Morningstar: Multifamily Should Remain Strong Despite Uncertainty

As experts wonder whether there will or won’t be a recession, CRE investors try to discern what categories will be, if not absolutely safe, then relatively so, losing as little value as possible. Morningstar puts its bet on multifamily and says it “should remain more stable than other commercial property types such as office, which are facing significant headwinds.”

Not that all is well. During 2020 to 2023, as part of the pandemic, there was a “short window” during which “especially strong fundamentals” and “a very accommodating cost of capital” drove popularity of the property type. The result of the interest were “record transaction volume and impressive value appreciation.”

The good times were not to continue, as everyone in the industry knows. “The frenzy ended up being short lived and contributed to the broader economy’s overheating and excessive inflation, pushing the consumer price index (CPI) to increase by 9.1% in June 2022,” the Morningstar report said. “To combat runaway inflation, the Fed stepped in with an aggressive rate hiking program, pushing interest rates from near 0% to 5.5%.”

The impact changed yield calculations and raised capitalization rates, with lower valuations resulting.

“Recent rent growth data has shown disinflation, with most markets returning to historical norms or even showing negative monthly rent growth,” Morningstar said. Rent growth peaked in the second quarter of 2022. By Q1 of 2023, year-over-year rent growth was down to 5.9% — higher than the 10-year average but the lowest since the third quarter of 2021. Quarter-over-quarter rent growth has fallen from 7.7% in Q3 2021 to -0.9% in Q1 2023, then moved back up to 0.7% in the second quarter. New construction coming online has been driving vacancy rates upward and that will have a negative effect on potential rents.

So, there are headwinds facing the economy and CRE. One is the still existing potential for a recession. Some are saying that a soft landing is likely and that the potential for a recession recedes into the background.

Morningstar holds to a recession as a “serious possibility” with a roughly 30% chance of occurring in the next 12 months. But even though, such an event would be “short-lived” and multifamily “should avoid a dramatic decrease in performance.”

While many tenants have leases from almost a year ago with rents that are lower than current market ones, continued time will see a full turnover of rent rolls, with prices coming up. Loan delinquency rates have been increasing, but multifamily properties, at a 1.45% rate in July 2023, are still second lowest with only industrial better positioned.

“While single-family home inventory remains scarce, multifamily owners and investors can continue to expect relatively stable net operating income, which can help mitigate the effect of rising interest rates,” Morningstar concluded. “If underlying performance remains stable, investor returns in the multifamily market should outperform other major real estate sectors.”