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224: Multifamily Macroeconomics in the Twilight Zone

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Buck: Welcome back to the show everyone. Today my guest on Wealth Formula Podcast, he’s been on the show before. He’s economist Ryan Davis. He actually joined us at one of our last Wealth Formula meetups. Of course, the last one we had was canceled but Ryan was at the one before that. He serves as a chief operating officer at Witten Advisors and provides fact-based research analysis and discussion to help clients like us formulate their apartment strategies and these insights and for investment decisions for multi-family development and buy/sell opportunities which as you can imagine we’re all looking for some of this advice these days. Ryan has a PhD in economics from the University of Texas. Ryan, welcome back to Wealth Formula Podcast.

Ryan: Thank you. Glad to be back.

Buck: Yeah it’s been like a pandemic ago when we last talked right? Listen, you know I want to kind of jump into the whole you know what the heck is going on, I mean the overall, if you would, you know kind of give me your overall assessment of the economy. I mean obviously we know these huge drops in GDP etc which were expected last quarter. How is this all affecting real estate asset prices especially you know apartments which is you know is our interest and something that you specialize in?

Ryan: Sure so yeah the great unknown is the pace of the recovery. So we had that big drop through April in terms of employment and then we got a bounce back in May and June and the hope was that it was going to be a V-shaped recovery. But then we saw virus cases ramp back up in the second half of June into the early part of July and the local economy started rolling back some of their openings and so with that, we’ve kind of stalled out recently. So we’ll get the July numbers this Friday for overall payroll gains and that could I think the consensus is anywhere between one, one and a half million jobs it could be negative so who knows but it looks like the hope for a v-shaped recovery in the economy has kind of stalled out after the first two months of optimism. And so we think that going forward we won’t see any the worst is behind us really and so we won’t see you know the big losses that we experienced in March and early into April so kind of what we’re calling for right now is for the national economy to continue to add jobs for the remainder of the year and then beginning next year a recovery should emerge and that would sustain demand for housing and ultimately apartments going forward. In the near term as far as multi-family goes we expect some pain through the end of this year and then into the early part of next year. In terms of pricing power, if we had to boil it down to one number it’s rent growth so year over year effective rent growth we think that declines to eight percent rent cuts this year and into the early part of 2021. That varies considerably on a local market basis I think our worst-performing market is Metro New York City probably no surprise there but then also many of the other gateway markets such as Boston, LA, the Bay Area, etc. We expect rent declines to be lower than that eight percent across the board, however many of the inner west, Texas, southeastern market should outperform still see rent declines but not closer to five/six percent range at the depth and so we expect near-term pain but then as we get out into 2021 and afterward and the economy begins to add a lot of jobs we would expect rent growth to return to multi-family. And then what that means for pricing in terms of apartment assets for right now in the second quarter hardly any deals trade at hand so it’s really tough to get a sense of where pricing is and with the deals that have traded though the cap rates have remained relatively stable which is a good sign. We’ve heard from some of our merchant builder clients where they had assets they had constructed and were going out to the market to sell in the early part of April they were saying 10 discounts in terms of the compared to pre corona levels but that has since come back in the last 45–60 days and maybe it’s only one to two percent in terms of the haircut that they’re seeing out there right now. And there’s a just a ton of capital that wants to get back into multifamily at the same time there’s hardly any distress out there right now so there’s a lack of available to you know supply to buy and so everyone is just kind of in this standstill there’s a big ass gap because buyers aren’t willing to pay yesterday’s prices for assets but sellers aren’t willing to give any you know deep discounts right now and so it’s kind of a standstill and we’ll see how all this plays out.

