Glencrest was formed four years ago with the aim of doing everything better and some things differently in the private multifamily investment space, thereby improving the lives of our residents, investors, employees and society. For individual investors participating in our Generations program, we think this means building a geographically-diverse portfolio that delivers long-term, after-tax equity returns net of fees in excess of 10% with consistent distributable cash flow along the way.
Although this is a journey rather than a destination, we are pleased with our progress to date, which includes acquiring 15 quality apartment communities across four states and building a top-notch team with diverse industry experience and broad perspectives (note: we're hiring - if you know of any interesting candidates for our open positions, please let us know). None of this could have happened without your investment confidence, which continues to make us feel honored and humbled.
As 2023 commences, we are reaching out, as we did last year, to give you an update on macroeconomic and industry conditions and a forecast for the remainder of the year.
Macroeconomic Conditions
The Federal Reserve and central banks around the world have dramatically tightened monetary policy and begun to remove excess liquidity from the financial system. Just as we thought their loose policy was the dominant driver of asset values and economic performance over the last decade (of the apartment industry and pretty much everything), tighter policy should have a reverse effect.
Exactly how this will play out is difficult to predict. Thus far, the economy is holding up fairly well with ongoing low unemployment and moderating headline inflation. But monetary policy acts with a lag and the ongoing tightening has been extreme and rapid by historic standards, so our base case expectation for 2023 is that there will be some degree of an inflationary recession going forward — hopefully mild and modest but potentially quite bumpy, especially with the ongoing volatility of divided domestic politics, the vestiges of the Covid-19 pandemic, and the Ukraine war. Recent distress in the banking industry exemplifies the kind of “bumps” that are likely to appear as our economy digests the tightening.
We do think central banks will act iteratively, pausing tightening and possibly even resuming loosening off and on over the next several years, likely causing ongoing volatility in asset values along the way, but we expect materially higher interest rates are here to stay. All of this is made more complicated by the fact that government data collection and presentation seems less accurate and more antiquated than ever and that globalization and technology continue to alter traditional economic relationships. As a result, we worry central banks will continue to play from behind, creating outsized macroeconomic swings with their actions.
Impact on Apartment Values
The Federal Reserve’s purchase of trillions of dollars of treasury and mortgage securities (often making 20%+ of the market) over the last decade kept interest rates and discount rates hundreds of basis points below where they would have been in a true free-market environment. This went on for so long that investment industries began taking for granted interest rates below the rate of inflation in a growing economy.
In the apartment space, Glencrest thinks capitalization rates (synonymous with the discount rate and analogous to a price/earnings ratio for stocks) have been between 100-200 basis points too low on average for a long time, although they made more sense if married to the low-cost, long-term debt the Federal Reserve was engendering. Now things are reversing. The market values of public multifamily REITS have declined more than 30% in the last year and we are seeing private market values down significantly as well depending on circumstances.
Generally, private values adjust more slowly but ultimately tend to mirror public market trends over time. The first step in a private valuation reset is usually a decline in transaction volume, as potential sellers hope that previous values will return and refuse to meet the market. We're starting to see this dynamic unfold — Newmark reports that the national volume of apartment sales was 69% lower in the fourth quarter of last year compared with the same period in 2021. Once it becomes clear that new valuation levels will persist, transaction volume picks up again. This is what we expect as this year progresses.
What does all this mean for the prospect of our current Generations investments? Very little, we are pleased to say. Although the price at which we could sell our portfolio today is surely less than this time last year, our Generations program is designed to produce attractive cash flow and income tax shelter rather than sale proceeds and capital gains tax. The discount rate others apply to the cash flow our assets produce is generally immaterial (except in the context of refinancing, where lenders will consider it among other factors).
Over the past few years our underwriting has steadfastly assumed significantly higher interest rates in the future and a deceleration of the inflationary rent growth our industry was experiencing back towards long-term trends. We used fixed-rate debt with extended term to finance our assets at interest rates that now look very attractive and at leverage levels that provided a significant cash flow cushion in the event of an economic downturn. Although it was difficult to find investments that allowed us to project our target returns with these assumptions, it was not impossible, especially when we looked towards places where the excess liquidity "froth" was less pronounced — generally smaller communities in strong secondary locations. This is one of the things we like about the multifamily investment space: ownership is still fragmented and management often inefficient, so it is possible to find some number of quality acquisition opportunities even when the industry feels mostly overbought.
