Welcome to our inaugural issue of the Kelley Real Estate Outlook (KREO). We cover the waterfront, with articles on a projected future population bubble and trends in the commercial real estate market. We also feature a section on the latest research as well as a dive into the multi-family housing market in our Monitoring the Metrics section, as we continue our focus on integrating research and practice.
- Doug McCoy, Al and Shary Oak Director of the IU Center for Real Estate Studies
Sara Coers, Associate Director, IU Center for Real Estate Studies Isaac Hacamo, Associate Professor of Finance, IU Kelley School of Business
We read a lot of journals and research papers here at the Kelley School and the Center for Real Estate Studies, as you can imagine. We want to share some of the more interesting and compelling studies with you, providing a brief summary and a link. Enjoy!
St. Paul, Minnesota and the 2021 rent control law – what was the impact on property values and what were benefits for low-income households? This study focuses on those rent control measures, particularly as they have regained popularity due to housing market conditions over the last several years. The authors found two significant outcomes: that rent control 1) caused a significant decline in property values and 2) provided the most benefit to higher income renters.
by Arpit Gupta, Stijn Van Nieuwerburgh and Constantine Kontokosta
Here is a great question: What is the impact of investment in urban transit infrastructure on real estate prices? The authors report substantial price gains resulting from increased rents due to shorter commute times and reduced risk to investors. New residents were more likely to use urban transit, indicating that more people move to be in proximity to transit options and therefore cause an increase in demand.
by Arpit Gupta, Vrinda Mittal, and Stijn Van Nieuwerburgh
Remote work led to a 39% decline in long-run value for the commercial office sector. This loss was due to reductions in rents, occupancies, and lease renewals and equates to over $400 billion in value destruction based on reduced cash flows and increased discount rates.The authors note that remote work has also led to a flight to quality, reducing the impact on higher quality buildings, but leaving the future of lower quality office buildings in question.
by Brent W. Ambrose, N. Edward Coulson, and Jiro Yoshida
Many questions have been raised on how housing is accounted for in inflation estimates from established price indexes, such as consumer price index and personal consumption expenditures. The authors propose a new method, one that is based on a monthly statistic of landlord net rental income over 20 years, rather than consumer surveys. This new method of calculating rent inflation could have significant implications for economic policies and decision-making.
Let’s examine the impact of interest rate decreases on housing wealth. Historically, changes in interest rates that increase affordability have been reported as having a modest impact on housing prices overall, but the author’s research demonstrates that the majority of the impact of interest rates falls on mid-priced homes, with minimal impact on the lower and upper ends of the price range. One of the driving causes of this effect is that buyers who were previously “mortgaged out” of the mid-price range are able to move up.
Phillip Powell, Ph.D., Clinical Associate Professor of Business Economics, Indiana University Kelley School of Business
Matt Kinghorn, Senior Demographer, Indiana Business Research Center, Indiana University Kelley School of Business
Participants in real estate markets, particularly residential, have many factors to balance for both the short-and long-term. Dramatic increases in interest rates, uncertainty about pandemic-induced changes in the way real estate is used, and new federal investments in reshoring and infrastructure are all weighing on the minds of real estate managers, investors, and developers.
These members of the real estate industry may have demographics in the back of their minds, knowing that real estate demand is created by factors like population, especially in residential markets. While macroeconomic trends can quicken or delay traditional housing investment decisions (such as Millennials purchasing their first home at an average higher age than previous generations), markets must ultimately adjust to ensure sufficient supply of multi-family and single-family units for the number of residents, which has driven substantial new construction in recent years. But, looking into the future, demographic variables will become as important as interest rates, income growth, and construction costs in determining the return on real estate assets as we head for a demographic-induced housing bubble.
At present, demographic pressure on housing markets is at its peak. This implies continued strain on supply in the next several years, followed by long-run erosion in demand that can only be reversed by high levels of immigration. Members of the large Millennial generation are now between their mid-twenties and early forties – the prime age range for new household formation.