Buck: Yeah you know it’s really interesting we’re obviously you know through, you work with Western Wealth Capital, one of my partners and you know it’s funny because we were kind of thinking well maybe there’ll be some real buying opportunities but you know we’ve seen a little bit maybe just you know from buyers who are sellers who just are just wanting to get out while they’re ahead maybe they made some money you know maybe they and at this point you know they’re just thinking let’s just cash out and maybe they’re willing to take a little bit less but for the most part you know if you look across our own portfolio and it might be because it’s largely again Texas and Arizona, etc that and maybe it’s because it’s mostly working-class B and you know high C class apartment but our portfolio you know the numbers are just as good as they’ve ever been in terms of you know occupancy in terms of even our we’re still raising rents. And so when you look at that you’re like well I mean how do you expect there to be any you know smoking deals out there if the sellers really aren’t feeling any distress. So is there a difference you know when you look at something like a B and C class apartment scenario versus A right now or have you been able to break that down a little bit because I think the people I know who are in the A-class and new build are you know they’re certainly feeling things a little bit more than we are.

Ryan: Yeah so what we’ve heard from some of our clients in terms of early on so may June in terms of rent collections class A’s were actually from a nationwide perspective actually exceeded the class B and C product. Now we don’t think that will continue going forward and the main reason is that new deliveries that are coming online they will compete with the existing top of the market product and so we think that it will be short-lived in terms of the top of the market outperformance and another part is due to just the nature of this downturn where low-wage sectors were hit extremely hard in April, got some bounce back in May and June but the leisure and hospitality sectors lower-paying positions those have been the most impacted so far. But going forward we don’t think that this downturn would be any different than prior recessions in terms of the class A leading the way down in terms of jobs and occupancy and also rent growth or rent cuts in the near term. So class A’s will lead the market down but then as we get out into the later part of next year and into early 2022 then class A’s would outperform the broader market. So yeah we think through the end of this year until early next that B’s and C’s will hold up relatively better but that’s mainly a function of just the competition that it takes to get these new projects they will get leased up it’s just a matter of the market-clearing price and so those have to compete those could be mostly with the top end of the spectrum and so we see big rent declines and concessions in the class A space going forward.

Buck: You know there’s this thesis that’s going around in the multi-family space and you know I’ve been sort of you know looking at it this way too for a while though I’m starting to you know feel like it’s maybe not gonna happen is this idea that there’s going to be a potentially before we really rebound and start heading up again that there’ll potentially be a you know big tsunami of defaults and things like that. Right now at least what I’m you know seeing and hearing about in terms of the lending markets and in terms of these properties, there really isn’t much indication of that right now is there I mean what do you think?

Ryan: No at least not in the short term I mean again there’s it goes back to my earlier comment there’s been no distress really and so that is due mainly to the huge stimulus packages that have been passed those from a fiscal standpoint and a monetary standpoint which is it’s crazy to think that GDP declined at an annualized rate by 32 however incomes soared and so that’s all due to the stimulus that we saw and so that’s helped prop up renters incomes and allow them to pay rent. Now going forward I think some of these the number of defaults I don’t think there will be a tsunami, at least that’s how we view it right now, ask me again in a week and it could change, but I think that the defaults will be very market specific and so those geographies that have been hit harder we’ll see a larger number but many of the Texas markets, Phoenix, Denver, southeast high growth markets where you’ve got this short-term tailwind in terms of folks at the margin more and the trends that have been in place for years of folks moving from gateway markets into these inner markets will be kind of you know given a stairway shot really in the near term and so that would help to prop up multi-family fundamentals and so yeah if you’re expecting a tsunami of defaults in any of those markets that I’ve mentioned again it kind of gets a little bit granular in terms of you know potentially Orlando might have some problems just with the amount of supply and then the you know low-wage in tourism industries being impacted more dramatically and that would lead to some weakness in Orlando but out outside of that maybe Houston you could argue you know somewhat but outside of those two and those those areas of the inner west Texas, southeast Florida should be but hold up you know relatively well and I would think that the main stress points will be out you know on the coast in California potentially portland we do think seattle holds up relatively well and then northeast in terms of you know New York and Boston as well so I think it’s very locally market driven.

