Hogan: “Signs are emerging that first-time home purchases are on the rise, although homeownership among the renter cohort remains depressed.”

COLUMBUS, OH–Tired of hearing of the Great Wait-and-See as the industry taps its collective foot in preparation for coming regulation? Making long-range acquisition or development decisions can be dicey in such an atmosphere.

In this exclusive Q&A, locally-based research director for RED Capital Group, Dan Hogan takes us through the landscape and provides us with some sure bets–and not so sure bets–all of which can help owners and developers alike navigate the current choppy waters.

GlobeSt.com: Let’s start with the macro picture. The RED Capital Group (RED) forecast provides a real mixed bag of trends, such as faster economic growth but a full-year forecast revised downward. What are the drivers at play here?

Dan Hogan: The full-year 2017 forecast is lower than before because GDP growth for the first quarter was unexpectedly weak, continuing a trend that dates back to 2014. Our GDP model points to moderately stronger growth for the balance of the year, but not enough to compensate for Q1 weakness.

Several trends point to faster economic growth in the next three to five quarters. Our research finds that lagged personal consumption expenditure, current dollar GDP, and home-price growth and rising annual S&P 500 returns are statistically correlated with subsequent GDP growth. So too are tightening credit spreads and decreasing slack in the economy. Personal consumption growth has accelerated for the last year in spite of lackluster GDP and personal income growth, a positive indicator. First-quarter nominal GDP growth was the fastest in nearly two years and year-over-year S&P growth was greater than 19%, the strongest in three years. Furthermore, the credit spread between Baa-rated corporate bonds and the 10-year Treasury yield was the tightest since 3Q14, and 0.95% tighter than the year earlier. Each is a bullish indicator, causing our model to project year-on-year GDP growth in the 2.2% to 2.4% range for the next 12 months or so, a modest improvement over the last couple of years.

In turn, faster GDP growth is projected to generate stronger payroll job formation, the economic factor most responsible for apartment absorption. Job growth, currently proceeding at a 1.6% annual rate, is projected to accelerate to 2.0% within a year.

Faster job growth couldn’t arrive at a more opportune time for multifamily. New unit supply is projected to reach a record high this year, with completions expected to be 50% greater than 2016. Faster job creation will help absorb this wave of supply and will contribute to wage and salary growth, benefiting rent growth.

But job growth isn’t evenly distributed geographically. The large metro areas that make up the RED 49 -the 49 major metros RED covers from a research perspective — grow at considerably faster rates, on average, than the nation as a whole, given their disproportionate concentration of digital industry, healthcare and financial services jobs. Consequently, our econometric models expect even a moderate improvement in national job growth to trigger meaningfully faster large metro growth. This is important because pending supply also is heavily weighted toward cities with concentrations of tech, finance and health care employment.

The good news is that our models suggest that, for the most part, job growth will be strong enough to prevent large decreases in average occupancies in most markets. There will be exceptions, such as Boston, New York and Washington, DC, but the larger picture is constructive; average major-market occupancy is likely to decline only about -50 bps.

GlobeSt.com: What are the major challenges facing the market, first from the investor side, and then from the developer side?

Hogan: First and foremost, supply pressures are the biggest threat to investor returns. Pending supply is likely to reduce occupancy in most markets, in some cases substantially. Competition from new product will cause occupancy in many existing apartments to fall and will extend the time required for new construction to stabilize. In turn, leasing competition often compels properties to offer increased rent concessions and acts as a revenue headwind as owner pricing power diminishes. Asking rent growth slows or declines, marketing costs rise, occupancy falls and lease-up takes longer; all eating into returns.

Cap rate movement also may threaten investor returns. Currently, cap rates are near historic lows. While recent trade evidences no meaningful upward pressure on rates, the realization of lower occupancy rates, slower rent growth, spiking concessions and disappointing lease-up durations may finally dampen investor appetite for multifamily product, causing cap rates to rise. This may have a negative effect on over-levered owners or owners seeking to sell or refinance properties.

Developers face a slightly different risk set. Unusually high construction cost inflation is a problem in some fast-growing markets. Cost over-runs may require developers to right-size loans with equity infusions or trim property amenities to stay within construction budgets.

Rising cap rates may prove to be a threat to merchant builders as well. Developers that seek to construct, lease-up and sell won’t find a weak leasing and higher cap-rate environment at all advantageous. Likewise, would-be developers will find construction financing more difficult to obtain. Banks are tightening underwriting standards or shying away from the apartment sector entirely.

GlobeSt.com: Virtually every market sector is facing a sort of extended wait-and-see, with all eyes pointed toward Washington. What is the impact on multifamily?

Hogan: Any prospective reforms coming out of Washington are likely to be constructive. Lower ownership-entity marginal tax rates will instantly raise after-tax rates of return, a boon for a “bond” type investment like real estate. Real estate is likely to benefit less from corporate tax reform than comparable corporate equity investments since its relative depreciation-rate advantage will be diminished, but this poses no fundamental threat to the business. There’s some concern that the Treasury will reduce or eliminate the deductibility of mortgage interest, which would negate any benefit from lower entity level tax rates. But, it’s unlikely that this will be a part of a final bill.

