As the Federal Reserve begins its series of rate hikes to control record-high inflation, investors need to be aware of which real estate segments may face challenges in the foreseeable future. Real estate offers investors long-term stable income, protection from inflation, and diversification benefits due to its low correlation with other asset classes.
Home values across the U.S. have hit record levels in 2021, in many instances with prices skyrocketing around $100,000 vs. pre-Covid levels. The surge is happening with remote work flexibility tied with supply chain issues that crippled the construction of new homes.(1) According to Zillow researchers, U.S. home prices in March 2022 were up 18.8% from a year ago, forecasted to reach 22.0% by end of May with the acceleration in annual home price growth. For comparison, the largest 12-month uptick leading up to the 2008 housing crash was recorded at 14.1% only. Their latest forecast predicts a subtle slowdown in the annual growth rate by February 2023, reaching 17.8% which is still about four times greater than the average annual rate of home price growth recorded since 1986 (4.6%).(2)
In its May FOMC meeting, the Federal Reserve announced its plan to move forward with a half percentage point rise in interest rates to control the record-high inflation. This move, the most aggressive since 2000, has widely affected mortgage rates, with the 30-year rate reaching ~5.3% in May 2022 - its highest level since 2009. Elevated mortgage rates coupled with four-decade high inflation, rising home prices, and lagging home construction have made homeownership less affordable, especially for first-time buyers. This could delay home purchases for millennials looking to upsize, who may instead opt for single-family or one-/two-bedroom apartment rentals.
I. The Multifamily Market
Multifamily assets have remained resilient throughout the pandemic and experienced a record-breaking year in 2021. The sector set an annual absorption record of 617,500 units in 2021, with overall vacancy rates falling 2.2% compared to the year earlier, and net effective rents increased 13.4% over the same period.(3) Strong multifamily fundamentals have persisted even through Q1 2022 due to favorable migration trends, high household formation, and strong wage and job growth - all of which contributed to the continued demand.
The multifamily sector is set for an unparalleled year ahead, with increased household formation and the return of workers to offices driving multifamily properties in urban areas to fill up vacant spaces. Urban areas experienced an average vacancy rate increase of ~2% during the peak of the pandemic. According to a recent CBRE report, vacancy rates are forecasted to fall to 4% by the end of 2022.(4)
Demand for rentals is expected to match the pace of new deliveries in 2022. CBRE forecasts that multifamily occupancy rates would remain above 95%, and net effective rents to grow at ~7% throughout the year. Construction is likely to remain elevated with around 300,000 units expected to be delivered in 2022, compared to an average of 206,000 units delivered annually since 2010. Multifamily annual investment volume set a record of $355.3 billion in 2021, nearly double the previous record set in 2019 ($193.1 billion).
According to Freddie Mac, the investment volume in 2022 is forecasted to reach ~$475 billion driven by continued demand for multifamily properties, especially with mortgage rates reaching a decade-high record that prompts prospective homebuyers to tap into the rental market vs. the for-sale market.
II. The Office Market
Covid-19 sparked the remote-work flexibility movement across the U.S. which has significantly impaired office assets throughout the country. Employees’ desire for workplace flexibility is consistently growing, prompting many employers to support a hybrid environment and remain competitive in attracting and retaining human capital. Data from Green Street shows that office utilization has declined 70% from pre-Covid levels, and although it is likely to pick up by the end of 2022, it is expected to continue to lag behind non-office social environments.
One clear trend observed is the outperformance of new or redeveloped office buildings post-Covid. Higher quality office buildings are increasingly being positioned as an incentive for employees to leave the home office and adhere to their flexibility requirements. According to Green Street, this trend is expected to favor Grade A offices over Grade B offices on an unlevered return basis, generating mid-5% and high-4% IRR, respectively, which has not been the case historically.
The U.S. office market activity strengthened in the second half of 2021 and the momentum would likely be sustained throughout 2022 by strong job growth and demand for Grade A office space. The conversion of low-grade office buildings to warehouses is also becoming more popular to accommodate the rise in demand for industrial space driven by the e-commerce boom across the country.
The industrial market has reached record-low vacancy rates of ~5% in 2021, whereas Class B office spaces have seen consistently high vacancy rates during the same period.
As high-quality office assets are prioritized to retain and attract workers, more landlords of low-grade office buildings are opting for the conversion path.
III. Single-Family Rental Market
The Single-Family Rental (SFR) space has strong fundamentals, mainly driven by the millennial generation aging into prime family formation years, high cost of ownership, and supply that has constantly lagged new household formation. This segment is seen as an arising opportunity as the Fed continues to raise rates that push mortgages to record highs, making homeownership for first-time buyers unaffordable and consequently forcing them into the rental space. Green Street's analysis suggests that although mortgage rates remain low relative to the long-term history (back to levels seen in 2018), it is the speed and magnitude of the change in rates coupled with significant cumulative home price appreciation that leave homebuyers with much higher debt service loads seen in the market over recent years.
SFR fundamentals could benefit most directly from the recent rise in homeownership costs. In the near term, the limited inventory of affordable single-family homes (both for rent and for sale) may experience further reductions. This is due to existing SFR tenants being forced to stay in place for longer periods to save on down payments. In addition, a growing number of prospective homebuyers are “trading down”, which will take up rental inventory off the market.
The space is experiencing strong demand primarily by aging millennials looking to move into bigger spaces to grow families. Freddie Mac forecasts that sole-person households are expected to increase from 36.1 million to 41.2 million by 2030,(5) and millennials are not the sole cohort to participate in this rise.
A larger share of sole-person households will shift to baby boomers and Generation X-ers as they look to downside to single-family homes.
Petiole grew its expertise in private real estate through many cycles of investing in this asset class. We maintain a disciplined approach in deal selection, risk management, and portfolio construction. Contact our team to know our real estate strategy in the U.S. and key regions.
Investing in Real Estate During Covid?, Alison Cenname, JP Morgan, 15 March 2022
Zillow February 2022-February 2023 Home Value & Sale Forecast, Zillow, 16 March 2022
U.S. Multifamily Cap Rate Report, CBRE powered by Valuation VIEW, Q4 2021
U.S. Real Estate Market Outlook 2022, CBRE, 8 December 2021
The Growth of Sole-person Households: Creating Even More Demand for Smaller, More Affordable Homes, S. Khater, L. Kiefer, A. Atreya, Freddie Mac, 26 August 2021