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  • Writer's pictureJason Tuvia

Higher Operating Costs Amid Softer Rent Growth Poses Challenges

The real estate market is in constant motion, shaped by various factors such as seasonal demand, development trends, rental market dynamics, and the impact of changing interest rates. In this blog post, we will analyze recent developments in the real estate sector and offer insights into what to expect in the coming months.


Seasonal Demand and Apartment Stabilization: The spring months of 2023 witnessed a resurgence in apartment demand, following the disruptions caused by the pandemic. From April to June, approximately 80,000 units were absorbed on net, marking the largest quarterly total since early 2022. However, net absorption fell short of the 107,400 rentals finalized during the same period, leading to an increase in vacancy rates. This trend suggests that while household creation is improving, economic uncertainty and inflation are hampering it. As a result, positive net absorption is expected to continue through the end of the year but will lag behind the record construction.


Historic Development Trends and Concentration: The first half of 2023 saw the completion of 200,000 units, making it the largest six-month total on record. An additional 200,000 units are slated to be delivered in the second half of the year, resulting in historic annual inventory growth of 2.1 percent for 2023. However, this construction is concentrated in migration destinations in the Sun Belt, including cities like Austin, Charlotte, Jacksonville, Nashville, Raleigh, Reno, and Salt Lake City. Conversely, major population hubs like Chicago, Los Angeles, New York City, Orange County, and San Diego will experience more modest supply expansions.


Coastal Hubs and Rental Markets: Some markets are better equipped to weather recent challenges. As of mid-2023, only ten major U.S. metros displayed year-over-year vacancy increases below 200 basis points, maintaining sustained sub-5 percent vacancy rates as of July. This list includes six of the nine major markets with average effective rents above $2,500 per month: Boston, Los Angeles, New York City, Orange County, San Diego, and San Jose. Despite their relatively high living costs, these cities remain attractive places to live and work, particularly due to extreme homeownership barriers, which make renting a more affordable option.


Class C Rent Realignment: The gap between average Class B and Class C effective rents widened significantly in recent years. However, lower-tier rents have started to catch up with the market. Over the past nine months, Class C rates experienced the fastest growth among rental segments, at 4.9 percent. As of June 2023, they maintained an average $340 monthly discount compared to Class B counterparts.


Changing Rent and Expense Growth Paths: After a period where average effective rent rose faster than expenses, the trend reversed over the last 12 months. Operational costs increased by an average of 8.6 percent year-over-year in the second quarter of 2023 due to inflationary pressures affecting expenses across the board. While turnover, marketing, and insurance costs surged by more than 10 percent, administrative, taxes, management, and payroll also grew over 7 percent. However, the pace of expense growth has started to taper after reaching its peak last year.


Impact of Rising Insurance Costs: Insurance costs per unit have surged by an average of 33 percent year-over-year in the second quarter of 2023. This increase has affected operations in existing apartments and construction projects alike. Higher debt costs, coupled with rapid insurance hikes, have caused delays in some project proposals and construction sites. As a result, some developers may shorten hold times upon completion to manage unexpected cost adjustments that strained their budgets. Certain metros prone to natural disasters, such as hurricanes, floods, and earthquakes, have experienced particularly steep increases in insurance costs.


Variations in Insurance Costs Across Markets: The insurance cost per unit increased by less than 10 percent year-over-year on average in just five major U.S. markets as of the second quarter of 2023. These markets included Columbus, Detroit, Milwaukee, Pittsburgh, and St. Louis. Other metros like Charlotte, Las Vegas, Raleigh, and Reno experienced relatively mild adjustments and remained among the ten lowest major markets for insurance costs per unit. These variations may influence the decisions of developers and investors in choosing their next locations.


Investment Outlook for 2023: The multifamily investment landscape has faced challenges in recent quarters, with reduced deal flow due to financing hurdles and misaligned buyer/seller expectations. Private investors, however, are seizing opportunities as they perceive reduced competition. Assets priced between $1 and $10 million accounted for approximately 76 percent of trades in the first half of 2023, up from 71 percent the previous year. Buyers and sellers are also gradually aligning, with cap rates rising and sale prices declining. The mean cap rate reached 5.4 percent, the highest since 2018.


Federal Reserve and Interest Rates: The Federal Open Market Committee resumed its rate hikes, raising the benchmark lending rate by 25 basis points at its July meeting, reaching a lower bound of 5.25 percent. This marked the 11th increase since March 2022. Despite these increases, encouraging signs such as declining CPI inflation and the resilience of the labor market suggest a potential soft landing for the economy. The Fed's commitment to data-dependent assessments may provide greater rate stability moving forward.


Financing Challenges and Stability: Financing in the apartment sector has faced challenges, particularly with rising interest rates and liquidity constraints due to bank seizures. Loan-to-value ratios have generally been in the 55 to 65 percent range, occasionally nearing 70 percent in markets with higher cap rates. Agency financiers have been the most active, while banks and credit unions often require significant recourse and shorter amortization periods. CMBS lenders have been less competitive, quoting higher rates. Mezzanine debt and bridge financing options are emerging for assets facing cash flow challenges.


The real estate market is in a state of constant evolution, shaped by a multitude of factors. Understanding the current trends, challenges, and opportunities is essential for investors, developers, and real estate professionals to navigate this dynamic landscape successfully. Whether you're a buyer, seller, or investor, staying informed is key to making informed decisions in this ever-changing environment.

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