A lot of new apartment buildings are good news for renters, but perhaps less good for developers. What about REIT investors?
In this podcast, Motley Fool analyst Matt Argersinger and host Ricky Mulvey discuss the state of the multifamily market and why REITs (of any stripe!) aren't down for the count quite yet.
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Matt Argersinger: 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, they can't refinance, the rents and occupancy that they thought was going to be there. It's not there. They're facing a liquidity crunch, like a lot of small businesses in the country.
Mary Long: I'm Mary Long and that'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.
Ricky Mulvey: Matt, one of the biggest real estate trends over the past few years has been the growth of the Sun Belt. Story goes like this. People want more flexibility in how they work. Remote work has allowed them that. 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 REIT holder, that maybe the Sun Belt's overbuilt. Has multifamily become overbuilt in these cities that had a lot of those population trends?
Matt Argersinger: I think it's a very fair question and it's a question that I'm probably going to say yes to. I think there has been a lot of overbuilding. You could almost see it, Ricky. You mentioned people having more flexibility with work and wanting to move to warmer places. Totally, we could see it in the U-Haul data, which is interesting to track. You could see U-Haul data, which shows you where people are picking up stuff and dropping stuff off of and immediately even before the pandemic, but certainly after the pandemic. This huge migration of people from coastal cities, northern cities, into the Sun Belt. For all the reasons you've mentioned. It's better weather. People had more work flexibility than ever before. 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. That's for a lot of reasons. Land is cheaper. It was cheaper for a lot of apartments to get built. We're certainly seeing that.
Ricky Mulvey: For a while, you saw these double digit rent increases, which, I myself I am a renter, so I'm not a fan of them. Then it's starting to dip. One-bedroom rents in Nashville are down 4% from last year, Denver has also seen some rent stabilization, although there's 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. I think the thing that I'm worried about as an investor now. To put that hat back on, is, is this a stabilization, or is it the beginning of a boom and bust cycle?
Matt Argersinger: I think it's the latter, actually. I just to put some numbers around it. If you look at data from RealPage Market Analytics, which really tracks apartment developments, 2023 was a 36-year high in terms of deliveries of new apartments. Four-hundred-and-forty-thousand 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. As we've already talked about, a lot of that development is in the Sun Belt, and look at Denver where you are. Construction there is supposed to add 9% to the existing inventory this year. Nine percent to an entire metro areas 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, LA, or Boston, a lot of it is coming down to there's this affordability issue before we even get to rents. If you look at data from John Burns Research and Consulting, for example, right now it's costing roughly $100 more to buy a home in a lot of these market centers, it is to rent a home. That's obviously because we are 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. You have existing homeowners who are reluctant to sell because they're probably locked into a rate that's like 3 or 4%. They don't want to move up even if they want to to a mortgage rate that could be 7 or even 8%, and a lot of young home buyers, potential homebuyers just can't afford the mortgage costs. It's cheaper to rent. In Denver, for example, the number is 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 alluding to, this is a bit of a boom-bust cycle. A lot of this development all these units that are coming to market, we're based on the tremendous demand we saw immediately coming out of the pandemic. You're starting to see rents come down. As you mentioned, you're seeing rents flat line a little bit in certain markets. It's all about there's lower absorption. There's a lot of supply. I think the key for looking indicator is if you look at development stats, which is this 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 stats nationwide, we're down 40% in Q4 2023 alone, and stats are coming way down, deliveries are supposed to peak mid-2024 this year. I think this boom-bust cycle is about to enter a bust and it might take a good year, so before we get to an equilibrium, where 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.
Ricky Mulvey: The basis of this segment Matt, I was at a restaurant with a mutual friend of ours, who was 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?" 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 50-30 years. But for the builders of these large apartment complexes, the debt works just not even a little bit, a lot of bit differently.
Matt Argersinger: 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 best a 5-7 year mortgage that usually has a floating rate to it, not a fixed rate. 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 to acquire the development or the proceeds to do the development. For a lot of developers, it's actually even trickier. If you're starting from scratch, looking to construct a brand new apartment building where one's never been before. In most cases, you're looking at a 2-4 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/LTC, loan-to-cost, might be 60%. At best, you have to come up with at least 40% equity, if not more, to secure the proceeds to even start that development. Think about that across the country with rates the way they've gone, and it's much more expensive to construct a building or even acquire a multifamily apartment building today than it was just a couple of years ago. That's why you've seen those stats come way down. That's why they're down 40%. That's why they're going to fall precipitously this year. That's why even though we're probably in the midst of a bust, if those stats 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 in the near term.
Ricky Mulvey: This is the story that I'm worried about playing out or 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 on that 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're not filling up the buildings like they thought they would. 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.
