The US is facing its greatest housing affordability crisis since World War II. According to the United States Census, the average cost for a new construction home in the country was $388,200 in March 2017, putting ownership out of reach for more than 80 percent of the population.
Unfortunately, the issues exacerbating the problem are lining up simultaneously, creating a perfect storm. For investors in multifamily housing, the outcome of this storm is an economic positive as rental rate increases exceed the consumer pricing index. Overall, however, the trend is irrefutably a negative for the US, as it challenges the notion of a stable home environment and so undermines efforts to address many of the country’s societal challenges.
Against this backdrop there is a special opportunity for multifamily investors, developers and financers that are willing to think creatively about both existing properties and new developments.
Because of the country’s current demographic trends, the holy grail for investors is going to be well-built, value-based apartments in desirable communities. While the demand trend is readily apparent, barriers to new supply in terms of cost and financing are immense. Inflation in construction costs, the potential for increased interest rates, and a compounding of financing regulations are each contributing to the difficulty of providing affordable new development. These factors, combined with rapidly increasing land costs in many US markets, have compounded to the point that creation of new value-based properties without some type of subsidy has become impractical.
Yet demographically, the US has a real, long-lasting need for more housing. The country’s millennial generation is 83.1 million strong, and the United States Census found that 22.8 million millennials are currently living with their family members or are in school. The generation’s birth rates peaked in 1990, but the peak was eclipsed in 2007. Therefore, the demand side of the equation will not likely see any relief until 2032, when the generation born beginning in 2008 (when there was a decline in births) starts to hit its peak rental years. On the current trajectory, the pressure this generation will face when seeking housing then will be immense.
While there has been an increase in construction, new activity has yet to break the historical annual average of 397,000 new multifamily units per year reached between 1968 and 2016, according to property data firm CoStar. Multifamily Executive magazine recently predicted that in 2017, multifamily starts could even be as low as 200,000 units. When you consider that most of these new developments are likely to be luxury homes at the very top of the market – combined with the fact the US loses approximately 100,000 units annually to obsolescence – it is easy to envision the affordability crisis.
Trulia, a real-estate website, found that in a first responder making the job’s median salary in Raleigh, North Carolina could afford just 19 percent of homes for sale in that market. In 2014, that same first responder could have afforded 30 percent of the available homes in Raleigh. In Madison, Wisconsin, that first responder could afford 19 percent of the available homes in 2017 compared to 32 percent of the homes for sale in 2014. Trulia also found that teachers could afford less than 20 percent of the homes for sale in 11 of the 93 major US metro areas that it studied. These rising prices are already beginning to put housing beyond the reach of significant sectors of the workforce, just as the millennials are starting their careers and seeking out homes.
Refurb over replace
Part of the solution to this problem involves taking a second look at older, more affordable properties rather than tearing them down and replacing them with new product at much higher rents. The investment thesis is to find opportunities to purchase value-add properties and improve them to attract a superior clientele, while not pricing out the majority of the workforce. Improvements can include instituting quality property management and adding amenities and better finishes inside the units. This is more cost-effective for the developer, maintains much-needed units at a good rate, and when purchased at a favorable basis, provides a good return on investment for investors.
We have seen this work to great effect at our own Sterling Glenwood Apartments in Raleigh. Although the property had a convenient location, its amenities were outdated, its appearance was dingy and its reputation tarnished. Upon purchasing the property, we installed a professional, proactive property management staff, made major renovations to the lobby and fitness center, built a new pool and pool house, and added a dog park and cycle center. All this enabled us to attract a different clientele and drive rent growth. At the same time, we did not want to drive away the property’s long-term residents, who were a valuable part of the community. That is where our policy of capping rents for residents who have lived at a property for five years or more becomes effective. This avoids losing the sense of community that long-term residents provide. Of course, the problem with investing in the existing housing stock is that prices have risen to a point that margins are razor thin and the business case for them often does not take into account inevitable bumps in the road. We have found the development of value-based apartments to be a more compelling opportunity as a consequence.
New development also has a critical role to play in addressing the affordability crisis, particularly given the continued increase in household formations and the demographic makeup of potential renters. Investors and developers that care about this issue should look at how to provide the most efficient and cost-effective apartment homes in urban communities with high housing costs, thereby filling a void obviously not met by luxury construction.
