Bullish on Multifamily?

[Serge S.]

https://www.forbes.com/sites/forbesrealestatecouncil/2019/02/21/multifamily-outlook-and-the-interest-rate-conundrum-in-2019/amp/

Interesting article regarding Multifamily into 2019. Sounds bullish on Sunbelt Multifamily in particular though it feels like this article could have been written in 2006.

[Jonathan Twombly]

Originally posted by @Serge S.:

@Ethan Smith I really wish that was the case but history says that Is not true and Multifamily is very tied to economic swings. Funny thing is that if you polled investors 2 yrs ago probably 60-70% would have been predicting pending recession. Today 2 years further into the cycle you can’t find a nay sayer.

Serge, you and I are in full agreement on this.

When you purchase a REIS report on a property, it shows market vacancy statistics going back 5 years.  So, when I first started downloading them, back in 2013, the vacancy stats included the GFC (Great Financial Crisis) and its aftermath.  And, for the markets I was looking at, in SC, the stats were shocking - market vacancy rates in the teens during the worst of it.

But in the aftermath of the recession, a lot of conflated and selective memory - and gurus with stuff to sell - resulted in a false narrative about apartments and recessions.

Let me unpack what happened.

Before the GFC, during the peak of the housing bubble, two related things happened.  First, government policy, loose money, and human psychology combined to push the home ownership rate to nearly 70% - nearly 5% higher than the "natural" rate of home ownership in the US - about 65% over the long term.

Second, there was a related spike in vacancy at apartments.  That 5% of home owners who never should have owned homes came from somewhere, and that somewhere was apartments.

So, when investors purchased MFRE during the bubble, they were paying inflated prices in the form of low cap rates, but this was mitigated by the fact that vacancy rates were higher, so NOI was lower. The lower cap rates created less of an inflation in asset values because NOI was lower too.

When the GFC hit, unemployment went to about 11% nationally.  This caused physical and economic vacancy in apartments to rise.  Many owners without enough cushion went into default. 

However, as the foreclosure crisis, which many people conflate with the GFC, took hold, apartments were well-positioned to benefit. As people were forced out of their homes or walked away, they had to go somewhere, and that was rentals.  And, as lending standards were made stricter, all those would-be homeowners also had to go somewhere, and that was rentals.

What is VERY important to note here is that vacancy ROSE before it fell.  It rose as the recession took hold, and people lost jobs, and then it fell when economic growth returned, but the foreclosure crisis continued.

What causes a lot of confusion is that, even after the GFC ended and growth returned, unemployment remained high, and the economy still FELT terrible. So, colloquially, people talked about still being in a recession, even though we were not.  Times were tough, and unemployment was still very high, to be sure, but economic growth had returned.

Because of the confusion between what actually happened during the recession (vacancy ROSE) and what happened after the recession, when the economy still felt terrible and people were still struggling but the foreclosure crisis pushed people into renting (vacancy FELL), it became a popular thing to say that MFRE does well in a recession.  And, of course, this narrative was pushed heavily by the new crop of syndicators and real estate mentors that rose as multifamily rose over the last few years.

Multifamily asset values actually dropped more than 30% during the GFC.  However, because pretty much every other real estate asset class fell more, it was commonly and correctly stated that MFRE is more resilient during recessions than other real estate asset classes.  However, doing less bad is not the same thing as doing "well" or being "recession proof." Again, sloppiness with words and analysis led to a self-serving narrative that apartments are "recession proof."

Furthermore, anecdotes abound about individual owners who did just fine during the recession, and no doubt many of them will chime in to deny all the evidence because "I did just fine" in the recession.  What is also important to remember is that, nationally unemployment went to nearly 11%.  Among four-year college grads, unemployment peaked at less than 4%, meaning that it was much higher than 11% for everyone else.  And individual markets did better than others.  If your market was a state capital or dominated by a big public university, unemployment did not go much above 6%. That means there were many markets where it was worse than 11%.

This state of affairs has led to a very dangerous complacency among real estate investors. Many are paying record high prices, with the current good economic news baked in and forecast to continue forever, and justifying these prices on the basis that "rentals are recession-proof." Many of them also seem to be convinced that, in the next recession, there will be another foreclosure crisis that will save MFRE again. However, the foreclosure crisis was a one-time event caused by the preceding one-time event of 5% of the population, which never should have owned homes, being pushed into homeownership during the bubble. Since then, lending standards have been made more strict, and history is not going to repeat itself.

The level of investor complacency you mention is a sign of being very late in the cycle.  It's just when people start to be lulled into a false sense of security that crashes generally happen.  Bubbles take a long time to form and an instant to break.  When they do, the trip down is fast.  We will soon have another chance to test the hypothesis that "rentals do well in recessions."

By the way, a couple of years ago, even I was starting to internalize the "MFRE does well in recessions" narrative, and I felt the need to get some outside perspective.  So, I reached out to my property manager, a man who runs a management company that manages institutional quality assets and serves on the national board of the NAA, who has been in property management for more than 30 years.  I asked him what happens to MFRE during a recession.  He said, "vacancy goes up."  Then we shared a good laugh over people talking about how vacancy goes down in recessions.