The Monthly Multiple: January 2022

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Quick Stats:

• 13.5% annual rent growth in the multifamily sector
• 6.3% projected NOI growth in the multifamily sector, ‘22-’25
• The prices of key materials rose 77% in 2021

As markets go, commercial real estate markets tend to be pretty sluggish. Stringent zoning regulations, misaligned perceptions of value, and construction complexity can all hinder growth in new supply, even where robust demand brings strong incentives. During a recovery, supply of newly built space typically lags rent increases; higher projected values for completed space tip more and more projects into viability, bringing developers and capital out of the woodwork. Researchers are now forecasting a very exaggerated version of this dynamic: average rents are expected to continue climbing for the next couple of years, while the change in supply growth continues to decline, with supply growth not expected to turn positive until 2026*.

Why? Input costs are the main factor. The prices of key materials rose 77% in 2021, putting an additional drag on new construction starts. In time, global supply chain pressures will subside, inflation will abate, and steadily increasing demand will push new projects into viability. For now, though, supply is likely to remain suppressed, even as rents climb ever higher. Multifamily rents grew 13.5 percent in 2021, more than double any prior year, and apartment absorption on the year was roughly 50 percent more than the previous annual high, set in 2015. For the moment, the demand/supply imbalance stands to benefit real estate investors across sectors and markets; with new supply lagging, rents and asset values have nowhere to go but up as the recovery plays out.

Operational Real Estate Takes Center Stage

Multifamily and ecommerce-ready industrial remain strong bets. However, with plenty of institutional capital chasing deals in those sectors, “operational” assets look better and better. For forward-looking sponsors and operators, cold storage, self-storage, student living, senior living, data centers, car washes, and a host of other niche asset classes are all coming into focus.

While core CRE asset classes may offer predictability and stability (particularly multifamily), operational assets allow investors to also tap into the potential of the underlying enterprise. In many cases, the businesses driving the value of operational real estate benefit from substantial macroeconomic tailwinds, such as the increased demand for dispersed medical services, favoring medical office buildings.

Stricter Traditional Lending Standards

Debt markets broadly favor real estate investors at present. In past instances of prolonged inflation, rising rates posed a threat to borrowers reliant on refinances as part of their business plan. This appears to be less of a threat now. While the Fed may move more aggressively in 2022, rates would move from what are still historic lows. The spread between property yields and aggregate interest rates remains favorable.

As traditional lenders tighten lending standards, doors open for private debt capital. With investment volume and average deal size forecasted to grow, there should be ample opportunity for debt funds, hard-money lenders, and other sources of non-bank CRE debt capital. In inflationary periods, borrowers stand to gain and debt investors stand to lose in real terms. However, CRE debt still looks attractive relative to fixed-income assets given higher prevailing yields and the fact that CRE debt is typically collateralized by an inflation-hedged asset. In an inflationary environment, debt on existing or transitional real estate increases in safety over time as asset values and revenue generation at properties inflate.

EquityMultiple will seek to pass along these opportunities from the private CRE debt market for more secure, current yield-focused investors.

Market Selection Is Back

During the decade preceding the pandemic downturn, the performance gap between sectors and markets normalized. Cap rate compression and falling interest rates uniformly boosted values across markets and sectors. Market dynamics were placid. Since the pandemic began, sector performance has varied greatly. In the next few years, we can expect market selection to drive variance in asset performance. Some markets feel like relatively safe bets, such as business-friendly sunshine metros like in the Southeast.

Certain gateway CBDs (central business districts) may stand to gain through more accentuated recovery dynamics. Downtowns of major markets tend to perform better during recoveries due to agglomerative benefits of a dense, central location — network effects may spur demand in the office market, attracting new talent, and creating a virtuous cycle of upward demand pressure for office, multifamily, and retail space. Indeed, CBD office submarkets are starting to outperform: rents were up 1.5% in 2021 vs. 0.6% in suburban office markets.

A broad geographic footprint may serve real estate investors well over the next few years.

*Sources: Yardi Matrix, Green Street Real Estate Analytics, PGIM Real Estate

Further Reading

PGIM — Real Estate Trends for 2022
Pitchbook — Landlords are Betting Workers will Choose the Office
Wall Street Journal — COVID Fuels Best Ever CRE Sales

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IR Insights – Doing Your Due Diligence 

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“Elevated costs will have an effect at the margin, weighing on construction starts now — and, therefore, limiting potential future supply growth — even if occupier demand and rents start to grow more rapidly.”