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Perspectives
February 23, 2015

Keep Calm and Carry On

David Brickman
By
David Brickman, EVP Multifamily Business

Having recently participated in the string of real estate industry conferences that herald each new year, what still echoes is all of the buzz about the strength of capital flows into commercial real estate, especially the multifamily market. Strong flows of both debt, in the form of mortgage loans, and equity, raised through investors, have created a market that is awash in liquidity. It was the talk of every event.

This naturally raises questions about "bubbles," irrational exuberance, and concerns about lax credit conditions – and the inevitable comparisons to the years leading into the financial crises. Comparing the situations then and now, however, the resemblance between the two actually is pretty slight.

The main difference: Economic and market fundamentals (along with government-mandated and industry-initiated reforms – which we won't cover here).

Demand. The percentage of renter households shrank from 1995 until 2004, according to the U.S. Census Bureau, but has grown each year since and now stands at the highest level in 20 years. As many as two million U.S. households became renters last year alone. Rental demand generally is expected to stay strong as the combination of demographic changes, shifting preferences, and new urbanization continue to fuel renter household growth.

Supply. Despite concerns about the increases in new supply, most markets are readily absorbing the new rental units, with only a handful of markets experiencing modest rises in vacancy rates and increased concessions. And these are mainly in top-tier properties. By and large, conditions for other property types remain very tight.

Household formations. Of course, all of this is occurring amid an improving job market and steadily growing U.S. economy – catalysts for household formation. Around three million jobs were added to the economy last year. In January 2015, a respectable 257,000 more were added and average hourly wages moved in the right direction, rising 0.5 percent. Indeed, viewed in aggregate, far too few new housing units in total are being built to accommodate the current and projected growth in households that will likely accompany continued job growth.

Cooler heads regarding credit. Further, while leverage levels appear to be inching up, and credit standards vary by financial institution, few, if any, are lending against projected income or relying on future rent growth to service debt, as many did in the feverish days of the housing boom. Because loans today are made on a more solid basis, it would take a much broader shock than simply missing projections to trigger a challenge to credit. One such shock could be a rapid increase in interest rates. But such an event is always a risk in credit markets. The one truly unique and unusual aspect of the current credit environment is the extremely low absolute level of interest rates. Yet with yields on European corporate and sovereign bonds in negative territory and the Federal Reserve signaling a very measured approach to any prospective increases in short-term rates, it’s hard to lose much sleep over the possibility of a rapid and unexpected increase in Treasury bond yields.

Relative values. But we've seen low interest rates before (current rates are comparable to those seen in the 1940s and 1950s), and surging asset prices – on everything from U.S. stocks, to corporate bonds, to contemporary artwork – are a global phenomenon. The only exception these days seems to be oil. There is nothing about the low-rate environment that is specific to real estate, let alone multifamily, so any concerns about overvaluation must be looked at in terms of relative, as well as absolute, value. And compared to other asset classes, multifamily's growth prospects, low volatility, inherent inflation protection, and moderate liquidity seem reasonably compelling in this exceptionally low-yield environment. Indeed, relative measures of multifamily values, such as capitalization rate spreads and growth-adjusted yields, make current valuations seem fair compared to historical averages.

So a lot of capital is flowing into the multifamily market, like it did leading up to the financial crises. But the climate has changed for the better since then. Fundamentals, leverage, credit standards, and relative values are all more supportive of current conditions and prices than they were pre-crises. Certainly, capital could suddenly turn elsewhere – but where would it go?  Given the current environment, conditions are right for the multifamily market to stay strong.

For more insights into the multifamily market, visit Multifamily Research on FreddieMac.com, where we regularly post our original research.

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