Multifamily is one of several asset classes in the Commercial Real Estate (CRE) space. CRE investing has a host of great benefits in general that apply to all asset classes as I have previously described in article Top Benefits for CRE Investing.
Within multifamily, there are different types or classes of property. Class A, or luxury, multifamily is typically newer product, built in 2000 or later, in very good locations with top of the line amenities. These typically cater to the ‘renter by choice’ cohort with household incomes of $65K+. Workforce housing is generally considered to be Class C & B properties built between 1960 and 2000 that cater to the ‘renter by necessity’ crowd who have annual household incomes of $35K-65K.
In this article, I dig deeper into the specific reasons why multifamily, particularly workforce housing, is one of the most compelling asset classes within CRE.
1) Highest Risk-Adjusted Returns
If you have read a few of my other articles, you can see that I always view investments from a risk perspective and how I can minimize risk to achieve the highest possible returns. Based on historical data, multifamily has proven that it achieves the best risk-adjusted returns. The chart below shows returns, standard deviation (volatility) and sharpe ratio by asset class.
It should be evident that multifamily (apartments) returns are the highest over the holding periods with the lowest risk (standard deviation). This is further illustrated by having the highest sharpe ratios, which indicates return per unit of risk.
Another way to view the risk-return profile of multifamily is via cap rates. Cap rates are a measure of risk, as I explained in the article Why Cap Rates DO Matter. The graph below from CBRE, shows US Cap Rates by asset class over the last 20 years.
Multifamily has consistently had the lowest cap rates compared to other asset classes, which reflects that it has the lowest risk as well. The fact that multifamily has provided high returns with the lowest risk illustrates it’s huge popularity as an asset class.
2) Favorable Supply vs. Demand Dynamics
Supply and demand are fundamental in understanding the economics of any business, product or investment. There are various ways in which supply and demand dynamics favor the case for multifamily investing:
a) Demand Increasing with Diminishing Supply
New technologies are driving significant changes on how products can be made and are often able to increase the supply to match growing demand. It’s rare to have a product that has dwindling supply yet increasing demand but multifamily, particularly workforce housing, has this exact dynamic happening right now due to the following (source: CBRE 2019 Multifamily Report):
- Barriers to home purchase are higher than ever especially with tighter lending standards and the fact that home prices have soared since 2009. There are few low-priced homes being built and hence home purchase is out of reach for many Americans, especially those in the workforce housing segment.
- Shift towards renting as home ownership rate is now only 64% versus 69% in 2006 (all time peak). A 1% decrease represents an increase of approximately 1 million renters. The shift toward renting is aided by societal acceptance for renting and demographic trend changes in terms of millennials desire for flexibility and delaying marriage and starting families.
- Lack of growth in the supply of workforce housing stock as there is obsolescence of poorly maintained properties and it’s cost prohibitive to build new product to the lower rent levels. Aside from government subsidized housing, which is it’s own unique sub-class, all new construction is typically high-end class A product that can command the highest rents such that the project pencils out. This decrease in supply can be clearly evidenced by the following chart (source: Marcus & Millichap 2020 Multifamily Outlook) that shows class C demand increasing as vacancy decreased from 10% in 2009 to nearly 4% currently, resulting in very strong rent growth!
b) Investor Demand Increasing (Liquidity)
Not only is the demand for the apartment units increasing due to the aforementioned reasons, the investment demand has steadily been increasing as well, which results in good “liquidity” (relative to real estate) of the asset class. The table shows how multifamily market share has grown to 29%in 2016 versus 24% in 2009 and this trend undoubtedly will continue to increase as evidenced by the continued cap rate compression in multifamily.
3) True Economies of Scale
Multifamily offers real economies of scale, especially for 100+ units, as illustrated by:
- Efficiencies of spreading costs such as management, maintenance, payroll, capex, etc. over a large number of units.
- Vacancies not having a material financial impact on operations as business plans are structured with expected physical and economic (e.g. collections) vacancy; e.g. 3 units vacant on a 100-unit property is only 3% vacancy versus 3 units vacant on a 10-unit property is 30% vacancy.
- Leases are typically 12 months as compared to 3-5 years for office/retail, which enables the property to adjust quickly to changing market dynamics. Further, leases are often staggered throughout the year so that exposure to large amounts of lease expiring simultaneously is greatly minimized.
- Multifamily has a large number of leases where an individual lease is a small portion of the overall asset income. As such, tenant credit risk for multifamily is decreased and is a huge advantage over office, retail, etc., which have a smaller number of leases that produce a higher amount of asset income.
4) US Government Backed Financing
There are large sources of financing for all asset classes but multifamily has the most favorable terms, leverage and pricing. The main benefit that multifamily has is the ability to get non-recourse debt that is backed by the US Government (i.e. “agency” debt via Fannie Mae or Freddie Mac) that is not available to other asset classes. This results in interest rates often 25 to 50 bps lower and LTV’s 5 to 10% higher for multifamily than other asset class as per 2017 research from Real Capital Analytics.
5) Serves a Basic Human Need
Though it may be cliche, everyone needs a place to live and housing is a basic human need and will always be. Though income and expenses can fluctuate, there is always demand for the product and it’s less volatile than other asset classes. As a basic human need, housing will be prioritized over other desires that would result in purchases at restaurants, on travel, on entertainment, etc. that indirectly impact other asset classes like retail, hospitality, etc.
6) Large Community Impact
Multifamily investing is truly a ‘feel good’ business in that investors can significantly impact hundreds of families with a single investment. Studies have shown that people are spending more and more time in their residences due to technology and ability to work-from-home. Investments in workforce housing often include significant capital improvements (e.g. amenity upgrades, interior rehabs, HVAC maintenance, etc.) that positively impact the day-to-day lives of the families and if done correctly, can create long lasting communities.
The above mentioned benefits outlines some of the rationale that makes multifamily, specifically workforce housing, a compelling investment vehicle. In addition to high risk-adjusted returns and favorable supply/demand dynamics, the asset class serves a basic human need and provides the ability to positively impact hundreds of families with each investment. This is truly a win-win.