The multifamily sector is currently experiencing a dynamic market environment that has been influenced by a range of macroeconomic and sociodemographic factors. As we begin our empirical analysis of this complex market, it is important to first understand the current state of the market and how it has evolved over the last few years. At present, the multifamily sector is experiencing both a seller's market and a buyer's market depending on the location and product type. The demand for multifamily units varies greatly across metropolitan areas and submarkets as renters demand more modern, up-to-date amenities and landlords see increased competition from new construction. To fully understand the multifamily market, it is important to analyze key variables such as changing interest rates, shifts in employment rates, and population growth. Additionally, we will explore the impact that demographic factors and changes in lifestyle have on multifamily demand. Finally, we will seek to unpack the conventional wisdom that surrounds multifamily investing and explore whether it still holds true in today's market.

Multifamily construction is making headlines for reaching the highest levels in 50 years, with almost one million units under construction in the US. However, stating this fact is both true and misleading. Here are three reasons why:

1. Today, there are roughly 2.5 times more multifamily units in the US than in 1970, meaning 1 million units today yields almost 30% of the impact it had in the early 1970s. The relative expansion rate is what matters. At its peak, new supply expanded the US multifamily stock by 6.5% in 1973, while in this cycle, the inventory growth rate will measure 2.2%.

2. Multifamily starts have remained consistently at around half of the levels seen in the early 1970s. These starts usually involve smaller projects that can get approved and built much faster than current ones, which means today's projects take longer to complete. Therefore, 1 million units today is not the same as 1 million units 50 years ago.

3. The US population is much greater today than in the 1970s. Today's construction delivers to a more significant potential renter base, with 70 million adults between 25-54 years old in the 1970s and nearly 130 million today. Despite this, builders did not construct for millennials at the same levels as the baby boomers, necessitating additional housing in different areas.

While it is true that we are building a lot of apartments that will impact fundamentals, the claims of reaching a "50-year high" should be put into context. Instead, it's the areas with construction expanding the multifamily stock at high rates that require attention. As demand eventually catches up to supply, there will almost certainly be a short-term supply/demand imbalance.

Although developers delivering lease-ups in 2023 and 2024 will face a challenging road, it will probably not compare to the challenges that developers in the 1970s and 1980s faced.

Multifamily housing has been recognized as a mainstream investment class for a decade, experiencing a growth in apartment sales nationwide, as reflected in record-high sales in 2021. However, some markets have experienced a drop in the number of apartment units sold consistently, such as Washington DC, Manhattan, Los Angeles, San Francisco, and San Jose. Interestingly, the number of units sold as a percentage of total stock has also consistently decreased in these markets, indicating diminishing investor interest and a restricted buyer pool, mainly institutional and locally-tied capital.

In spite of opportunities in coastal gateway markets, mounting regulatory risks, and the emergence of other markets with more appeal, particularly in the Sun Belt region, have changed the investment equation over the last decade. Besides issues such as rent controls, eviction moratoria, and screening limitations, regulatory risks also emerge from tax issues. For example, Los Angeles recently increased its transfer tax to 6%, reducing asset liquidity instantly and resulting in a more favorable environment for long-term holds. Chicago is considering a similar measure.

Therefore, even though investments in these markets can still work, an increasing number of them conform to "opportunistic" rather than "core" investments. A report published in 2018 for the Pension Real Estate Association highlighted that revenue fundamentals for multifamily in gateway markets had lower value appreciation compared to non-gateway markets, indicating this trend existed before the pandemic-induced work-from-anywhere movement.

In conclusion, regulatory risks and changing investment dynamics suggest a drop in liquidity for coastal gateway markets. Nonetheless, such investments can still succeed, mainly through long-term holdings and newer constructions, which create opportunities as they counterbalance the underlying challenges.

The "flight to quality" investing strategy has historically led to higher occupancy rates in Class A apartments. However, this may no longer hold true for a few reasons.

First, in the 2000s, Class A apartments consistently saw higher occupancy rates through the Great Financial Crisis and the first part of the 2010s. However, this trend changed in 2015, and Class B and Class C apartments surpassed Class A occupancy.

