September 2024 Insights: The Shifting Outlook on Commercial Real Estate
September through December is normally a quiet period for the multifamily industry, but 2024 has proven to be anything but that. Ignoring the presidential election, which will surely dominate headlines over the next month, September experienced a continued shift in sentiment and expectations by not only investors, but now the Federal Reserve themselves. Supporting the Fed’s policy shift, we saw a number of data releases in September that support our belief that, while the economy is slowing down, the multifamily industry is already coming out of its recession. We are a data-driven firm at our core and the following are the most important data releases from September that you should be focusing on.
Fed’s 50bps Rate Drop
Apartment cap rates nationally have leveled off in the mid-5%s, according to MSCI, with some well-located Class A properties compressing into the 4s. Whether it was 25bps or 50bps, most assumed rate cuts were on the way, which helped justify the negative leverage and rate cap compression that we have seen over the past 6 months.
So how much is today’s rate cut already priced into apartment cap rates? I assume the answer is “quite a bit.” But that doesn’t necessarily mean cap rates hold flat from here. The answer to that question is dependent on how much further the Fed will cut over the near term.
My guess is we’ll see investors start to price in the NEXT cut, which might compress cap rates (especially for well-located assets without heavy deferred maintenance) a bit more but where my expectations deviate from the market is the expected rate of decline from here. Absent a severe event in the economy, don’t expect rate to come crashing down. Especially the longer end of the curve, which has already seen a significant decline.
Also, don’t expect cap rates to keep pace with the decline of interest rates. Negative or neutral financial leverage (Cap Rates < Interest Rates) is not the norm but rather a biproduct of rapidly rising interest rates. As interest rates likely continue their decline, cap rates will likely settle in the high-4% to mid-5% range, with cap rates on Class C properties likely 50 to 100bps higher.
Has Rent Growth Really Outpaced Income?
Inflation has been painful for almost everyone; don’t even get me started on my trips to the grocery store these days. Rent and shelter costs, being the largest component of inflation, are no exception. But what is interesting to see is the relationship between rents and income growth over the past 5 years.
Apartment rents again held mostly flat through August, marking the 21st consecutive month where wage growth has topped rent growth. Should this trend continue — and it almost certainly will — we’ll see the rent to wage growth gap of 2021-22 completely erased later this year. That’s a stat that I don’t think many realize. Put another way, rents adjusted for income growth are remarkably close to reverting back to the levels seen prior to the pandemic.
This is not to say that rents are at a fundamentally healthy level overall, but they are on par with where they were prior to the pandemic which is likely a surprise to many. As discussed in July, August, and below, new supply of apartments is anticipated to drop significantly so the gap between income growth and rent growth will narrow over the next 12 months but likely not before fully correcting the 2021-2022 dislocation.
Increased Investor Demand Over the Next 6 Months
Despite the significant level of distressed properties remaining, which we expect to peak mid-2025, investor sentiment for commercial real estate has shifted remarkably positive in the most recent survey by John Burns Research and Consulting. Our experience across the ninety-three investments that we’ve underwritten and offered over the past 3 months has shown the same. The apocalyptic fears from 4Q2023 and 1Q2024 are behind us and with the decline in interest rates, investors are flocking back into multifamily as the preferred asset class.
Construction Starts Continue to Plunge
A topic covered frequently in our past monthly newsletters, so I’ll keep this one short – multifamily construction starts have now fallen at the fastest rate in recorded history (1968). This is extremely bullish for rent growth after the current construction pipeline is absorbed.
However, there is still a wave of supply coming online over the next 12 months. Below is a list of markets nationally with the highest level of supply coming online in percentage terms and the estimated peak in deliveries, overlayed with vacancy rates and rent growth. As you can see, the darlings of the pandemic (i.e., the sunbelt markets) continue to experience a significant amount of newly constructed apartments coming online and this is expected to continue through the first quarter of 2025. As a result, rent growth will remain muted throughout 2025.
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At Vanamor, we combine an institutional approach with an often overlooked middle-market focus to employ a flexible and disciplined investment philosophy. Our goal is to provide stable cashflow with above-market total returns. Since inception, Vanamor has averaged a greater than 33% annual return with an average of 8% annual cashflow distribution.
