Real estate has a remarkable ability to deliver returns for investors, even when the stock market or other economic indicators are pointing downward.
But resistance to bad economic indicators is not immunity. As the Federal Reserve started raising interest rates, the previously red-hot single-family housing market began to show signs of slowing down. While home prices are still high compared to historical trends, real estate takes longer to sell and for less.
Now even housing rents are falling in many markets. According to data from the CoStar Group, which collects nationwide data on commercial real estate trends, average rental prices for apartments in America’s 40 largest housing markets fell 0.04% from August to September. That means the average national demand rent for that period dropped from $1,641 to $1634.
A 0.04% drop may not sound like much, but it’s important to note that this was the first time in nearly two years that apartment rents have fallen in consecutive months. The last time it happened was in December 2020, when the country was still firmly in the grip of the COVID crisis. More importantly, there was not a single market among the top 40 markets CoStar studied that saw an increase in average rents during this period.
While the year-over-year rent average for August was 7% higher than a year ago, that is a significant drop from CoStar’s 8.4% increase in July. Perhaps even more important than the decline itself, is where the decline occurs.
The Red-Hot Sun Belt Market Cools Down
In recent years, the American Sun Belt has been one of the strongest real estate markets in the country. The Sun Belt runs from the Southeast to the Southwestern United States. It includes Texas, Florida, Georgia, Arizona and Nevada. Year-round warm weather has made these states popular vacation destinations. But in recent years, their combination of affordable housing and low state taxes has been a strong draw for buyers and renters alike.
That popularity pushed cities like Tampa and Orlando, Florida into the spotlight as some of America’s hottest real estate markets. The same goes for Houston, Dallas and Phoenix. As you would expect, investors and developers followed this trend. They proceeded to aggressively build new stock in those hot markets. A number of real estate investment trusts (REITs) have assets in these markets that are either already online, planned to come online, or already built and in their stabilization phase.
That’s where the CoStar data really starts to paint a vivid picture. Some of the most popular Sun Belt markets are now seeing the biggest rent declines. This includes
- Orlando: -2%
- Tamper: -1.1%
- Phoenix: -1.5%
- Dallas/Fort Worth: -0.7%
- Las Vegas: -1.8%
Not only is the national rental market cooling down, the markets that used to be the hottest are also cooling down the fastest. In fact, the large declines in these markets are responsible for many of the largest declines in demanded rents. This, of course, begs the question of what is causing the downtrend. After all, the weather is still warm there and taxes are still low, so why are rents falling?
A combination of factors
There is rarely, if ever, one reason why rental markets in as large a geographic area as the Sun Belt plummet. It is usually a combination of factors. Supply and demand is one of the first rules to rule economic markets, and when people first flocked to the Sun Belt, there wasn’t enough supply. This meant that owners and developers of existing apartments or single-family homes had a captive audience.
In many cases there were several tenants competing for the same property, and this demand put pressure on rents. However, developers responded to that demand by delivering more than 100,000 new homes in the past year. CoStar estimates that more than 220,000 units will hit the market before the end of this year. The fact that many units simultaneously flood the hot markets will undoubtedly have a cooling effect.
Another problem is inflation. It’s no secret that the price of just about everything has gone up. From fuel to staple foods, there is hardly a consumer product that doesn’t cost more today than it did a year ago. When consumers feel such a pinch, they naturally have less confidence in the economy and their ability to make big purchases or take big strides.
The sour economy, or at least the storm clouds gathering above it, keeps people from moving. Even a local move costs a lot of money. There is a security deposit, plus the first month’s rent that must be paid. Then the movers have to be paid.
That’s all why consumers are much more likely to move out of their current living situation than to take a big step. They are even less likely to move to the Sun Belt if they don’t already live there. When you add all these new stocks to inflation concerns, it’s not hard to imagine why vacancy rates are rising.
What does this mean for investors?
When rents start to fall, so do real estate investors’ profits. In response to increased housing demand in the Sun Belt, many REITs have made strong strides in the Sun Belt to meet the area’s housing needs. They acquired many assets to renovate and land to build new developments. Naturally, they raised funds through investor contributions to finance these ventures.
REITs and all real estate partnerships make money in a few different ways. In the case of multifamily or rental assets, the return depends on the ability to increase rents over the life of the investment. These rent increases not only provide passive income for the partners, they also add value to the property. As investors’ returns grow during the REIT’s holding period, the assets in the REIT become more valuable.
When rents don’t rise, or worse, fall year after year, the expected returns REITs offer investors aren’t realised. In addition, the assets do not increase in value at the same rate. That means they have a lower resale value at the end of the investment holding period.
The high cost of acquiring and renovating or building new real estate assets means profit margins are incredibly thin. In most cases, multifamily assets cannot provide a return for owners if the occupancy rate falls below 96% during the year. It’s a very fine balance. You want enough vacancy to be able to raise rents, but not so much vacancy that you get an excess of it and have to start renting.
When markets where multiple REITs operate — such as Tampa, Orlando, Phoenix, Las Vegas, and Dallas — simultaneously see rents drop as much as 1%, it poses a direct threat to investors’ expected returns. It doesn’t necessarily mean investors are going to lose money (assuming the market doesn’t keep falling), but it does mean that many REIT assets in the Sun Belt could miss their expected return targets.
When looking at REITs to invest in, it would be good to really zoom in on where the assets are. One of the greatest advantages of REITs is that they hedge against the risk of loss for investors by spreading their assets over a wide geographic area.
If you are looking at a retail REIT with assets in some of the markets that are currently in decline, there is a chance that your investment will not meet some of its objectives. That means your expected 20% internal rate of return over a few years of the vesting period may be as little as 17%.
Focus on other sectors
Looking at this data may or may not be enough to worry you about the prospect of residential REIT investments. That’s a decision you need to make based on your investment goals. On the other side of the equation, when REITs have assets that fall short of their goals, that can create opportunities for your chosen REIT to pick up some value-priced assets at some point in the near future.
Another thing you can do is remember that multifamily homes are not the only segment of the REIT investment industry. There are also REITs that focus on medical buildings or industrial properties. The same applies to individual investment offers. While multi-family homes receive the lion’s share of investor attention, the real estate market in general offers other opportunities to take advantage of.
Whatever you decide, the tea leaves show it gets a little more complicated to steer multifamily investments toward predictable returns and steady appreciation. It doesn’t mean that multi-family investing is also dead. Remember that real estate should be a long-term game. Over the course of a five or ten year investment cycle, you may have some bad quarters or even bad years.
But the history of real estate has shown time and again that it is a reliable market that gains more than loses for investors. The real estate market will almost always warm up or cool down. Down markets have proven to be some of the best times to acquire assets.
Regardless of the latest economic data, your job as an investor will not change. You need to weigh the risks, consider your investment goals, and make the best decision you can at the time.