Second, COVID-19 has inverted the job market, where industries such as hospitality, comprising of working-class jobs, have experienced high demand and large pay rises. This change has positively impacted Class B and Class C apartments, and while higher-paying office jobs have generally performed well, we're seeing cracks form in the tech sector.

Third, with a substantial increase in supply volumes for 2023-24, there is an under-discussed factor where Class B and Class C apartments are relatively insulated, given the significant rent gap with Class A apartments. Even with generous concessions, it's challenging to lure Class B renters into new lease-ups since new lease-ups are at least 27% more expensive than typical Class B units. Additionally, 57% is the average increase in rent for Class C apartments. In most cases, renters' incomes need to meet the full rent value, making it difficult to compare and lure Class B renters.

Finally, building Class B or Class C apartments is challenging due to the high costs of land, labor, construction, and regulatory fees. This results in new apartments being priced at Class A rental levels, and even "workforce" projects being more like an A- in terms of rent. Meanwhile, federal programs like the Middle Income Housing Tax Credit are needed to facilitate more workforce housing.

Suburban Class A apartments are generally better positioned than downtown apartments, especially with considerable new supply entering the market. In the next few years, Class B apartments, with higher occupancy rates than Class A and significantly higher rent incomes than Class C apartments, seem to be well placed. Ultimately, Class A apartments should still maintain their value in the long term.

The US apartment occupancy rates have experienced volatile swings in recent years. In 2021 and early 2022, it skyrocketed to record highs, only to plummet at the fastest pace in over ten years. There are newfound indications that apartment occupancy rates may be stabilizing in 2023.

The graph illustrates the month-over-month change in occupancy without seasonal adjustments. Despite the high levels of seasonality associated with occupancy rates, the pandemic era dislodged traditional seasonal patterns. Winter, which usually sees a dip in occupancy rates, saw a surge instead. Conversely, during the peak leasing seasons, spring and summer experienced a substantial reduction in occupancy rates, contributing to a deviation from usual seasonal trends.

Thus, it is noteworthy to observe occupancy rates stabilizing amidst current circumstances, hovering beneath 95%, which accords with long-term averages. Why is this happening? Unprecedented events occurred in 2022, where very little housing demand existed despite a year of strong job and wage growth. Analysts attribute it to low consumer confidence levels, which compelled people to stay put rather than move houses. Lately, we have observed some feeble moves towards normalcy, partly due to housing demand's return to the market as consumer inflation reduces slightly.

However, the upcoming months are marked with implications more significant than the former months as seasonal demand picks up, and a flurry of new apartment supply hits the market, mainly in H2 2023 and H1 2024. Supposing that there are no significant fluctuations in the economy, one would expect a continued rebound in demand this year. Nevertheless, it may not keep up with the multi-decade high in supply, resulting in a further reduction in occupancy this year. Ultimately, landlords, this year will have to grapple with intense competition as renters have an abundance of options.

Some headlines on 2023 rent data are sensational and alarming, but the truth from April data is less frightening. Rent trends are normalizing, though some areas are cooling more than others.

Asking rents decreased in the last four months of 2022 and increased in the first four months of this year. While these fluctuations are seasonally normal, COVID-19 disrupted normal seasonality in the last three years, leading to increased concern about the return of seasonal patterns.

Rent growth has been consistently in line with or lower than normal levels due to the abnormal growth witnessed in the previous two years. Effectively, asking rents rose by 0.34% in April, which is half the month's ten-year average.

This year's outlook revolves around the theme of "kinda sorta reverting to some semblance of normalcy." Nevertheless, the performance and rent shifts by asset, asset class, submarket, and the market would differ significantly, resulting in high variability. This year, a smart investment and operational strategy would be rewarding, and operators need to compete for leasing demand due to supply and vacancy rates at multi-decade highs.

In conclusion, renters have an upper hand in the current market, benefiting from a wide range of options. In contrast, operators must compete on various factors to retain and expand their leasing demand.

The Consumer Price Index's April rent data reveals an important trend: rent growth, according to the CPI, has cooled for the first time in two years. The CPI's "rent of primary residence" metric typically experiences a 12-month lag effect between asking rent growth, which several studies have shown. Accordingly, the CPI rent growth appears to have peaked in March 2023, exactly a year after RealPage's asking rent growth data peaked.