Buck: Yeah it’s interesting you know we did we were a little worried about Houston too but our you know Houston portfolio is actually doing awesome it’s not having any problems at all which is which was you know again, knock on wood that’s what it’s been so far. Let me ask you another question you mentioned the pent-up demand of you know money on the sidelines waiting to get back in and you know and in many situations, they have to get back in right they’re mandated to deploy capital and that sort of thing do you the one thought that I’ve had through this is you know multi-family and well multi-family in general has held up so well during this period of time does that potentially create a situation where you know the big money that’s coming in starts looking at this even harder as potentially a little bit of a hedge or a little bit of safe haven. What what do you guys think is going to be the effect of that you know the relatively stable performance and then ultimately you know having all of this money on the sidelines,? Do you see paradoxical even further compression of cap rates over the next couple years? What’s your thought on that?

Ryan: Yeah and so kind of pre-corona our forecast was for cap rates to continue to decline and you know taking a step back it was mainly driven by global factors with the aging populations across the globe that have built wealth up and all that investment needed to be placed somewhere. And so those trends were driving returns lower for longer and so those are the demographic that have not been affected by the pandemic. And so just from a global standpoint, we’re expecting returns across all assets whether stocks bonds you know all classes of real estate whether it’s multi or industrial retail office, etc those returns would continue to head lower. Now we’ve had the pandemic and we’ve seen multi-family and industrial hold up exceedingly well and who knows what to make of retail office and lodging just lots of pain and in those sectors and so if you need to be allocated to real estate then multifamily and industrial or where you want to be at least in the short term and especially if you’re looking for consistency of returns and you know risk-adjusted on a risk-adjusted basis you know multi-industrial or have outperformed other asset classes and so really to get into the lodging office retail space probably more opportunistic mindset in terms of those assets may need to be repositioned etc and so I think a lot of that money that’s out there is not looking to get there’s a lot that’s looking for that type of asset turnaround story but there’s also a lot of money out there that needs the stability. And so that should continue to compress cap rates or put a really put a cap on that cap rates and so it would be no surprise if cap rates on an aggregate basis hold steady and maybe even decline despite a deterioration in short-term fundamentals and part of that is due to the long-term belief in apartments going forward and so yes there’s a short-term dislocation where we expect some move-outs that you know this year actually there are a lot of move-outs that we expect and so there’s going to be a lot of doubling up folks moving back in with their families but then there’s going to be pent up demand as we as that recovery takes hold next year and that will be released and so we see leasing to be through the roof next year and then out into 2022. Then at the same time as that demand story improves in the short term we see starts decelerating dramatically so we’ve we’re going from a 400,000 unit run rate to about 200,000 units by the early part of next year. And so new production is going to get cut in half now that we don’t get any benefit of that immediately so we have to wait till later part of 2022 and 2023 before we see that slowdown and production really lift fundamentals and so I think everyone is seeing that yes there’s some short-term disruption in the multi-family market right now, but the long-term drivers are there and if you have the capital to wait out this very painful period in the short term then there will be major benefits after that we should see after next year.

Buck: Now one of the things you said I think earlier is that the worst is behind us do you believe that’s the case in terms of rent growth and you know rent cuts and that sort of thing right now?

Ryan: I think the worst is behind us in terms of the economy. I think that going forward we should continue to produce job gains on a monthly basis, though this next report could see some layoffs we’ll see the consensus is one million one and a half. In terms of multi-family we do not think the worst is behind us we think that fundamentals will continue to deteriorate into the early part of next year we think that you know kind of right now in terms of year over year rent growth in the early part of this year let’s call it three, three and a half percent we’ve since gone down to zero percent in the second quarter. So on a quarterly basis we’ve seen some dramatic rent cuts, again this is on a national basis and then as we move forward we see occupancy dropping by about three percentage points into the early part of next year, rent declines of about eight percent through the remainder of this year into the first quarter of next year and so no we do think that there will be some deterioration and fundamentals going forward. On the flip side of that might present some opportunities and so any assets that were purchased specially in your space in terms of if they were bought at the top of the market at the end of last year in the early part of this year and now that value-add story isn’t there where you might not be able to get the rent bumps that you were expecting so some of those assets will have to be recapitalized and so that might present some opportunity as the year progresses but again like you said we haven’t seen that materialized so far.

