse economies and high-cost housing. Places such as Washington, D.C. and Philadelphia have always fit the bill as they have large percentages of government, medical and education employment, along with growing science and technology sectors. We see less potential in more rural locations that are more than 20 miles from population and employment centers.
You launched your Nova Appian strategy in 2013 to purchase and develop workforce housing properties in transit and lifestyle-oriented locations throughout the Northeast and the Mid-Atlantic. Has your focus changed after almost 10 years?
Kline: Other than expanding into additional markets and submarkets within our footprint, which was always intended, no, it hasn’t. When we started, we focused solely on Essex County, N.J., and radiated out from there as we grew. This led to other locations in New Jersey, Pennsylvania and Maryland. We now expect to enter Virginia, New York, Connecticut, Delaware, Rhode Island and Massachusetts when we can tie up deals that are well priced and fit our model.
How do you think the Treasury Department and Internal Revenue Service’s latest regulation on criteria for LIHTC qualification will impact the workforce housing market in these regions?
Kline: There is minimal overlap between our market-rate workforce housing targeting households earning within 60 to 120 percent of the area median income and LIHTC renters that typically max out at 60 percent of the AMI. In general, I think the goals of LIHTC reform are to promote more development and, in particular, serve more residents at the lower end of the AMI spectrum. This would offload some of the subsidy burden from the government to private developers and, if successful at driving enough volume, potentially increase the average incomes of market-rate workforce residents as voucher recipients, and low AMI renters would have more options. If this happens, it will also support more sustainable rent growth for market-rate workforce.
How can investors plot new deals in this high interest rate environment? What does OneWall Communities do?
Kline: Prices have to come down from where they have been to make financial sense and generate equivalent risk-adjusted yields to what the market has typically experienced. Otherwise, accepted return expectations must come down. We have seen a clear divergence in the bid and ask pricing for the last few months and the opportunistic sellers of three to 12 months ago are opting not to sell, leaving fewer realistic deals in the market.
We continue to rigorously underwrite as we always have and we are looking for sellers who have a need or a catalyst to sell and then require discounted pricing, financing contingencies and/or extra time to identify equity investors. We are also attracted to loan assumptions in this environment so that we can secure certain financing costs and bet on refinancing at normalized interest rates down the road.
Are there any new markets that you plan on entering in the next few years?
Kline: We plan to enter the additional states within our footprint as we scale and as long as our underwriting translates into attractive deals. The entire region has similar characteristics, such as unaffordable single-family housing relative to rentals and substantial demographic demand. We seek out pockets where value-add and core-plus business plans best support rent upside from income, population, employment and demographic change while maintaining affordability during our holding period and reserving some upside for a future owner.
What makes workforce housing a solid investment in the long run?
Kline: Outside of very low-income housing, it has the largest supply-demand imbalance, and we are consistently able to acquire assets for well below replacement cost. As a result, we enjoy sustainable rent growth, consistently high occupancy, ongoing upside from value-added renovations, significant mark-to-market rent cushion relative to newer or newly constructed apartments, limited competition and substantial downside protection. In addition, growing asset values and institutional interest in the sector have increased liquidity and buyer pools upon sale.