Rent is the CPI's largest category and the largest variable in the shelter category, making it crucial for rate and inflation watchers. The rent survey used to determine rental inflation is also utilized to estimate homeowners' inflation (OER). Although OER is given greater weight than the rent of primary residence, it is the same core dataset.

Due to the lag effect, rent is predicted to experience significant cooling over the course of 2023, which is welcome news for those monitoring inflation. The CPI's rent inflation mirrors the path of asking rents and data substantiates that CPI rent and broader shelter will substantially cool off over the year.

Between May 2022 and February 2023, the CPI's rent data exhibited the greatest spikes in month-over-month rent data. Unlikely those numbers will be achieved, thus it is expected to see the CPI's year-over-year change number decrease consistently each month as each month rolls off from the 12-month change calculation. By spring 2024, it is predicted that it will return to the normal range, or close to it.

The predestined down ramp of the largest variable (rent) in the CPI's largest category (shelter) indicates that inflation will continue to drop over the year, irrespective of any developments in CPI categories such as rates or jobs. Although one may not consider themselves a monetary policy expert, simple math suggests that the largest variable in the CPI's largest category is set to lead to inflation's reduction over the following year.

The percentage of U.S. submarkets registering apartment rent cuts month-on-month is gradually increasing, with approximately 10% of submarkets reporting YoY rent cuts on new leases in March. While this is slightly higher than the 2019 pre-pandemic share, it is still significantly lower than the 2020 lockdown period. Nevertheless, rent cuts are concentrated in specific markets.

In Phoenix, 19 out of the 23 submarkets had a lower average effective asking rent YoY as of March. Gilbert, North Glendale, and Peoria/Sun City/Surprise landed in the top five in the country for the most significant rent cuts, each in the -5% to -6% range.

Las Vegas had nine of twelve submarkets with rent cuts in the last year. The Green Valley submarket had the largest YoY rent cut in the country at -6.3%.

Phoenix and Las Vegas remained poster-child roller-coaster markets, experiencing the nation's highest rent increases in 2021 and quickly becoming the first to report YoY rent cuts by late 2022.

Other notable markets with a majority of submarkets cutting rents include Vallejo/Napa, Reno, and Sacramento. Average effective asking rents in Roseville/Rocklin (in the Sacramento area) dropped by 5.5% YoY.

Other markets with a large percentage of submarkets turning negative include Oakland / East Bay, Austin, San Francisco, Atlanta, and Tampa.

On the other hand, 132 markets out of 164 analyzed reported zero submarkets with YoY effective rent cuts. These markets included Boston, Charlotte, Dallas/Fort Worth, Denver, Miami, Nashville, New York, Orlando, Portland, Raleigh/Durham, Riverside, Salt Lake City, San Diego, and San Jose. It is interesting to observe that the San Jose metro area is holding up stronger than its Bay Area neighbors.

In March 2023, only 5% of U.S. submarkets reported YoY rent increases for new tenants in double digits. This constituted a significant decrease from March 2022, when the percentage was at 77%.

Expect the list of submarkets reporting YoY rent cuts to increase, particularly among urban core neighborhoods inundated with expensive new supply competing for a limited pool of renters over the following years. Conversely, most suburbs, primarily those with a high share of Class B apartments, will likely continue to experience positive rent growth albeit at a moderated rate.

A prevalent misconception is that the abundance of new apartments will attract renters from old properties to lease brand-new ones. However, this is only easier said than done as it is not a realistic option for a vast majority (80%) of current renters even with attractive concessions. Here's why:

The chart indicates the considerable difference in rental rates between new apartments constructed in the 2020s and older apartments. The gap has widened with increased land, material, labor, and fees costs needed to construct new communities, resulting in higher input costs and, subsequently, higher rents.

Moving from an apartment constructed in the 1970s to a lease-up will incur a 50% increase; for apartments built in the 1980s, it's 41%, while for those in the 1990s, it's 26%. It's a 15% increase for apartments built in the 2000s, and there may be an impact in this space. However, for apartments constructed in the 2010s, there's only a 4% increase, and this is likely to be the space most affected by brand-new lease-ups. Despite being renovated, older apartments still have significant price reductions compared to newer ones.

