While most real estate asset classes have been impacted by the current recession, the multifamily sector as a whole thus far appears to have weathered the storm of this pandemic-induced crisis. In fact, investor appetite for apartments remains strong, with interest in Class B value-add communities particularly robust.
But why is Class B multifamily more resilient than its Class A and Class C counterparts? Below we examine the reasons Class B remains stable even in the face of one of the most unpredictable periods of our lifetimes.
COVID-19 pandemic creates disruption in the apartment market
Let’s start by taking a look at the challenges Class A and Class C multifamily have experienced in the current environment. Class A—or luxury, newly constructed multifamily—has struggled in two areas: occupancy and rental rate. In this uncertain economy, renters are simply being tighter with their checkbooks and reexamining the value that they’re getting for their dollar in the higher-priced communities. It’s also worth mentioning that Class A properties developed in the last decade were built with increasingly smaller individual floor plans while offering outsized community amenities. During much of the pandemic, many of these amenities have been taken offline, and with more people working from home, the smaller floor plans are starting to feel a little cramped. The result has been a softening in renter demand for Class A communities resulting in a decline in rental rates as operators seek to maintain their occupancy.
On the other end of the spectrum are Class C communities which are facing a different set of challenges as they remain well-occupied with consistent, and even growing, renter demand. However, a disproportionate percentage of residents that typically occupy Class C apartments work in some of the industries that have been hit hardest by the pandemic such as retail and hospitality. The result has been a noticeable decline in rent collections among this demographic, impacting Class C communities to a greater extent in this regard than other multifamily classes.
Situated between the above two asset classes are Class B communities. On the whole, Class B continues to attract a relatively financially stable renter base that’s employed and paying rent, so collections have been less of an issue here than in lower-class assets. Additionally, Class B communities have been attracting those residents who are gravitating away from the higher-end, (and more expensive) communities as they rethink their housing preferences and now seek more affordable and spacious housing options. The result is stable cash-on-cash returns with strong NOI growth for Class B communities.
All of this disruption caused by the pandemic has put Class B in the “sweet spot” of the three apartment classes.
A shift towards suburban living
An additional dynamic that is driving demand for Class B offerings is the shift towards suburban living where many of these communities reside. In many respects what this pandemic did was hyper-accelerate trends we were already experiencing in the multifamily space. Millennials had fueled much of the urban growth for the past 15 years. This renter demographic was once willing to pay more money for less square footage in an urban, new construction apartment where the city was their playground. But with restaurants and entertainment venues closed, and the current work-from-home trend, people are now more confined to their homes, which in the case of Class A, are often smaller apartments with shared elevators and corridors.
Over the past few years, however, as this demographic has matured and begun to marry and have children, there is a new emphasis on space and strong school districts. So we’d started to see a gradual shift away from urban apartments towards those in the suburbs even prior to the pandemic. Thanks to COVID-19, what was a gradual shift has now been placed in overdrive as the features that attracted this group to city living in the first place are no longer compelling for them in the current environment. The ability to “work from anywhere” coupled with the trend of Millennials hitting household formation age has put suburban housing top of mind and will help Class B stay resilient in this downturn.
New construction slowdown bolsters workforce housing
The apartment development boom that we’ve experienced over the past decade is expected to slow down considerably during this period. Projects that are currently in the pipeline and already being developed are now expected to lease-up more slowly and at potentially lower rental rates than originally projected.
With these forces at play, upgrades to Class B inventory will pay off in place of investments in Class A holdings. In fact, investing in basic pandemic-guided protocols around increased cleaning, enhanced customer service, safe social events, and more outdoor amenities are expected to go a long way toward driving demand. This is especially vital given the opportunity to attract Class A renters who are looking to spend less but are more accustomed to an amenity-rich lifestyle.
Strong investor appetite for Class B multifamily
Values for Class B apartments are at an all-time high right now as investors have taken note of the recent trends that are driving the strong performance in this asset class. Indeed, rent growth in the Class B space notably accelerated in the third and fourth quarters of 2020. That strong operational performance coupled with inexpensive debt continues to drive cap rates lower and values higher.
Everyone needs a place to live and in challenging economic times, there’s an even bigger emphasis on value. Investing in Class B in 2021 and beyond is expected to provide stable cash flow and relatively consistent returns with perhaps less volatility than Class A and C products.
As the senior vice president of operations at Morgan Properties, Greg Curci oversees all strategic property management operations, marketing, leasing and training for the firm’s growing portfolio of wholly owned and joint-venture assets. Curci has been in the residential and commercial real estate industry for over 20 years.