The current bubble in demand generated by Millennials will slowly deflate, as Baby Boomers downsize their living space and age out of the housing market. Falling fertility rates mean post-Millennial generations will be smaller. The net impact is slow or stagnant population growth or even population loss. In fact, several parts of the United States are already experiencing population decline, including historically popular states like New York and California.
Plainly put – a generational housing bubble is on the horizon. New housing built now to meet strong demand may sit vacant in a decade. Demand reversal will intensify by the mid-2030s when the annual number of homes that seniors add back to the market is expected to be 40% higher than current levels.1 This negative market impact of anemic population growth can be counteracted by policies that increase the share of seniors who age at home instead of a nursing facility, reduce the average age of a first-time home purchase, or elevate the volume of immigration.
Data from Marion County (the home county for Indianapolis) in Indiana reflects the national trends shared here. Between 2019 and 2021, a 2.0% annual rate of new household formation more than doubled the 0.8% average rate witnessed between 2013 and 2019.
Recently elevated demand for homes in Indianapolis is thus real and persistent. This is true despite a population decline in Marion County since the beginning of the pandemic. A rate of new household formation that is greater than the rate of total population growth, though, cannot be demographically sustained.
Under these conditions, any demographically driven increase in new home demand becomes temporary. While the rate of new household formation will eventually fall, the volume of houses put back on the market by seniors will steadily increase. For example, the share of homeowners aged 55 or higher in the Indianapolis metro area was nearly 50% in 2021, up from 36% just twenty years earlier. Without a sudden spike in population inflow, residential real estate in Indianapolis must prepare for an eventual peak in demand within the next decade.
The real estate industry can use this knowledge to make better long-term investment decisions. Certain markets will peak earlier than others:
Regions with older demographic profiles, stagnant economic activity, and low in-migration from other regions are most at risk of an early peak.
Even within a single region, localized geographic areas can peak at very different times or never peak at all.
Neighborhoods populated by communities that exhibit higher fertility rates are better insulated from negative demographic pressures.
Areas near natural amenities, transit hubs, or high-income commercial districts are also less vulnerable.
Depending upon geographic linkages, a residential area in demographic decline can generate negative spillover in neighboring retail, entertainment, and mixed-use markets. Conversely, reduction in residential demand releases space and property for other economically valuable uses.
While managers, investors, and developers make decisions to ensure good returns in the short run, they must keep their eye on demographic factors that fundamentally change market dynamics in the long run. Population trends strongly suggest that many local housing markets will peak within the next decade. As Millennials pass through their first-home buying years and Baby Boomers through their last stages of life, the current period of strong demand will transition into a period of slowly declining demand. The industry must adjust current business decisions to this eventual changeover in market conditions or risk substantial oversupply and value loss in the housing market of the future.
Is multi-family running out of demographic runway?
Sara Coers, Associate Director, IU Center for Real Estate Studies
Apartments have been a hot commodity over the past decade, thanks to a shortage of single-unit residential construction and perceived preferences for renting amongst younger Millennials and older Gen Zers.
According to NCREIF and Cushman & Wakefield, multi-family investors who held properties for just three years as of 2022 were able to realize a 41% return.1 It is no secret what has driven these returns: unprecedented YOY rental rate increases. The average asking rent for apartments in the US has experienced colossal growth of more than 66% over the last decade.
But rising rents have been coupled with a rising number of cost-burdened households (those paying more than 30% of their income towards their housing expense), particularly renter households. Cost-burdened households as a percentage of total households remains stubbornly close to half the country, and the number of cost-burdened renter households have been on the rise, increasing almost 13% over the decade ending in 2021. In the Indianapolis MSA (our backyard), the number of cost-burdened renter households has increased a whopping 28% over the past decade.
Therefore, a growing number of households find themselves trapped between income-qualified affordable housing and market-rate housing. Is there a business case for creating more housing that falls between affordable housing, with its tax credits and government programs, and market-rate housing, which is driven purely by costs and rates of return?
