Motley Fool Money - Is Multifamily Overbuilt?

Episode Date: June 8, 2024

Last year, 440,000 new apartments went on the market – a 36-year high. This year, even more new builds are coming. That’s good news for renters, but perhaps less good for developers. What about REIT investors? Matt Argersinger and Ricky Mulvey discuss the state of the multifamily market and why REITs (of any stripe!) aren’t out for the count quite yet. Host: Ricky Mulvey Guest: Matt Argersinger Producer: Mary Long Engineer: Dan Boyd Epic Bundle discount link: www.fool.com/epic Companies discussed: MAA, PLD, DLR, SPG Learn more about your ad choices. Visit megaphone.fm/adchoices

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So there was just a lot of things that were underwritten just a couple of years ago, and a lot of those developers are just getting smacked right now because, as you said, it's just they can't refinance. The rents and occupancy that they thought was going to be there, it's not there. And they're facing a liquidity crunch, like a lot of small businesses in the country. I'm Mary Long and Matt's Matt Argersinger, our go-to real estate guru at The Motley Fool. My colleague, Ricky Mulvey, caught up with Matt to check in on the state of the multifamily market. During the pandemic, flexible work sent a lot of people packing. Newly able to work anywhere, folks flocked to cities like Nashville, Austin, Denver. Builders saw those trends and began to do what builders do best.

They built. Now, though, there seemed to be a lot of empty new apartments in those places. In today's show, Ricky and Matt put some numbers behind those trends. They discuss what a mismatch in supply and demand means for renters, developers, and, of course, investors. So, Matt, one of the biggest real estate trends over the past few years has been the growth of the sunbelt. Story goes like this. People want more flexibility in how they work.

Remote work has allowed them that. So why not go somewhere warm to a fun city like Nashville? But now I'm starting to worry a little bit, and part of this is because I'm a Mid-America apartment reed holder, that maybe the sunbelt's overbuilt. Has multifamily become overbuilt in these cities that had a lot of those popular? population trends. I think it's a very fair question, and it's a question I'm probably going to say yes to. I think there has been a lot of overbuilding. And you could almost see it, Ricky. You mentioned people wanting or having more flexibility with work and wanting to move to warmer places. Totally.

I mean, we could see it in the U-Haul data, which is kind of interesting to track. You could see U-Haul data, which shows you kind of where people are picking up stuff and dropping stuff off of. And immediately, even before the pandemic, but certainly after the pandemic, so there's huge migration of people from coastal cities, northern cities, into the sunbelt. And for all the reasons you've mentioned, I mean, it's better weather. People had more work flexibility than ever before. And by the way, it's a lot cheaper. That's probably the number one reason. It's just a lot cheaper to live in a lot of southern, southwestern cities than it was in coastal cities or northeastern markets.

And that's for a lot of reasons. Land is cheaper. It was cheaper for a lot of apartments to get built. And we're certainly seeing that. And for a while, you saw these double-digit sort of rent increases, which I myself am a renter, so I'm not a fan of them. And then it's starting to dip. So one-bedroom rents in Nashville are down 4% from last year.

Denver has also seen some rent stabilization, although there's a sort of another story here with a ruling on building affordable units into multifamily buildings, which is for another time. But for the purpose of this discussion means that you had a lot of developers rushing to start projects before that rule came into effect. And I think the thing that I'm worried about is an investor now. So to put that hat back on is, is this a stabilization or is it the beginning? beginning of a sort of boom and bust cycle. I think it's the latter, actually. I mean, just to put some numbers around it, if you look at data from real page market analytics,

which really tracks apartment developments. 2003 was a 36-year high in terms of deliveries of new apartments. 440,000 new apartments came to market in 2023. But hold your beer, because in 2024, this year, 671,000 apartments are expected to deliver. That's going to be a 50-year high. And as we've already talked about, a lot of that development is in the Sunbelt. And you've had, I mean, look at Denver where you are.

Construction there is supposed to add 9% to the existing inventory this year. I mean, 9% to an entire metro area's apartment inventory is big. But that's nothing compared to cities like Austin, Phoenix, or Charlotte, North Carolina, where there's going to be at least 14% increases to total multifamily stock this year. That is more than six times the growth rate you'll see in coastal markets like New York, L.A. or Boston. And it's really, a lot of it is coming down to there's this affordability issue before we even get to rents. I mean, if you look at data from John Burns Research and Consulting, for example, right now it's costing roughly $1,000 more to buy a home in a lot of these markets than it is to rent a home. And that's obviously because we're in a situation where the mortgage rates are a lot higher than they were just a few years ago.