Industry Conditions
Because of the strong economy and excess liquidity flowing to consumers, the last few years have been some of the best ever for the apartment business. On a national basis, asking rents have increased by 21.7% since May 2020 according to Yardi Matrix and occupancy has averaged more than 96% according to Berkadia. Expenses have grown as well, but generally not as fast, leading to strong growth in net operating income and cash flow. Simply put, it has been a great time to be a landlord.
But our business is cyclical, and things appear to be moderating as we enter 2023. Occupancy is down to 95% and year-over-year rent growth has decreased to 3.3%. While these are still healthy numbers, we expect further deceleration in 2023, especially because the supply of new apartments will be more than 50% higher than the last several years. We still think it more likely than not that rents will stay flat or grow modestly (rather than decline significantly), in part because higher interest rates will drive more people to rent rather than buy. Should the economy experience a severe recession, however, the apartment industry will be affected as rent is such a significant portion of our residents' monthly expenditures.
One silver lining of weaker industry conditions may be a reduction in political pressure, which has grown intense in many localities as rents soared. More cities and states are considering and passing rent control than ever before, and there has even been talk of national rent control at properties financed by Fannie Mae and Freddie Mac.
Investors often ask our opinion about rent control. Theoretically, we are opposed because we believe in the efficiency of the free market and because empirical evidence is strong that rent control hasn't made rental housing more affordable over time. Practically, however, rent control is a very nuanced issue where the devil can be in the details. Some rent control really just prevents what many would call “price gouging” — a landlord can’t double the rent of an existing tenant, for example, but can get a price increase each year at least equal to inflation for existing residents and can set the rent at whatever the market will bear when a new resident joins the community. This kind of rent control really doesn’t get in the way of the business, and can be healthy as it gives politicians cover when constituents complain about high housing costs. There can be more egregious forms of rent control, where permitted rent increases for existing residents don’t allow for an inflationary return and/or, in the worst case, rents can’t be reset when a resident moves out. And, unfortunately, rent control isn’t the only way that government regulation can have a negative impact on an apartment business. For example, there are still a few jurisdictions that prohibit evictions for non-payment of rent under the guise of the Covid-19 pandemic even though the broad economy has reopened and unemployment is at historic lows.
While we view undue government interference as one of the biggest risks to our business, we are nonetheless relatively sanguine in the long-term. This issue has been around for decades — regulatory burdens tend to flow when rent growth and occupancy are high, and ease when the inevitable down-cycle follows. We believe that, over time, our democratic system will work and allow for a healthy housing industry. This doesn’t mean we take this issue lightly, however, and we regularly monitor developments and shape our investment strategy accordingly. The biggest mitigant to inherent political risk is to own lots of different qualities of rental housing in lots of different geographies, and, on-balance, to focus on places where the risk seems to be lower. This explains why we have focused more on buying in suburban and exurban locations over the last few years, although we will still consider selective buying in more progressive jurisdictions when opportunities are priced appropriately, as in our latest acquisition of Township Eastside.
2023 Forecast
We expect that the remainder of 2023 will likely continue on the recent trajectory for our industry, making operations more difficult but creating investment opportunity.
Although we expect headline inflation to moderate, possibly sooner and more substantially than expected, we think the Federal Reserve will continue quantitative tightening and keep interest rates significantly higher, on average, than they were in recent years. Slowly but surely the impact of tighter monetary policy will influence the economy in the form of worse employment conditions and lower consumer confidence. A weaker economy, combined with high deliveries of new apartments, will reduce the pricing power of landlords and result in flat to low rent growth on average, while expense pressure persists. Operations will be tepid rather than unbelievably good as we've seen in recent years.
Mediocre industry conditions combined with ongoing higher interest rates will gradually make clear that the recent significant decrease in asset values is going to persist and transaction volume will accelerate. This should create buying opportunities for Glencrest given our long-term focus and strong balance sheet.
Compared to the last few years, we expect to be able to buy larger assets in a broader range of locations at valuations that satisfy our foundational investment criteria as pricing returns to reasonable levels and we face less competition from momentum-driven competitors. In addition, we believe that, over time, some owners and developers that utilized shorter-term, floating-rate financing strategies and aggressive underwriting assumptions will experience investment distress. These dynamics may create corresponding buying opportunities for well-capitalized, experienced investment platforms like Glencrest.
* * * * * * * *
If you have any comments or questions about these thoughts, please feel free to reach out by phone or email. We are always happy to talk. Thank you, as always, for your partnership.