Repeal of some of the least lender-friendly aspects of the Dodd-Frank legislation also will be an unalloyed gain. While banks will still have to contend with higher Basel III risk-based capital requirements, Dodd-Frank relief will make it easier to engage in riskier lending activities, including construction, land and mezzanine finance. In turn, this should make financing easier for multifamily investors and developers.

GSE reform is an area of legitimate concern. But at this juncture, there’s no indication that the Trump administration is leaning toward a radically free-market oriented reform that would shudder the GSE MFH lines of business. Indeed, it’s more likely that it will endorse a recap-and-release strategy that would entail only cosmetic changes to the GSE business model.

Interest-rate risks also seem modest. While the Federal Reserve seems determined to raise short-term rates aggressively, the impact on the long-end of the curve against which fixed-rate multifamily loans are priced is likely to be positive. Indeed, the 10-year yield declined to its lowest level since the election in the aftermath of the Fed’s latest overnight funds hike. Floating-rate debt, like construction loans, will be more costly, but this may be a net benefit since it’ll contribute to reduced pending supply in 2019 and beyond.

How the Fed addresses its $4.5 trillion portfolio of government and mortgage debt securities accumulated pursuant to its Quantitative Easing programs is another matter. An aggressive disinvestment program would put upward pressure on term interest rates, a potential threat to borrowers, investors and lenders alike. Current thinking has it that the Fed is likely to step carefully in this regard, but we sail in unchartered waters.

Tax reform will have a much different impact on the affordable housing industry. A sharp decrease in corporate tax rates will diminish the value of tax-credit equity. Total-return-oriented buyers will exit the market, if they haven’t already. Buyers are likely to be limited to regulated entities with Community Reinvestment Act exposure. Already depressed credit prices will fall farther.

Nor is it likely that lost tax-credit equity will be replaced by more generous direct HUD subsidies. In fact, the Administration seeks to cut HUD funding from the current baseline level in its proposed budget.

GlobeSt.com: How does large metro market performance vary across regions?

Hogan: Expected occupancy and rent performance varies widely across geographic regions. With respect to occupancy, markets that are expected to receive moderate levels of supply will record stronger occupancies than supply-heavy primary markets. The Midwest metros, especially those with healthy economies (such as Cincinnati, Columbus, Indianapolis and Pittsburgh) should digest the pending supply with relative ease. Slow and stable Northeast/Mid-Atlantic region markets (like Baltimore, Suburban Maryland and Central New Jersey) should do likewise.

Primary and growth markets are at greatest risk. Primary markets outside of California and Southeast Florida will struggle to keep pace with massive pending supply waves. Boston, Denver, New York, Portland, Seattle and Washington will experience materially higher vacancy rates over the next 18 months if supply materializes as projected.

The growth markets face similar fates. Occupancy will likely drop materially in Austin, Charlotte, Houston and Tampa, and to a lesser degree in Atlanta, Phoenix and Raleigh. Texas may be the exception to the rule since Dallas, Fort Worth and San Antonio appear in good stead, at least for the next couple of years.

Rent prospects are somewhat different. Occupancy is not universally a statistically significant predictor of rent growth by any means. More frequently, job, income and home-price growth and market history are greater economic influences on rent. In other words, the barrier protected large markets may continue to enjoy above average rent growth irrespective of occupancy losses.

But not all primary markets will emerge unscathed. Denver and Southeast Florida are forecast to achieve less-than-average rent advances, and Washington/Northern Virginia is likely to record soft rent gains.

As for the growth markets, the future is generally bright. Atlanta, Austin, Charlotte, Dallas, Fort Worth, Jacksonville, Orlando and Raleigh may experience a few rough quarters in the near term, but longer term rent growth should average 3% or more. Markets with few spatial barriers to entry, including Nashville, Phoenix and Tampa, are likely to record below-average growth.

Rent growth in the Midwest will remain slow and steady. While those markets are largely at or above equilibrium in terms of occupancy and are likely to remain there, income growth and home appreciation are not strong enough to ignite above average rent increases.

GlobeSt.com: What are the best bets regionally then for 2018?

Hogan: For return driven investors, the Pacific Coast markets remain the most attractive options, despite high costs per door. Texas markets also are compelling options for investors seeking lower price points. Atlanta and the Carolinas have appeal, although risk-averse investors may be wary.

As for income-oriented investors, the Mid-Atlantic provides the strongest risk/reward relationship. Midwest markets also earn high marks on this count, and one may be pleasantly surprised by rent growth in the better markets of what was once decried as the Rust Belt.

GlobeSt.com: So, what’s the Number 1 challenge that all market players have to keep an eye on?

Hogan: For me, it’s the economy. As they say, a rising tide floats all boats. A strong, growing economy will hold multifamily in good stead, and a poor economy under the current supply circumstances will drown both the virtuous and profligate. It’ll also pay to keep an eye on homeownership trends. Signs are emerging that first-time home purchases are on the rise, although homeownership among the renter cohort remains depressed. A continuation of this trend would be a bad omen for apartment performance.

 

Note: The views expressed herein are those of the author and do not necessarily reflect the views for RED Capital Group or of the author’s colleagues at RED.