As the commercial real estate sector reaches a ninth year of recovery in 2018, two true but seemingly opposing trends have manifested. First, the unabated gains in multifamily revenue growth and occupancy have lost their steam. Rent growth is decelerating, and even occupancy has been dipping in many areas that looked fantastic a few years ago. Second, the general crisis in US housing has not abated at all for median income households, despite the growth in apartment construction. Many Americans still lack access to quality affordable housing, and this consistent demand unearths significant needs-based opportunities within the nation’s housing stock that offer better risk-adjusted returns than conventional multifamily.
Tale of two subsectors
Why is this? When large investors talk about the multifamily sector, they are generally referring to newer, highly amenitized, 50-plus unit buildings. Beneath this highly overinvested subsector is workforce housing – a vast and much less ‘institutionalized’ stock of assets that offer quality housing for the masses. While the two subsectors obviously have interplay, it is less lockstep and more favorable to workforce assets than many have assumed, mainly due to how difficult it is to meaningfully increase the supply of housing at rents low enough to shift the market. Meanwhile, many CBD areas are seeing double-digit rates of annual inventory growth.
“Workforce tenant demand is more stable during downturns than higher-end multifamily tenants… rental rate growth potential in this subsector is generally higher throughout the market cycle, with lower troughs and longer lasting growth periods”
Workforce housing can be defined in a few ways. It must be affordable for households making at least 80 percent of the area median income for a particular region or metropolitan statistical area and be acquired for roughly 50-70 percent of replacement cost, depending on the market. To provide a basic margin of safety from the higher rents in the costly, recently developed multifamily stock, the average rent price on a trended basis and after improvements must generally be below $1,100 per unit (assuming average metro rent costs). Additionally, markets for acquisition must be diverse, growing economies with noteworthy historical performance, and promising forward expectations. These assets, typically B/C class properties, but still perfectly functional, are the most affordable options for median-income renters. With value-add renovations, they can extend their appeal, filling both a deep social need while offering strong total returns and sustainable yields to investors.
A compelling prospect
These assets are particularly attractive on two fronts. Workforce tenant demand is more stable during downturns than higher-end multifamily tenants. Additionally, rental rate growth potential in this subsector is generally higher throughout the market cycle, with lower troughs and longer lasting growth periods, as seen currently. Promising workforce housing opportunities are often found in quieter markets like Indianapolis, rather than in high-profile gateway markets (New York and San Francisco, for example) and typical high-growth markets (like Raleigh in North Carolina and Austin, Texas). These quieter markets have often not yet experienced overinvestment or meaningful rental rate growth, despite an appealing economic and employment backdrop.
This workforce housing approach has served Virtus Real Estate Capital’s cycle-resilient strategy well in the past few years, but there are workforce housing opportunities to be explored beyond B/C class multifamily properties. For example, firms can partner with the public sector in delivering Class A properties where a subsidy or tax abatement can allow for more affordable rent as part of a public-private partnership or related structure. Similarly, disruptive building techniques or co-living arrangements may also deliver affordable housing to the broader renter market. Housing is one of the most needs-based asset classes in existence, and workforce housing ably addresses a social need that will be further exacerbated due to the wave of demand coming from Generations Y and Z.
There is not only social value in identifying communities with a genuine need for quality housing for the masses, but also compelling investment value in supporting this stable and growing market. Virtus expects this to be a meaningful part of its allocation in the coming years, especially in its value-add and opportunistic strategy.