Multi-Family Market Sentiment Continues to Be Mixed

Allen Matkins

Allen Matkins

[co-author: Jason Parr]

Multi-family market expectations have improved in Silicon Valley, Orange County, and San Diego, while in the other markets surveyed, panelists do not see 2023 as having higher occupancy and rental rates compared to today, according to the latest Allen Matkins/UCLA Anderson Forecast California Commercial Real Estate Survey. Overall, though the pandemic has changed the nature of the demand for apartments — both geographically and in their footprint — multi-family development is still expected to grow in California as the economy rebounds and housing demand grows again.

Multi-family housing industry leaders, Jason Parr of Cushman & Wakefield and David Blackwell of Allen Matkins, discuss what lies ahead for this sector of the California commercial real estate market.

1. The recent Allen Matkins/UCLA Anderson Forecast California CRE Survey shows there is more optimism in multi-family development in regions where it dipped slightly during the Summer Survey, and even improved in regions where there remained a strong outlook. Why and how is multi-family holding steady?

Parr: It’s important to separate this discussion into two categories of development; suburban garden/mid-rise development and urban high-rise development. From our current activity of 10+ active multi-family development sites for sale or closed throughout Northern California, we have experienced pre-pandemic appetite as well as little-to-no discount in price on garden-style and mid-rise development. Alternatively, recently completed urban high-rise developments are experiencing record high vacancy, rent decline, and concessions. These factors have caused much more turbulence in development activity and pricing. Developers and capital partners struggle with agreeing on today’s effective rents and how to trend the rent and vacancy assumptions over the coming 1-2 years. Although most developers agree the market will have recovered by the time new developments are in lease-up, they cannot turn a blind eye to the current state of the rental market and will not irresponsibly trend two years into the future.

One commonality across all multi-family product types is that developers understand the extreme housing difficulties, both in supply and affordability, throughout the Bay Area and believe in the resiliency of the economy. Regionally, suburban multi-family has maintained collections close to 98 percent on existing buildings with lease-up activity on new suburban developments unchanged from before the pandemic. The market is also experiencing significant cap rate compression due to an insatiable appetite from investors to purchase stabilized suburban multi-family. We expect this trend of cap rate compression for suburban multi-family as investors accelerate their capital placements into short-term rent growth suburban markets with cash-on-cash focus and not internal rate of return (IRR). We also predict urban apartments will underperform in 2021-2022 but outperform suburban over 5-7 years.

Blackwell: First, the state’s chronic housing shortage persists, and the pandemic has had little impact upon it. Even though moving companies’ data indicate that there is a net outflow from the Bay Area and California in general, the numbers are small compared to the local and state deficit in housing units. For example, California’s Department of Housing and Community Development (HCD) determined last June that the Bay Area’s regional housing need for the current cycle exceeded 441,000 new units (Southern California’s allocation the year before was 1.3 million new units). California’s exceptionalism does not exempt the state from the laws of supply and demand, and multi-family development is the most efficient means to increase supply.

Second, other than industrial, multi-family is currently the most attractive asset class, as the other classes have suffered from the pandemic and related economic downturn. At the current interest rates and cap rates, the multi-family product is still considered a good investment, yielding 6-8 percent cash-on-cash returns.

Third, the state Legislature has been pushing pro-housing legislation for the last few years, and continues to do so. Even though the results are mixed, Sacramento is trying to make multi-family development, particularly in transit-rich areas, more streamlined and less exposed to roadblocks created by local agencies and their anti-development constituents. The Governor’s recent budget allocates resources to strengthen HCD’s monitoring and enforcement of existing housing production laws through the creation of a Housing Accountability Unit. It is essential that there be increased top-down enforcement of these pro-housing laws; otherwise, local agencies will continue to impede housing development.

Fourth, the pandemic should be controlled by the end of this year. Multi-family housing developers and capital partners understand that it usually takes several years from submitting a development application to commencing construction, so COVID-19 will not be a barrier to demand when these projects are ready for occupancy.

2. What will be the biggest challenges the multi-family market will face in 2021 and beyond, either from a development or political standpoint?