Buck: Yeah that’s the tricky part right I mean it’s sort of like I think when you’re on the buy side here you’re saying well I mean these prices that we’re seeing right now you know with prolonged you know low-interest rates which we can pretty much guarantee at this point for a period of time and then the pent-up demand. It’s sort of like okay well I mean this actually might be one of the better times to buy if you consider what could potentially happen in the next you know 18 to 24 months in terms of you know explosive growth. When you look at those indicators that you’re you know that you’re talking about that may lead to some of the more explosive growth metrics what markets come to mind the most for you?

Buck: Now one of the things you said I think earlier is that the worst is behind us do you believe that’s the case in terms of rent growth and you know rent cuts and that sort of thing right now?

Ryan: Yeah so our general geographic areas that we like we like the southeast, parts of Florida, Texas and the inner west. We really like Atlanta, we like South Florida though there’s a little more pain in the short term some of our clients are saying it kind of in terms of you know rent collections you know northeast but also yeah LA but then South Florida is outperforming those two areas but still lagging some of these other markets. So we like the Texas markets long term the interwebs you have Phoenix, Denver, Salt Lake as well. We like Seattle that’s an outlier on the west coast but then the other markets whereas in the Bay Area we expect those you know rent growth numbers to average four, four and a half percent which stack up really well across the nation but for those markets that’s a recession pretty much and so compared to what’s normal and the cap rates you have to pay the rent growth numbers there kind of you know lackluster. So the midwest the markets they won’t be hit as hard but still they don’t get that explosive growth going forward and so we really like the inner West Texas, southeast of Florida markets and you know part of that has been driven being driven by the migration flows. So domestic migration numbers have really helped out all of these markets we’ve seen outflows from the northeast boston new york the bay area Southern California we’ve seen migration outflows from those markets into the you know inner west you know Las Vegas the inland Phoenix, Denver you know people moving from the coast into those markets and then you know also parts of texas as well but then in terms of the northeast the flows that are coming in to the Nashvilles the Charlottes, Raleighs, Atlanta, Florida markets we and then also Texas as well and so those trends have been accelerated at least in the short term, but it’s important to remember that those have been going on for a decade at least even more and then other markets and so it’s not anything new but at the margin that will support many of these other markets.

Buck: Yeah on the west coast I mean there’s that flight to Arizona as well right from California. One of the things that you know is worth talking about is what effect this has had you know the pandemic and the recession on the lending market, with Fannie and Freddie and you know how that might be playing into any of the growth or lack of growth.

Ryan: Yeah I think on the financing side you know debt for stabilized assets it’s there and it’s cheap you may have to you know have higher reserves than you’ve had typically but for the most part it’s there and so that’s part of the appeal of buying assets right now with these record low interest rates. So I think for stabilized assets yeah it’s there for new construction it is dried up considerably and this is a change in the last 30 to 60 days and so the fed does a survey each quarter of banks and their tightening of multi-family construction lending standards and that the latest report shows 70 percent of banks tighten their multi-family construction loans last quarter which we haven’t seen those levels since 2008/2009. And so I think part of it’s the lenders are trying to make sense of what they have in terms of all these other asset types in terms of real estate or retail, lodging, office loans, they’re trying to you know spend a lot of time working those out and so then you add on the uncertainty in terms of the economic recovery etc, they’ve pretty much put a halt on new construction loans. And so that’s been a big change here in the last two months call it. Then on the equity side I think returns have been increased but still available and interested but you know a lot of you know equity and especially focusing in on the new starts pipeline if all the deals that have been started are continuing and it’s kind of a mixed bag from our clients in terms of are you seeing delays or actually some other clients that reported these they were able to speed up the timing in terms of getting able to get trucks into sites very easily and then also the construction workers that were on you know working on hotels motels those have come into the apartment sector and so that’s provided more manpower in terms of getting these deals done. And so those that were under construction are continuing to proceed, those that were capitalized I think that but haven’t begun those have been they haven’t pulled out completely they just said let’s press pause to see let’s say can we get any break in construction costs over the next several months and so the equity and banks they’re still willing to do it move forward on those deals that have been capitalized but are you know slow playing it. And then you get to the others where there’s land sites and they hadn’t been entitled and haven’t been capitalized those deals we think have been shelved for right now and so it kind of where some opportunity could be is on the land side of you know potentially purchasing some land sites that might be teed up for development as we get further along in this recovery.