In fact, they're at multi-decade highs. And so you have existing homeowners who are reluctant to sell because they're probably locked into a rate that's like three or four percent. They don't want to move up even if they want to to a mortgage rate that could be seven or even eight percent. And a lot of young homebuyers, potential homebinerers, just can't afford the mortgage cost. So it's just it's cheaper to rent. And in Denver, for example, the numbers over $1,400. It's $1,400 a month cheaper to rent than buy in Denver. In Austin, it's something like almost 1,700.

But as you were kind of alluding to, this is a bit of a boom bus cycle. A lot of this development, all these new units that are coming to market were based on the tremendous demand we saw immediately coming out of the pandemic. And it's, you know, you're starting to see rents kind of come down. As you mentioned, you're seeing rents flatline. a little bit in certain markets. It's all about, you know, there's lower absorption. There's a lot of supply. And I think the key forward-looking indicator is if you look at development starts, which is this is a construction that has just begun where the delivery is probably out more than a year, probably 18 months plus, that number is coming way down. In fact, multifamily starts

nationwide, we're down 40% in Q4, 2003 alone. And so starts are coming way down. Deliveries are supposed to peak mid-20204 this year. So I think this boom-bust cycle is about to enter a bust. And it might take a good year or so before we sort of get to an equilibrium, we're demand, once again, equal supply, supply being way outsized right now. That's going to take some time to work out. And we're going to see probably rents come down. Yeah, I was at a, so the basis of this segment, Matt, I was at a restaurant with a mutual friend of ours who was sort of pointing at the construction of these large apartment buildings around us and saying, like, Do you think anyone's going to fill that up?

You think they're getting full rent for that? And then I found myself getting a little heated. And I was like, you know what? I should talk to the real estate person at the Motley Fool about this. There's another component to this story for people who aren't as familiar with this space, which is how the mortgages work, essentially, for these large multifamily buildings. If you own a house, you have a locked-in rate of 15 to 30 years. But for the builders of these large apartment complexes, the debt works just not even

a little bit, a lot of bit differently. Very differently. There are things like HUD loans, which can be long-term loans for developers who are developing apartment buildings. But putting those aside, that's a smaller part of the market. For the most part, if you're a developer of an apartment building, you're looking at a, you know, at best, a five to seven-year mortgage that usually has a floating rate to it, not a fixed rate. And the max LTV loan to value is usually around 70%, which means you have to come to the table with at least 30% of a down payment or upfront equity to even get in, you know, to acquire the development or the proceeds to do the development. And for a lot of developers, it's actually even trickier.

You know, if you're starting from scratch looking to construct a brand new apartment building where one's never been before, I mean, in most cases, you're looking at a two to four year loan with a very high interest rate, maybe a nine or 10 or even low double digit interest rate. you have to set aside a lot of cash reserves, and your LTV slash LTC loaned to cost might be 60%. So at best, you have to come up with at least 40% equity, if not more, to kind of secure the proceeds to even start that development. So think about that across the country with rates the way they've gone, and it's much, much more expensive to construct a building or even acquire a multifamily apartment building today than it was just a couple of years ago. And that's why you've seen

those starts come way down. That's why they're down 40%. That's why they're going to fall precipitously this year. And that's why, even though we're probably in the midst of a bust, if those starts come down and rates stay high, we probably get to a point where demand and supply equal out, but it's going to be really tough, tough in the near term. So this is the story that I'm worried about playing out

that I think you're describing is you have a builder in a zero interest rate environment that is betting on a very hot city with apartment renters that are going to completely fill up their building, and they build their cap table based off of that for this, for a zero interest rates, full occupancy. Then what's happened since then is that the interest rates have gone up. The debt's gotten more expensive. They're not going to build in the rent increases that they were previously betting on. And they are, and they're not filling up the buildings like they thought they would. And this is a pretty, I would say, low margin for error business. Great for a renter if you're looking for an apartment and one that I might benefit from if I look for an