Parr: Suburban multi-family development will likely continue to thrive. Urban development in major gateway cities, such as San Francisco, will face challenges with lease-up velocity and maintaining effective rents near the developers’ proforma projected rental rates. Occupancy and concessions will continue to be a major challenge in 2021 for urban projects. For lower-income properties, collections and bad debt will continue to negatively impact net operating incomes.

Blackwell: Politically, even though the State Legislature continues to promote multi-family production, the results have been uneven. Last year, a number of housing bills died on the Assembly Floor, due in part to COVID-19 administration issues and some political gamesmanship. Several of these bills are being reintroduced this year, and it will be interesting to watch their progress. As noted above, these efforts in Sacramento must continue if the State ever hopes to increase housing supply, particularly in the multi-family market.

The pressure exerted by the State on cities to approve multi-family housing is often counterbalanced by local development opposition, which is more visceral. Bay Area cities, in particular, have sophisticated Not In My Backyard (NIMBY) groups that oppose multi-family development for a wide variety of reasons: traffic, “neighborhood character,” gentrification and displacement, and unstated (usually) opposition to the introduction of lower-income households to the area. The California Environmental Quality Act (CEQA) has been misused for decades by project opponents to extract concessions from developers under the threat of litigation; unfortunately, true CEQA reform is unlikely due to the dynamics of Sacramento.

We are also seeing a pitched battle between the State and cities regarding local control and the fairness of the regional housing allocations mentioned above. Some cities are questioning the methodology behind these determinations, and some city councilmembers have stated that they intend to ignore their respective allocation requirements. This may simply be public bravado to gain local political support, but it underscores the level of antagonism that cities feel toward state control.

Each of the political and legal reasons above creates headwinds for multi-family developers. Assuming that the Legislature continues to promote multi-family development, the entitlement process will become incrementally better, but it will not change overnight.

From a development perspective, familiar constraints continue. Hard costs continue to rise during the pandemic, as do soft costs such as development impact fees. These increases reduce profit margins and thus make available capital more scarce. A new concern is the suppression of demand caused by the pandemic and economic downturn. Not only has this resulted in significant rent reductions, but it also raises concern among some developers about the timeline for when renters will return to the inner Bay Area.

3. Many companies have openly reported that they will allow, and even encourage, employees to work from home long term, and in some cases permanently. How will this notion impact the future of multi-family development?

Parr: COVID-19 has, of course, greatly impacted the real estate industry across the board and in different ways, whether it be trends in e-commerce/logistics or for office/tech-using jobs, especially as it pertains to working from home. I believe a significant percentage of these workers will return to the office once the pandemic is at a more controlled point. That being said, it is clear that the remote work segment of the market will not vanish and will very likely continue to grow as part of the workplace ecosystem. The result on multi-family development will likely impact unit mix, unit interiors, common spaces, and parking ratios. We may see slightly larger floor plans with flexible spaces, layouts to better accommodate work-from-home needs, and more balconies/outdoor space. In the common areas, I expect to see more co-working spaces with flexibility to create individualized spaces, more thoughtful outdoor space, and best-in-class technology. Regarding unit mix, I would not be surprised to see a tranche of units designed with designated small offices or dens to accommodate the full-time work-from-home renter.

Blackwell: The immediate assumption is that this trend will adversely affect multi-family development in larger metropolitan areas, as employees will forgo small expensive apartments in dense urban areas for affordable housing in the suburbs, exurbs, or in less expensive states. Adding a lingering fear of viral transmission could indeed result in a steady outflow from urban areas.

We have to admit, however, that the current pandemic is so unprecedented in duration and scale that its effects on future housing patterns are unknown, so we are all guessing to a certain degree.

That said, it will be interesting to see whether the companies that encourage working from home will continue to do so, or will they revert back to a more typical arrangement when COVID-19 is no longer present? It is very possible that these companies determine that employees working from home do not work and that they change their policies to require employees to work in the office on a full- or part-time basis. If so, then those employees that moved further away from the office will have to decide whether to move back or to change jobs. Even if the reduction or cessation of working from home is not employer-driven, I expect that some employees will find that living far from urban centers lacks the vitality that they need, even if they won’t admit it at first. If and when this realization hits, there will be a migration back to the urban areas where the offices are located, which will increase demand for multi-family housing in those urban areas (assuming the employer stays in California, of course).

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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