Buck: Again one of the things that you’re saying though in terms of construction loans not being there again it helps us for those of us who have apartment portfolios already that are already there that that again goes to the issue of a simple supply and demand issue which we can benefit from if there’s not a whole lot of new builds. You know this is a major driving variable in in apartment buildings nationally can you give us a little bit of the idea of you know just not being able to keep up with you know population growth in various parts of the country, can you give us a little bit of you know sort of a thousand-foot view on the perspective on how big of an issue that actually is?

Ryan: I don’t know if it’s that big of an issue you know on on the whole and I think that you know some of these higher growth markets in terms of where we’ve you know call it the Atlantas and North Carolina markets, Central North Florida, Texas, the inner west regions where we’ve seen large population growth statistics you know high growth markets but they’re also they also tend to be the highest in terms of supply for housing and so it’s more easy to build in those markets especially you know out as you get away from the know central cities etc and so where we’ve seen the the biggest barriers to supply are out on the coast and so we’ve seen you know job growth be pretty good in those markets but the supply hasn’t kept up at all and so that’s why you’re seeing you know these big you know rent affordability you know problems in the coastal markets and so we think that supply not keeping up with the population dynamics is more of a coastal problem but then you know as you get into the markets that are more accepting of new development then you know we’ve seen housing supply increase at a rapid clip in many of these other markets I think you know Austin you know even through the June of this year permit activity for multi-family continued to set it reached big big levels and so I think year to date in Austin it’s already pulled permits on almost 10,000 units already which is you know huge numbers. And so I do think that while these population growth numbers and some of these markets are you know off the charts especially compared to you know some of the coastal markets, that supply has been able to keep up there and so yeah you see pockets of where you know rent growth you know bumps up to you know five, six percent levels, it’s especially that was the case in Phoenix and Las Vegas over the past two to three years where those markets were leading in terms of rent increases but they tend to you know be markets that you know will accept more new supply and so that will tend to even out over the long term.

Buck: How’s Vegas doing out of curiosity because that one was just crushing it. It seemed it seemed a little dangerous you know it seemed like one of those markets where it’s like wow is it real or is it one of those things that’s just gonna go back to Vegas.

Ryan: Yeah exactly and yeah kind of thinking that you know before kind of goes back to your comment earlier about people moving from the coast to getting in their car and driving to the riverside and then Las Vegas and Phoenix and so it was benefiting from a real out-migration from expensive coastal California. That said that just the nature of this pandemic crushing leisure and hospitality and the conference circuit that the job losses in Las Vegas I think you know through April into May led the nation. We’ve seen some a bit of a bounce back there but really the question is you know how fast does the the conference you know a circuit come back, how fast are people willing to travel to casinos, I know they have already, but I think that pre-corona the growth was real and yeah absolutely now it’s a little bit different you know market in terms of the cost and you don’t want to go in there and if you’re a developer you don’t you know want to build a high-rise there and so your strategy is a little bit different but so far it’s held up relatively well, all things considered, but still a lot of weakness that is materializing in Vegas.

Buck: Interesting stuff. Well listen I don’t want to keep you all day long, Ryan, but it’s been great talking to you. Where can we learn more about your work?

Ryan: Sure. Probably the easiest is wittenadvisors.com you can go there, all our contact information is there, feel free to reach out with a phone call or send me an email anytime and I’ll be happy to give you more details on the services that we provide and how we add value to many clients that are in either owner, operators, developers, equity or lender clients.

Buck: Fantastic thanks again and we’d love to have you again you know in a few months to reassess where we are at.

Ryan: All right. Sounds good. Looking forward to it.

Buck: We’ll be right back