Conceding with high-value incentives might not lure renters from older apartments because renters must have sufficient income to qualify for the full rental cost. On average, renter households that lease apartments built in the last decades earn more than $112,000 per year, making it unlikely for lower-income renters to lease new units.

This chart highlights why the 50-year high in apartment supply will have a limited macro impact on the sector. Instead, this impact will primarily affect the Class A+ space, particularly urban core submarkets with dense populations of expensive units vying for higher-income renters. This challenge isn't just unique to the Sun Belt region, but rather, it pertains to various downtowns in all regions of the country.

Conversely, this trend is not a significant obstacle for most suburban apartment operators with properties built over fifteen years ago. This group represents the majority of the apartment stock in the US.

In the first quarter of 2023, net apartment demand in the US increased back to positive territory, ending three-quarters of negative absorption. However, it was not as strong as the demand surge in 2021, and instead, closer to some resemblance of pre-COVID normalcy.

The US apartment market welcomed 19,243 new net renters in the first three months of 2023, which showed a marked improvement from 2022. However, it was the softest first quarter since 2013 and fell short of the 95,237 new units completed at the same time.

Consequently, apartment occupancy rates continued to slide but to a much lesser degree than before. Occupancy peaked in February 2022 at 97.6% and plummeted by 2.7 percentage points by December. Since year-end 2022, occupancy has inched back only by 0.2 percentage points, climbing to 94.7% in March.

The recent trends indicate that seasonality – or at least a milder form of it – may be returning to the market after a three-year absence. The pandemic erased normal seasonal patterns, but the last six months played out closer to the traditional leasing cycle. The last quarter of 2022 brought seasonally weak leasing and rent cuts, which was followed by a moderate acceleration in both leasing and pricing during the first quarter – which was a normal pre-COVID pattern.

The first quarter numbers are in line with the prediction that demand would improve in 2023. However, the traditionally busy leasing season in spring and summer is critical for apartment owners and managers, particularly with so much new supply this year.

While inflation cooling and the increase in consumer confidence is good news, there needs to be a lot more demand for housing – including apartments – between now and August. Moreover, the constant speculation of a potential recession could affect the outlook for 2023's continued unlocking of pent-up demand for housing. Nonetheless, Q1 demonstrated that there may be a release valve for job growth, and it remains to be seen how it will continue to play out.

After analyzing the multifamily market, it can be concluded that it is a turbulent but sound investment opportunity for the savvy investor. However, it is important to consider the different property classes and submarkets when making investments. Large cities like New York, Los Angeles, and Chicago are extremely competitive, and prices may be too high for investors seeking higher returns because values are being driven by foreign capital and large institutions. Instead, investors may want to concentrate on smaller metro areas or suburbs with a high share of Class B apartments, which have shown to have positive rent growth.

Market trends can also affect the decision to invest in multifamily properties. For instance, the growth of the rental market driven by demographic changes, increased student loan debt, and higher housing prices have resulted in a higher demand for multifamily properties. These trends tend to be particularly strong in areas with high job growth rates that are attractive to millennials. Therefore, investors who are seeking long-term growth may find multifamily assets an attractive opportunity.

However, the uncertain market environment means that careful analysis is needed before investing in any multifamily property. Moreover, investors should be mindful of the increased competition in the multifamily market, particularly in areas with new construction activity. Development deliveries have stagnated and built up over the last couple of years since Covid and a lot of projects are being delivered at once in certain submarkets which are outpacing the demand and driving up vacancy and stagnating rents creating more competition for investors.

Nonetheless, the multifamily market remains a stable investment for savvy investors, provided that they conduct thorough due diligence and are highly selective in their investments. The net operating income predictability is now more of a driving factor than ever in investing in this asset class. The days of not offering concessions and double-digit year-over-year rent increases are gone for the most part across the nation. Properly positioned product will drive value, but cap rate expansion is occurring across the market with unpredictable rent growth, growing borrowing costs, and oncoming supply.