apartment in the next year or so, but one where I'm worried about the implications, not just for the companies building these buildings, but also if they say, hey, we're bankrupt and nobody could have seen this coming. Yeah, it's a totally different environment than it was. And a lot of these developers, especially on the smaller side, just, they didn't underwrite this. I mean, no one underwrote, you know, a 500 basis point increase in the Fed funds rate over the course of, say, 18 months. So, you know, gosh, a lot of these starts, these apartment starts that you saw 2019, 2020, 2021, I saw this firsthand because I was on a service here at the Motley Fool that was looking at a lot of these deals, these private deals. And they were underwriting, you know,

hey, rents are going to go up, continue to go up 5% a year. You know, hey, I'll be able to refinance the construction loan in three years. years and lower the rate significantly. My exit cap rate will be 5% as opposed to like 7% as it is today. So there was just a lot of things that were underwritten just a couple of years ago. And a lot of those developers are just getting smacked right now because, as you said, it's just they can't refinance. The rents and occupancy that they thought was going to be there, it's not there. And they're facing a liquidity crunch like a lot of small businesses in the country. We've looked at the smaller developers. Let's talk about a big one, which is.

Mid-America apartments, builds a lot of apartment buildings in the Sun Belt region. You can do the pitch better than me, but it's basically slightly more affordable apartments that are not quite in the center of town, but still in a desirable area. But they have a lot of apartments in these areas where oversupply might be a problem. And they've highlighted this on earnings calls. The price of the reet has gone down dramatically since 2022. But with this oversupply, they call it a headwind. How strong of a headwind is this?

Are we looking at like a 30-degree gust? Are we looking at a hurricane? What's the vibe meter on the wind that Mid-America apartments is facing? Headwind definitely feels like an understatement. I would say, you know, maybe approaching tropical storm wind speeds. I mean, they've certainly experienced it with their apartments. They've seen their rents grow from, you know, go from double-digit growth just a couple of years ago to flat to negative over recent quarters. and, you know, they've talked about the supply situation a lot in a lot of their markets.

I would say the strength of Min America and with larger REITs in general, but Minne America especially, is just that they've been a really smart acquirer and developer. As you mentioned, they're often not in the center of cities. The departments that have struggled the most, I think, have been kind of the central business district departments, right? They've been kind of outside the main cities, but they've also been in the Sunbelt market. So they've benefited from that net by green.

while at the same time, of course, dealing with the bad supply situation. I would say that for them, if you look at their recent results, they're holding up a lot better than I would expect. And they're seeing better absorption rates in a lot of their markets. Resident turnover has been a lot lower than they expected, and that's due because of the tight housing market, which you've already talked about, high mortgage costs. It's keeping a lid on what first time home buyers can afford. And in just the first quarter, less than 13% of Mid America's tenant moveouts were due to home purchases.

So that's another indicator right there. That's the lowest rate they've ever seen. And renewal rents, so people who are deciding to stay in their apartment, those rents are up 5% for Mid-America, which is, again, surprisingly good based on the situation they're in. So I think they're in a pretty good spot. They've got a great balance sheet. And remember, they can take advantage of a market like this. We talked a lot about, you know, smaller private developers, strut. struggling. Maybe they're developers who have broken ground, they've done some foundational work,

they've done all the zoning work, but they just don't have the funds to get to the, to finish the build. Well, Mid-American can step in there, provide the financing, or take over the project at a much lower cost than it would take for them to start from scratch. And they can take advantage of that situation. They can use their balance sheet. And we've seen that a little bit with Mid-America. They're really stepping up their acquisition game lately. And I think that's a smart move right now. I think they're really going to make some acquisitions and some joint venture deals right now with. developers that are really going to pay off once this supply and demand situation equals out,

probably a year or two. This is, I would say the market is a little less optimistic about mid-America as you are, Matt. That's why the FFO multiple, which is sort of like a PE multiple or price tag for REITs, has dropped dramatically from 2022, from about 22 and a half to 14. for a stable-ish-looking chart, that's pretty precipitous. I think a lot of the pessimism is around oversupply. Do you think that's a fair sort of devaluation, or do you think the market is overreacting on Mid-America?