While cost-burdened renter households continue to grow, average asking apartment rates and the wages required to afford them (based on 30% of gross income) have also grown (see Figure 1):
2011: $1,084 per month ($43,360 per year) (~$21 per hour)
2021: $1,800 per month ($72,000 per year) (~$35 per hour)
As of 2021, an estimated 54% of households can afford the average rent in the US. This sounds like great news until we cut that number down to reflect the percentage of renter-occupied housing units. Even assuming the ratio of renter- to owner-occupied units remains constant as income increases (though ownership tends to increase in the higher income brackets), only about 19% of US households can afford the average rent in 2021.
Figure 1: Annual Average in Asking Rent and Percent Change
Source: U.S. Census Bureau; U.S. Department of Housing and Urban Development
At the same time, due to rising costs, most new housing development is being produced at the high end of affordability. Developers often struggle to justify anything but luxury or high-end apartments even with the use of tax increment financing, public-private partnerships, or other creative tools for the capital stack. As I often tell my students, it is easy to get distracted by the average in real estate. It is one thing to look at the rising average rents, but we must also recognize that those rents are being held down by the older, cheaper housing stock, which continues to age. Cushman & Wakefield’s Indiana Apartment Market Overview 2022, for example, shows that Class A apartments (assuming newer and better stock) average $1,492 per month, while the overall Indianapolis average is $1,160 per month, indicating an approximately 29% difference between rent for a new unit and average rent.2
If we extrapolate this to assume that new apartments enjoy a 29% premium over the average, the average rent for a new unit in the US goes from $1,800 per month up to $2,322 per month, and the hourly wage required to afford a new unit jumps to nearly $45 per hour (see Figure 2).
Figure 2: Wages Needed to Afford the 29% Premium for New Apartments
Source: U.S. Census Bureau; U.S. Department of Housing and Urban Development
If we factor in the households that can afford a new unit AND rent, we find that new apartments in the US are being developed for only 12% of households.
On top of this shrinking number of consumers for new apartment development, what Americans can afford can be deceiving. US workers have been losing traction over the years, with no real growth in income when considering inflation, which has essentially erased wage growth and eroded buying power. Average wages have increased less than 17% over the last decade, but the cost of goods and services has increased 20% (see Figure 3).
Figure 3: Comparison: Wage Growth to Inflation
Source: U.S. Bureau of Labor Statistics
So, higher cost residential supply continues to grow, while the number of people that can afford those units is a small and shrinking part of the population. Herein lies the heart of the affordability issue. There is a gap between developers and renters, with most new rental housing being constructed for a small portion of the population, and, all the while, the dollar is being stretched thinner and thinner. Can we realistically expect American renters to feel like they are falling further and further behind as their housing costs continue to increase? (Have we forgotten the Occupy protests of the Great Recession so quickly?)
What is the answer? Based on a recent panel we held at the IU Center for Real Estate Studies Spring Luncheon, I am convinced the answer is to re-think multi-family as we know it and innovate. New construction methods, new product types, and re-engineering/re-sizing living space will help us re-think the supply and cost sides of the equation. We can devise ways to create new supply for a greater percentage of the population, in a broader range of household incomes, without sacrificing the ability of developers to make a profit. With seemingly more developers creating apartments than ever before, it is like watching more and more people crowd onto a smaller and smaller airplane. Quite simply, household numbers are growing, but most of these households cannot afford most of the apartments coming online today. So, the looming question is: can we create a bigger plane before we run out of demographic runway?
Jeffrey D. Fisher, Ph.D., founding Director of the Center for Real Estate Studies, and Professor Emeritus of Finance and Real Estate, Indiana University
Post COVID-19, commercial real estate markets were enjoying a nice recovery thanks to the low interest rate environment resulting in “cap rate compression” that kept pushing up values relative to the net operating income being generated by the property.
Figure 1 shows the performance since the beginning of the financial crisis of commercial real estate held by institutional investors and tracked by the National Council of Real Estate Investment Fiduciaries (NCREIF).1 The NPI reflects investment performance for over 10,000 commercial properties, totaling $933 billion of market value.