Matt Argersinger: It's a totally different environment than it was. A lot of these developers, especially on the smaller side, they didn't underwrite this. No one underwrote a 500 basis point increase in the Fed funds rate over the course of say, 18 months. Gosh, a lot of these apartment stats 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. They were underwriting, hey, rents are going to go up, continue to go up 5% a year. Hey, I'll be able to refinance the construction loan in three years and lower the rate significantly. My exit cap rate will be, 5% as opposed to like 7% as it is today. 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. They're facing a liquidity crunch, like a lot of small businesses in the country.
Ricky Mulvey: 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, so 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. They've highlighted this on earnings calls. The price of the REIT 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?
Matt Argersinger: Headwind definitely feels like an understatement. I would say, maybe approaching tropical storm wind speeds. They've certainly experienced it with their apartments. They've seen their rents grow from double-digit growth just a couple of years ago to flat to negative over recent quarters. They've talked about the supply situation a lot in a lot of the markets. I would say the strength of Mid-America and with larger REITs in general, but Manera especially, it's 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 the central business district apartments. They've been outside the main cities, but they've also been in the Sun Belt markets. They've benefited from that net migration, 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 what first time home buyers can afford. In just the first quarter, less than 13% of Mid-America's tenant moveouts were due to home purchases. That's another indicator right there. That's the lowest rate they've ever seen. Renewal rents. 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. I think they're in a pretty good spot. They've got a great balance sheet. Remember, they can take advantage of a market like this. We've talked a lot about smaller private developers 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 finish the build. Well, Mid-America 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. 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 in a year or two.
Ricky Mulvey: 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-like a PE multiple or price tag for REITs has dropped dramatically from 2022 from about 22.5-14. 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 devaluation, or do you think the market is overreacting on Mid-America?
Matt Argersinger: That's a pretty stark fall from a 22.5 times funds from operations, multiple to 14. I would argue that at 22.5, Mid-America was probably a little overvalued. I think at 14 times FFO, they're probably a little undervalued. Again, truly Best in Class REIT with Mid-America, one of the best track records out there for public REITs. 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. Again, they're the entity out there that has the balance sheet. One of the advantages that REITs have that a lot of private dealers don't have, actually, no private dealers really have is, they can access the non-recourse capital markets for debt. Mid-Americans issue debt, billions of dollars worth of debt at reasonable rates, whereas small private developers, they're issuing debt at high single digit low tin 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 senior debt all day. 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.
Ricky Mulvey: 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 oversupply and then boom-bust cycle. Any other companies REITs that you want to bring into the conversation as we wrap it up?
Matt Argersinger: Sure, I'll just say just stepping back in general, real estate is right now the only sector, I believe, last I checked in the S&P 500, that's negative year to date. I think that is, you've got institutional investors who are myopically selling REITs because A. high interest rates, REITs are often treated as bond proxies. Rates are higher with sell REITs. 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 REITs. I used to be 20%, if you go back just a decade ago. Historically, REITs have done quite well in moderate to high inflation and moderate to high interest rate environments, which we're in right now. 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. I think eventually pricing power comes back. I'll come back to Mid-America. I'll come back to multifamily REITs. I already exists in major industrial REITs like Prologis, for example, or data center rates 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. 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 the values look incredible. I think when I look at other parts of the market, like the technology, large caps, wow, you see some incredibly high valuations. I see nothing but historically discounted valuations in REITs. 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, whether it's Prologis, industrial, Mid-American multifamily, which we talked about, or a Simon Property Group, which, they own shopping malls, but hey, they own the best shopping balls in the country, and by the way, people are still going out and shopping, believe it or not. That just looks like one of the most attractive REITs as well. 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.
Ricky Mulvey: Usually a better idea to look at a sector when the valuations are depressed. 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 REIT 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 Argersinger. Thank you for your time and your insight on this.
Matt Argersinger: Hey, thank you so much, Ricky.
Mary Long: If you like hearing from Matt, he also runs our real estate winner service, which is a part of a new offering we've rolled up this year, called Epic Bundle. This service includes seven stock recommendations every month, model portfolios and stock ratings, 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. For more information, head to www.fool.com/epic. I'll also drop a link in the show notes for you. As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against. Don't buy or sell stocks based solely on what you hear. I'm Mary Long. Thanks for listening. We'll see you tomorrow.
Mary Long has no position in any of the stocks mentioned. Matthew Argersinger has positions in Digital Realty Trust, Mid-America Apartment Communities, Prologis, and Simon Property Group and has the following options: short June 2024 $120 puts on Prologis. Ricky Mulvey has positions in Mid-America Apartment Communities and Prologis. The Motley Fool has positions in and recommends Digital Realty Trust, Mid-America Apartment Communities, and Prologis. The Motley Fool recommends Simon Property Group and recommends the following options: long January 2026 $90 calls on Prologis. The Motley Fool has a disclosure policy.