That's a pretty stark fall, you know, from a 22-5 times funds from operations multiple to 14. I would argue that at 22-5, yeah, Mid-America was probably a little overvalued. I think at 14 times FFO, they're probably a little undervalued. And, I mean, again, truly best in class read with Mid-America, one of the best track records out there for public reads. I don't think it deserves quite this level of discount. Yes, the clouds of oversupply, lack of rental pricing power right now, it's going to take a while for those to dissipate. But again, as we talked about, I just think the developments are doing now, the acquisitions are going to be able to make in this environment are going to look really smart in about a year or two. It's really going to pay off.

And again, they're the entity out there that has the balance sheet. One of the advantages that REITs have that a lot of private developers don't have, actually no private dealers really have, is they can access the non-recourse capital markets for debt, right? Mid-American issue debt, billions of dollars with a debt at reasonable rates, whereas small private developers, they're issuing debt at high single-digit, low-teen rates, and that debt has to be recourse to the property. Those are mortgages or debt that's secured against other collateral.

Mid-America doesn't have to do that. it can issue unsecured, you know, senior debt all day. And so even if they run to trouble, the assets are still protected and they have plenty of liquidity to, again, take advantage of this environment that we're in. So it doesn't have to take out a second mortgage on the buildings that they're putting up there. We've talked about the broader trend and we've also talked a lot about mid-America. But I'm sure there's a lot of other companies REITs being affected by this, this oversupply and then boom-bust cycle. Any other companies REITs that you want to bring into the conversation is as we wrap it up. Sure. Well, I'll just say, just stepping back in general, I mean,

real estate is right now the only sector, I believe, last I checked, in the S&P 500, that's negative year to date. And I think that is, you know, you've got institutional investors who are sort of myopically selling reits because, A, high interest rates, reits are often treated as bond proxies, so rates are higher with sell reeds. They're also worried about office. I get it. All the challenges there. But as a category, traditional office is only about 5% today of the total value of public reeds. It used to be 20% if you go back just a decade ago. And historically, reits have done quite well in moderate to high inflation and moderate to high interest rate environments, which we're in right now. And you get with real estate, you have to

remember, there's inflation protection with the assets, there's inflation protection built into the leases that often have inflation escalators to them. There's generally pricing power and rents, particularly today in categories like data centers, industrial warehouses, infrastructure, And I think eventually pricing power comes back. It'll come back to Mid-America. It'll come back to multifamily rates. And it already exists in major industrial reits like Prologis, for example, or data center reits like digital realty.

Those don't have the same supply demand imbalances that we see in multifamily. But they're also getting sold because of higher interest rates and just because there's a general disdain against reits. So I just think there's a lot to, you know, I can name a bunch of reits that I like. But I just think in general, that sector, needs to stop being ignored by the market. I think it's, the values look incredible. I think when I look at other parts of the market, like the technology, large caps, I mean, wow, you see some incredible high valuations. I see nothing but, you know, historically discounted valuations in REITs. And so,

I think this is a fantastic time to just take a look at the sector, get familiar with it, look at the big players in the space, like whether it's Prologis, industrial, mid-American multifamily, which we talked about, or a Simon Property Group, which, yeah, they own, they own, they shopping malls, but hey, they own the best shopping malls in the country. And by the way, people are still going out in shopping, believe it or not. And that just looks like one of the most attractive reeds as well. So I think there's really not a better time to be investing in reits right now. I think a few years from now, we'll look back and say this was a darn good time to be buying them. It's usually a better idea to look at a sector when the valuations are depressed.

And you know, we can plug it. Matt leads a service. It's called real estate winners at the Motley Fool. And that's where you get some more of those reet names. I'm a member of it. And it's also why we're having this conversation right now, Matt, is because I enjoy reading your work on there and checking out some of the opportunities. Matt Argusinger. Thank you for your time and your insight on this. Thank you so much, Ricky. If you like hearing from Matt, he also runs our real estate winner service, which is a part of a new offering we rolled out this year called Epic Bundle. This service includes seven stock recommendations every month, model portfolios, and stock rankings, all based on your investor type. We're offering Epic Bundle to Motley Fool Money listeners at a

reduced rate as a thanks for listening to the show. So for more information, head to www.fool.com slash epic. I'll also drop a link in the show notes for you. As always, people on the program may have interests in the stocks they talk about. And the Motley Fool may have formal recommendations for or against, so don't buy ourselves stocks based solely on what you hear. I'm Mary Long. Thanks for listening. We'll see you tomorrow.