Optimism and Opportunity Amid Challenges in Multifamily

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Optimism abounds across the U.S. multifamily sector as the second half of 2023 commences. Multifamily demand remains strong nationally, driven by positive quarterly absorption of roughly 84,000 units, according to research by RealPage Market Analytics. That represents the largest quarterly absorption since Q1 2022.

Occupancies reached 94.7% in Q2 2023, which is 10 basis points above the national 20-year average. National rent growth for the second quarter was 1.1%, an improvement from the previous two quarters when aggregate rents contracted roughly 1.2%. While most markets experienced strong growth, there are some along the West Coast and in the South that experienced rent decreases in the second quarter of 2023.

A review of key West Coast markets reveals those that are strong, those that face challenges, and where opportunities lie. This multifamily snapshot starts with an overview of development activity, continues through investment prospects, and concludes with an examination of solutions to counter issues presented by pandemic-era eviction moratoriums.

Development Pipeline, Buying the Dip

Strong market fundamentals continue to drive an expansion of supply as roughly 108,000 new apartment units were delivered nationally during Q2 2023, according to researchers at RealPage. That brought the trailing 12-month supply figure to roughly 370,000 new apartment units. While an increase in supply is worth monitoring, multifamily experts don’t see an oversupply issue on the horizon in almost all markets. In fact, new housing supply is critical to help bring a better balance between supply and demand in many markets across the U.S. following more than a decade of underbuilding.

Seattle is one of the markets where the development pipeline remains full. More than 140,000 apartment units are currently under development, according to a report from Kidder Mathews’ multifamily team led by Dylan Simon and Jerrid Anderson. Soaring demand, job growth, and other economic engines across the region have fueled apartment development in the Puget Sound. The pipeline of apartment units under construction in the region is currently the highest on record — besting the previous peak in 2019 by 20%.

“While it’s clear that projects under construction will be finished, uncertainty abounds for projects that don’t yet have a shovel in the ground,” says Simon “That’s because it will take several years to absorb units that are currently under construction and, with a slowing number of new starts, demand will likely outpace new units in the next 24 to 36 months.”

The market has experienced an excessive halt in deliveries in 2023. “As of May 2023, Seattle has delivered just 337 new apartment units year-to-date. Thus, if there was ever a ‘buy the dip’ moment, it’s now,” says Simon. “It could be tomorrow or 12 months from now, but it won’t be long before every deal that was missed was an exceptional one. Accordingly, rents are poised to jump, and the investors who will be rewarded are already going all in on the supply imbalance in Seattle.”

West Coast Investment Prospects

The Kidder Mathews investments team of Holly Yang and Jay Bennett notes that housing in the Greater Seattle area continues to be in short supply. “We see this permeating through our community in many ways from homelessness to elevated home prices, to high crane counts,” says Bennett. Density is viewed as a way to increase supply in order to meet the undersupply, though it will require time.

They predict the property types capable of commanding the highest prices will be well-located TODs. “We see good value in Kirkland and Redmond apartments as Google and Microsoft continue to concentrate in those areas,” says Yang. But from a supply and demand perspective, “the high cost of land in Western Washington and skyrocketing construction costs mean the only projects that pencil without subsidies are Class A buildings.”

Similarly, geographic limitations, rising costs, and capital constraints are hampering investment in the Bay Area. Kidder Mathews FVP Matthew Clark says, “Prices are off peak highs reached last year. For new assets, you’re seeing deals trading below replacement costs in certain markets.” That said, Clark notes, capital markets remain difficult given Fed policy and the failure of banks — which resulted in tighter lending requirements.

Clark predicts the debt market will remain a challenge in 2023, as multifamily prices readjust off the period of ultralow interest rates post Covid. Sellers must be willing to adjust to the current capital markets, which is also posing a challenge for buyers to select an appropriate exit cap and other factors.

On the technology job front, we are starting to see positive signs locally. It’s looking like AI will lead the next cycle in Silicon Valley as companies such as Hive AI, Hayden AI, Anthropic, and Tome AI have taken recent leases in San Francisco. Each firm has posted job openings online. At the end of June, Inflection AI raised $1.3B, and Google is working on its own AI product. The San Francisco to Redwood City unemployment stood at 3.2%, which remains below the national average. Yardi has predicted San Jose to be the #1 rent growth market on the West Coast. Other counties remain strong with Sonoma County at 3.3% and Contra Costa at 3.7% unemployment.

The Bay Area’s supply constraints are a key factor in the market dynamics, according to Kidder Mathews FVP Louis Kwok. “Rising construction costs and the complexities associated with new construction have limited the amount of new supply entering the market,” he says, noting this persistent undersupply contributes to the potential for long-term price appreciation. “However, in the near term, the gap between capitalization rates and debt costs may lead to a gradual decline as existing loans come due.”

In the medium term, Kwok says there are opportunities for investors in the Bay Area multifamily market. That includes adding accessory dwelling units (ADUs) to existing multifamily assets or pursuing true value-add deals. “These value-add opportunities can be appealing to investors who are capable of revitalizing the property and mitigating potential risks associated with lawsuits or tenant safety concerns,” he says.

Strategies for Navigating Los Angeles’ Regulations

While some of the issues facing multifamily investors in Los Angeles are similar to what is occurring in Northern California, others are different. Multifamily has always been popular among investors as it is easier to lease, finance, and sell compared to other asset classes, says Kidder Mathews SVP Robin D. Ossenbeck. Southern California has long been a high-demand area both for renters and landlords. That doesn’t mean the Los Angeles multifamily market is without complications.

Older, rent-controlled assets in Los Angeles present challenges, notes Ossenbeck. “New rent control measures are changing the ordinances, making it nearly impossible to evict tenants in the City of Los Angeles for any reason, and it is compounded by the fact that a new eviction moratorium was recently extended until the end of 2023. Landlords recovering from the Covid issues are now facing increased financing and operating costs,” she says. “Those costs have shot up recently due to inflation metrics such as labor, staffing, utility costs, and the recent decision of several major insurers to leave California and not issuing new policies or, in many cases with older buildings, not renewing existing policies, resulting in higher insurance premiums.”

Add this to the new mansion transfer tax, which increases the costs of a sale by as much as 5.5% as of April 1, 2023. “Opportunities exist for older rent-controlled buildings as the rents are low, providing an upside in future revenues with turnover. Buyers who look long term will succeed, as they find the motivated seller willing to accept the current values and improve operations going forward,” says Ossenbeck.

Kidder Mathews Sr. Associate David Evans adds, “The greatest challenge for landlords in Los Angeles is local regulation, paired with the increasing cost of debt and utilities, as well as property insurance costs.” However, Evans also notes that owners can successfully navigate the eviction moratoriums by offering tenant buyouts as a strategy to avoid a lengthy and costly process via the courts.

Despite the uncertainty, complexity, and challenges, there is much to be optimistic about in the U.S. multifamily sector. Savvy investors are still able to unearth opportunities to capture and create value — they may just need to be patient and know when to take action as the year unfolds.

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