Grubb Properties’ Link Apartments are exclusively focused on filling the affordable housing void in southeastern US urban areas. The primary driver of affordability is monthly rental rate as a percent of income. Unit efficiency is one of the best ways of achieving that, by driving down the rent per unit while focusing on the quality of the unit specifications important to today’s primary resident. Residents are willing to trade off overall size for quality, as long as there is a focus on items like closet space, vanity countertop length, and washer/dryer size – where small increases in square footage can be meaningful. In contrast, shrinking a living room size by 18 inches across the width of the unit and eliminating unneeded entry hall space can have a much more substantial impact on the total size and, correspondingly, the rent. Ten years ago, the typical one-bedroom apartment averaged 850 square feet. Today, our large one-bedroom is less than 650 square feet, and we have units below 500 square feet. At the same time, today’s renter demands modern conveniences and features, so a successful developer must deliver unique and desirable amenities within each unit and community. One of the biggest challenges with such new development is that financing sources tend to lump these projects in with luxury products. Many lenders are erroneously assuming that because the luxury housing markets in select submarkets shows signs of being overbuilt, the entire market for new housing is facing the same problem. This is not the case and funding sources should be more willing to differentiate between developments and the markets they serve.
Proper credit due
Another significant challenge is the unprecedented inflation in construction costs, something that has affected the entire housing industry. In our markets, we have seen the cost of construction increase approximately 50 percent over a three-to-four-year period. This inflation is primarily driven by the shortage of skilled labor in the industry, and is compounded by limited financing sources. According to Multifamily Executive, 10 years ago, developers could secure 90 percent construction loans at LIBOR plus 100. Today, they are lucky to get 55 percent loan-to-costs proceeds at LIBOR plus 300 – the result of a dramatic shift in financing policy because of regulations. Because of this lack of financing, the shortage of labor, and soaring land costs, housing costs continue to dramatically outpace household wages – piling on to the affordability crisis.
Of the financing currently available, much is short-term in nature, exacerbating new construction risks. There will always be certain things out of one’s control. For example, in the past year alone, Grubb Properties has had three projects delayed or damaged by unforeseen circumstances. One in Greenville, South Carolina, was delayed by 44 weeks largely due to unseasonable amounts of rain, as well as labor shortages; our multifamily property in Savannah, Georgia had water damage due to flooding from Hurricane Matthew; and seven months after its grand opening, our Link Apartments Glenwood South in Raleigh, North Carolina, was damaged in the city’s worst downtown fire in nearly 100 years. If we had financed any of these projects with a typical three-year construction loan, the results could have been catastrophic.
Additionally, investors should be concerned about the potential for increased interest rates. For example, a 200-unit apartment that cost $50 million to build, financed at 65 percent loan-to-cost, would require $1,300 annually in additional rent per unit to cover the increase of just a 1 percent increase in interest rates. This example shows the extreme risk every investor takes by financing real estate with short-term debt. Ideally, development should be financed with 10-plus year financing because the long-term demand trend will reward patience and short-term disasters would not disrupt the overall financial success of the investment. As most lenders will not offer long-term fixed-rate loans that exceed the life of the fund owner, this runs counter to the typical fund model used by the majority of real estate managers.
Housing affordability faces many challenges as described above, but the cost of developable land is usually the largest obstacle to creating new apartments in desirable locations accessible to neighborhood amenities and job centers. Land costs have soared over the past five years, more than tripling in price in many markets. Quality development sites at a reasonable cost are the initial barriers to any value-based development.
It is possible to offset certain costs. For example, our most recent planned development, Link Apartments Innovation Quarter, secured numerous subsidies to allow us to develop value-based housing in downtown Winston-Salem, North Carolina. In a joint venture with Wake Forest University, we were able to secure an attractive land lease, a $6 million direct subsidy from the City of Winston-Salem, a five-year tax abatement as part of North Carolina’s Brownfields program, and long-term parking leases for daytime use of our parking deck when most residents are not home. Such creative approaches are necessary to deliver value-based housing in areas with the most demand, and investors participating in such projects should be well-rewarded over time.
The supply and demand imbalance in US value-based housing is significant and growing. Investors which can finance their projects long-term, are creative in driving down cost components through design and subsidies, and find quality development opportunities with proximity to employment centers, amenities and transportation, will reap great rewards over a long-term investment horizon.
Sponsored by Grubb Properties