Figure 1: NCREIF Property Index (NPI)
Source: NCREIF
When the Fed started raising interest rates to fight inflation, however, cap rates began to rise, which pushed values down and, starting in the 3rd quarter of 2022, the returns became negative, followed by further declines in returns in the 4th quarter. Preliminary evidence suggests that returns will fall again during the first quarter of 2023.
Cap Rates
As noted above, falling cap rates were helping commercial real estate until the Fed started raising interest rates. Figure 2 shows how cap rates were declining for many years until they reversed course in 2022. They are still at historically slow levels. The question is how far they might rise as a result of the rising interest rate environment we are in as of the time of this writing.
Figure 2: Capitalization (Cap) Rates for Institutional Real Estate
Source: ALTUS
Returns by Property Sector
Industrial real estate, which is largely made up of warehouse properties, had especially strong performance until recent quarters of higher interest rates. Warehouse properties were enjoying record rates of return because of the growth in online shopping and supply chain disruptions. The reliance of “just in time” delivery changed to “just in case” need to have more supply in nearby warehouses.
As industrial space was benefiting from online shopping that was accelerated by COVID, the negative impact on retail space also accelerated for similar reasons. Figure 3 shows the returns since 2008 for the four main property types. The divergence in returns for industrial vs. retail space started in about 2015. The gap between industrial and retail properties widened with the advent of COVID, but the returns for these two sectors converged as the Fed began to raise interest rates starting with the third quarter of 2022.
Figure 3 also shows how returns for all the main property sectors declined as the Fed started to raise interest rates to fight inflation. Office properties have been hit particularly hard post-COVID, as many employees are still working from home despite much less concern about COVID in recent quarters. Whether they will eventually return to the office is not yet known. Many companies have found that their employees can be just as productive working from home, while others still feel that it is important for there to be in-person interaction, collaboration, and training at an office. We may see more use of a “hybrid” model in the future where employees work 3 or 4 days in the office and the other days at home.
Figure 3: Returns for Main Property Sectors
Source: NCREIF
Although rising interest rates tend to increase cap rates as discussed above, growth in net operating income (NOI) tends to lower cap rates since investors are willing to pay more for current income if they expect the income to increase in the future.
Figure 4 shows the NOI growth by sector during the 4th quarter of 2022. NOI growth is positive in all sectors and surprisingly strong for retail properties, with a quarterly growth rate of about 5 percent, followed by apartments at about 2½ percent and office and industrial properties at about 1½ percent quarterly growth.
Figure 4: NOI Growth by Sector
Source: NCREIF
NOI growth results from both rent growth and any increase in operating expenses. Figure 5 shows the rent growth by sector for the 4th quarter of 2022. We see that rent growth has also been relatively strong for all sectors. Retail again has the strongest growth, but is now followed by industrial, with office close behind and apartment with the lowest rent growth. The differences are a result of how expenses grew for each of the property sectors.
Figure 5: Rent Growth by Sector
Source: NCREIF
Conclusion
Whether returns continue in negative territory for commercial real estate will depend on whether there are further increases in cap rates due to rising interest rates versus the offsetting impact of growth in rents and NOI. If the economy weakens, rent and NOI growth could clearly drop and could become negative. Cap rates can also be negatively impacted by tighter lending by banks. The failure of some banks that started with Silicon Valley Bank is likely to cause a tightening of terms that banks are willing to provide for commercial real estate. That said, there are a lot of non-bank lenders for commercial real estate. And there appears to be a lot of “dry powder” on the sidelines that is waiting to see whether real estate values begin to fall. As has been true in past recessions, there will be opportunities for those who have the capital to deploy to benefit from the lower prices. Of course, knowing when values have bottomed is always the challenge!
Source notes
The National Council of Real Estate Investment Fiduciaries (NCREIF) is an association of professionals with significant involvement and interest in pension fund real estate investments who come together to address vital industry issues and to promote standards, education and research on the asset class. See www.NCREIF.org for further information.
