Overlooked Apartment Opportunites

The multifamily apartment sector continues to steam ahead unabated. However as the majority of new units coming to market are high-end/luxury (Class A), this is creating an affordability crisis for renters. Ironically, the increased rental rates commanded by new apartment buildings, becoming an ever increasing percentage of renters' disposable income, seems to perpetuate renters' reliance on apartment living as they are unable to save the down-payment necessary to buy a home.

According to Zillow, renters earning the national median income of $53,602 spend 30% of their income on rent. This is 5.5% higher than the historical average between 1985 and 2000. However, if you just look at six of the most unaffordable markets (New York, San Francisco, Los Angeles, San Jose, San Diego, and Miami) this number increases to 39.4%. In individual cities such as San Diego it is 43.2%, San Francisco it's 44%, and in Los Angeles it's 48.2%. These numbers increase yet again if you only look at the rents being paid for new construction units brought to market between 2011 and 2014.

In comparison, Zillow states that the average cost of owning a home today has gone down to 15% of median income, from the historic average of 21%. Unfortunately for a lot of renters wishing to buy, they are either unable to save the down-payment necessary, or their credit score got damaged during the recession. There is also a major supply issue, with very few new homes being built over the past eight years. Most development in the residential space has been concentrated on Class A apartments.

Class B Opportunity

There is a huge opportunity for investment returns within the Class B apartment space in primary markets, and for all apartments in general, in tertiary markets. Institutional Capital has been preoccupied with Class A product. There has been a proliferation of large private equity real estate funds in recent years. For practical reasons it can be very inefficient for a very large fund, with billions of dollars to deploy, to underwrite and bid on a relatively small transaction, of say $20 million. This creates a huge opportunity for individual investors and smaller funds.

With the booming Class A development pipeline, this has increased the cost of developable land and construction costs across the board. Therefore the cost to develop a new Class B property becomes prohibitive, unless availing of Government tax credits and incentives for an affordable rental property. The real opportunity lies with buying existing Class B product, and either renovating the property or managing them more efficiently. Many Class B properties can be acquired well below replacement value.

Class A properties can trade for a low as a 2% Cap Rate, but at the very least below 5%. Depending on the market location a Class B can trade for as high as a 10% Cap Rate. Within the same primary market though, the spread between a Class A and B property can vary between 100 basis points to 250 basis points.

The national average for rental rate premium of a Class A property over Class B & C, is 41%. It's quite a gap, but the average Class A renter does not tend to drop down to Class B. With the glut of Class A product on the market and still in development, and considering how far rents have escalated and the affordability issues, rental rate growth within Class A may become dampened down.

Within Class B there is actually a shortage of available units. The vacancy rate in this sector is now 220 basis points lower than Class A. As already mentioned above, there is no new Class B product in the pipeline because it is economically unviable to build for Class B rental rates right now. This is choking the supply of Class B units and increasing their rental rates. Therefore in the medium term, Net Income growth rates should be higher for Class B.

Class B has been historically looked at by long-term investors seeking a steady investment yield from rental income, not necessarily big capital gains. With the current lack of competition on acquisition, and the increasing Net Income, there appears to be a capital appreciation opportunity here.

If you have a development project or an investment property in need of capital, with either debt financing or equity co-investment, or you seek an experienced development/operational partner, please give me a call. Likewise, if you have capital to deploy we can assist with identifying appropriate real estate opportunities.