This year has been a monumental one for multifamily housing. After a rocky 2020, throughout which the pandemic shook the world, 2021 brought back multifamily demand in big ways. Year-to-date multifamily net absorption is at 450,100 units -- a new record -- while average rents exceed pre-pandemic levels in all but four major markets. It seems only logical that as multifamily rental demand soars, so does investor participation. But just because a market is on fire doesn't necessarily mean it's worth the price.
Personally, I feel the multifamily industry is extremely overpriced right now. And as an investor, that means it's an industry I'm treading lightly with before participating. While there is definitely still long-term opportunity in the multifamily sector and several solid picks among multifamily real estate investment trusts (REITs), I think multifamily is overvalued right now. Here's why.
Multifamily demand is at a record high
Just over a year ago, multifamily housing was in a bit of limbo. Double-digit unemployment rates made it extremely challenging for a number of tenants to pay rent, moratoriums prevented landlords from evicting past-due tenants, and most metro markets battled a tenant exodus. Sentiment for the future of the sector was low.
Fast forward a year, and it seems life and rental demand are not just back to normal but exceeding pre-pandemic levels. Unemployment is quickly closing in on pre-pandemic levels, while rental demand over the past year has pushed net effective rent up 8.4% year over year and vacancy rates down to a record low of 2.9% on a national average. Based on this data, there is a clear and unprecedented demand.
Things may not be as strong as they seem
But when you take a closer look, there are some cracks in this sector's foundation. According to the National Multifamily Housing Council (NMHC), 77.1% of tenants made their rental payments the first week in December. For the full month of November, 78.2% of multifamily tenants made their rental payments -- that's 2.2% fewer tenants who paid last month than in 2020 when many renters were considered at peak distress.
Also, rental assistance payments through the Emergency Rental Assistance program were issued to more than 521,000 renters or landlords in October 2021 alone. Both could be signs that economic recovery may not be as stable as it may seem.
It's also important to consider the types of properties being delivered in the market today. The majority of the multifamily properties being built today are Class A apartments serving the upper-middle class and higher-income earners in their respective markets -- not lower-income families, who are the primary demographic in relation to the current housing shortage.
Affordability continues to be a major concern as rents grow as much as 30% in many major markets. Even 2022's predicted wage growth of 3.9% won't help rising double-digit rent costs, especially when compounded with the current inflation rate of 6.2%.
Eventually, there will be a breaking point when either other goods become too costly for current wages and cause defaults in rental payments or demand for rentals within these price points is met with sufficient supply -- and/or prices simply become unsustainable -- and rental prices naturally come down.
There's a good possibility all of these will happen simultaneously. But all the circumstances above will result in a pullback in rental rates and demand, impacting investors' returns on investment (ROI) and revenue growth.
Cap rates for multifamily properties are hovering in the low 6% range, a testament to current investor demand for this asset class. But prices at these cap rates are only sustainable if the current growth and demand continue.
Overpriced = vulnerable
When prices become too high, it puts investors in vulnerable positions and leaves little room for error in the future. If a market correction comes or demand falters because of economic instability, multifamily operators will have to face a tough reality and may be forced to sell the asset to repay debt obligations.
According to Jones, Lang, and LaSalle, over one-third of the $363.8 billion in existing dry powder was placed in a distressed asset opportunistic fund in 2021. A number of investors believe the cracks in the foundation of the rental market today will eventually start to crumble and bring in a new host of bargain opportunities with it. Personally, I agree with that testament, but exactly when and how steep of a bargain could come is still unknown.
Many industry experts see multifamily heading nowhere but up in 2022, falling in line with 2021's activity. While they very well could be right, there's a good chance it could go the other way as well. For that reason, investors interested in participating in this growing sector should carefully research any investment opportunities, including popular multifamily REITs.
There are several worthwhile REIT stocks in the industry today that could likely withstand a market downturn because of their business model, markets, and asset diversification. However, knowing which REITs are worth investing in right now is key. For active investors entering this industry, tread lightly. Many factors substantiate long-term demand, but it's important to have the capital and wherewithal to wither the downturns in the interim.