The Inevitability of Future Rent Growth
I have already discussed my view that real estate rental rates will rise due to both inflation and higher interest rates, but I have not yet discussed when where it will happen. Knowing the underlying mechanisms is crucial to understanding the timing and not being misled by reports suggesting otherwise.
A growing number of reports are emerging suggesting that rent growth is slowing in recently boiling real estate sectors.
- Home sales are down 25% and the October 18 survey of homebuilders showed that lowest reading in many years.
- Apartment rents are down from the unprecedented 15% rent increases seen in the 1st and 2nd quarters to around a more moderate 5%.
- The industry has yet to slow down based on the TRNO report that we recently coveredbut as the offer comes in, it’s likely to cool down a bit.
I think headlines like this are quite confusing because they contradict the idea that real estate is a hedge against inflation. Given the high inflation environment, should rent growth not accelerate and not decelerate?
Well, there is a lag in the underlying mechanisms that govern rental rates.
I pose the following:
- Higher interest rates increase rental rates
- Higher OpEx increase rental rates
- Higher construction costs increase rental rates
In fact, I would even say that these increases are almost inevitable over a long period of time. The nature of the mechanism simply makes it take years to figure out.
Therefore, I anticipate a slowdown in comparable store NOI growth followed by an acceleration in a few years. Let me start with the source of the short-term slowdown in rental rate growth and follow the reasoning for a longer-term acceleration.
The supply is coming
Building commercial real estate is a slow process. Permits are slow, materials procurement is slow, construction labor is undersupplied, and physical construction of a large CRE takes a few years. So, from the planning phase to opening is often a 2-5 year process.
So the amount of supply arriving in any given year is less tied to today’s economy and much more tied to the economy 2-5 years ago.
It all comes down to spreads. The basic equation of development is:
Development involves risk and has deferred reward, so a rational developer demands a return on development that is substantially above capitalization rates on stabilized real estate.
2 to 5 years ago, the development comes back very well. The zero interest rate environment has made development financing extremely cheap, which has weighed on development returns. It was also a time when the “risk-free” rate was around 1% and stabilized cap rates were around 5% for these types of assets, which meant that a development return of just 6 % to 7% was enough to stimulate development.
Naturally, these factors have led to significant development over the past 5 years. Below is construction activity in the United States excluding housing.
Housing construction was also quite significant, although it was heavily focused on apartments rather than houses.
Due to the duration of these projects, the majority of this offer is online until 2023.
This is a large part of the reason for the slowdown in rental rate growth. It’s not inflation or rising interest rates, but rather the fact that interest rates were so low 2-5 years ago.
Zero interest rates are terrible for REITs because they stimulate the development of a competing supply.
Today, however, inflation and significantly higher interest rates with the 10-year Treasury at over 4% ushered in the opposite development environment. This same equation no longer stands out.
- Construction costs increase dramatically
- Operating expenses are up
- Required yield is approximately 8% to 10%
Rents have increased in 2022, so the property’s expected NOI is up, but it’s not far enough to offset the cost of construction and the now higher required level of return.
This is where market forces come into play.
Development will naturally slow down. In its press release on 3Q22 results, Prologis (PLD) cut its development forecast by $350 million.
In industry, developments are only slowing down a bit because rents have risen dramatically (more than 50% in just a few years).
In other areas where rents have risen more modestly, development will slow more significantly.
Like most things in economics, it forms a cyclical equilibrium. As rental rate growth slows, development becomes less financially viable, resulting in an undersupply of a given property type, which increases rental rate growth. Here is the basic feedback loop.
It can take up to a decade to complete the above cycle, but that’s how real estate cycles have been for generations.
External macro forces can impact the cycle. Currently, the main external forces are high interest rates and inflation, both of which are leading to a dramatic reduction in development activities.
With the cost of construction, one cannot usually get an 8-10% development return at current rental rates. This is effectively a shift in the supply curve.
For a given level of NOI, the quantity of properties delivered will be lower. Here are supply and demand curves in qualitative form to illustrate the concept.
The prize manifests itself in many forms. For a developer intending to sell the property on completion, this is the sale price of the property. For a developer who intends to own the property and rent it out, the price represents the net operating income of the property (rental income less expenses).
Rental rates end up being the dependent variable. They move to balance the amount of additional properties requested with the amount of additional properties provided.
Since construction costs and the required rate of return are rising, the level of rental rates that clears the market will be higher.
With that framework in mind, here’s how I see the trajectory of rental rates going forward.
Rental rate outlook by year
- Current property inventory levels are undersupplied for apartments and industrial.
- Current shopping center inventory levels are balanced.
These are measured by abnormally low vacancy rates in apartments and industrial with normal vacancy in retail.
2023 and 2024
Ongoing development is fairly heavy for apartments and medium for industry, while retail has minimal ongoing development. So, as the pipeline of current developments is delivered, I anticipate that the supply of apartments and industrials will change from an undersupplied supply to a balanced supply. Retail will shift from normal supply to slightly insufficient supply.
The easing of the supply shortfall in the industrial/multi-family sector will bring rental rate growth from the rapid speed of recent quarters to a more historically normal level. I expect rental rates to grow by around 5% for apartments and around 10% to 20% for industrials.
Shopping malls, however, are expected to experience a slight acceleration in rental rate growth, which could reach double digits.
2025 and beyond
Ongoing pipelines will be completed and we will see the slowed activity of development starts beginning to trickle down to completions. This will re-accelerate rental rate growth until it reaches a level high enough for development to be more viable on a large scale. The real estate cycle will continue with an alternation of over and underdevelopment.
Implications for investment
The fundamentally ideal sectors change. Retail is now among the best sectors from a growth perspective relative to valuation. Apartments and Industrials are still healthy sectors, but they no longer deserve the premium multiples they once offered. Valuations have already fallen quite far in these sectors, so these are reasonable buys at the current level, but I wouldn’t expect a return to FFO multiples of 25X to 35X.
REITs are grossly undervalued as the market interprets slowing rental rate growth as a new direction. Instead, it is a hiccup resulting from the aftermath of the zero interest rate environment. If interest rates stay in a healthy range with the 10-year Treasury at 3% or higher (4% today), the long-term outlook for rental rates looks pretty solid.
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