“Change is the only constant in life” -- The Greek philosopher Heraclitus
As we regroup and reflect on the recently completed third quarter earnings season and NAREIT’s REITWorld industry conference which just wrapped up in San Francisco, the antient Greek’s words are front of mind.
2022 by most accounts was a “historic” year for the rental housing industry in which the stars aligned and owner/operators benefited immensely from a plethora of tailwinds including a U.S. economy which lifted itself out of the pandemic-era doldrums thanks in large part to the triumph of scientific innovation over a dreaded adversary. The instinctive desire to de-densify and the evolution of the “work from anywhere” mindset coupled with monetary and fiscal policy efforts to keep the economy afloat while shutting down turned into an accelerant for the already strong housing market driving up values for all categories of shelter. Typical operating metrics used to define the health of rental housing portfolios, such as rental rate growth, occupancy and blended leasing spreads all achieved levels in 2022 that even the most seasoned veterans of the industry agreed was the strongest in modern history.
The primary takeaway from 3Q22 earnings season and the REIT industry conference is that the inevitable “normalization” in operating trends is now upon us and will likely be the operative trend into 2023. Industry fundamentals peaked in the first half of 2022 and started to retreat from those highwater marks in the third quarter. Management teams across the rental housing spectrum are quick to point out the nuances of what they are currently experiencing across their markets and are adamant that demand for rental housing remains strong even in light of recent challenges such as the slowing economy and high inflation. They attribute much of the 3Q/4Q deceleration in operating metrics to difficult year-over-year and sequential comparisons as we “burn-off” these record setting periods and transition back to normalization.
Industry leaders also note that in spite of recent announcements from several large technology companies, employment remains quite resilient and wages remain high. Data released by several REITs regarding newly signed leases reveal that residents are comfortably able to cover their rent payments and companies have been reporting rent-to-income levels which are in the range of 20-25%. One resident related outlier which should be positively impacted by normalizing trends in 2023 is bad debt expense. This line item has historically been quite low for REIT landlords given the overall quality of their portfolios and market positioning at higher price points in their respective markets. This metric became inflated as regional economies emerged from the pandemic and municipalities kept eviction moratoriums in place to protect those most financially impacted by the shutdowns. As a result, a small number of markets, primarily in southern California saw a standoff between residents unwilling to pay rent and landlords with no recourse towards collection, thus driving up bad debt expense levels. This challenge appears to now be in the rearview mirror as most courts are once again processing eviction documentation. It will take time for landlords to work through the remnants of this process, but the underlying cause has been addressed and bad debt should move back down towards historic levels of 0.5-1.0% by later in 2023.
One reason for optimism on the part of landlords as they look out to 2023 and a sign of strong demand remaining in place comes down to high current occupancy levels and embedded upside in lease rates as residents renew expiring leases or sign new leases. This upside from “marking leases to market” can represent a marginal gain of 3-5% according to apartment company leaders. With landlords going into the typically quiet holiday and winter leasing season at occupancy levels above 95%, they have the confidence to hold out on pricing and anticipate limited discounting or concessions over the next several quarters. We believe this commentary bodes well for revenue growth in 2023 and while it will fall well short of the record setting pace achieved in 2022, it should look quite attractive compared to pre-pandemic levels.
Many of our constituent companies have flagged operating expense inflation as one of the larger operational challenges going into 2023. We started to see a few cracks emerge in 3Q operating results and the we believe difficulties should start to subside by the second half of 2023. Based on our conversations at the NAREIT conference, management teams are confident that strong revenue growth in 2023 coupled with continued technological improvements will allow them to maintain margins at high levels, even with larger than trend increases at operating expense line items such as property taxes, insurance and repairs and maintenance.
New construction within the multifamily housing sector is being closely monitored, yet outside of several well telegraphed areas of heightened supply, most landlords are fairly sanguine going into 2023. The coastal landlords have flagged Seattle, central San Francisco and Washington DC as markets which will be impacted in coming quarters by higher amounts of deliveries and the potential for increased concessions. Sunbelt landlords have flagged Austin, Phoenix, Nashville and the Carolinas as markets which are seeing a high amount of supply coming over the course of 2023.
Another key topic of discussion which will be scrutinized in coming quarters is the impact that the interest rate cycle is having on asset pricing and transaction volumes. While residential borrowers have the benefit of access to government agency financing, it has still become a very difficult market for consummating transactions as traditional lenders remain non-committal at least through the end of the year, and if they are willing to quote new deals, the pricing is prohibitively expensive. The end result has been a material diminution in transaction activity across our constituent companies and industry sources indicate that this has resulted in cap rates for traditional multifamily housing moving higher by 50-100 basis point. Given the capital market conditions described above, we have seen companies pare back their expectations for acquisitions through the end of the year and we anticipate conservative 2023 guidance on external growth volumes. Even on the development front, expected returns have narrowed considerably relative to acquisitions, such that development projects are also being cancelled or pushed out to subsequent periods.
With 3Q earnings season and the NAREIT conference now behind us, and most companies putting the finishing touches on their 2023 budgets, we would expect the next eight weeks to be somewhat devoid of major company specific news leaving investors to monitor macro-level data points related to Federal Reserve policy, economic strength and the job market. Later in January we will start receiving the first glimpse of 2023 earnings guidance from our constituents. Based on what we have learned to date, we would expect conservatism on the part of many companies as the first half of the year could prove to be more challenging then the second half. Given the leasing cycle does not move into high gear until late in the second quarter and both revenue and operating expense comparisons will be more difficult in the first half as well, it is possible that managements will not have the confidence to make excessively bold assumptions to start the year. It is also quite possible that the U.S. economy could be in the midst of a recession at the start of the year, another reason for caution on initial earnings guidance. We believe the second half of the year on the other hand could be sparked by a more positive backdrop for interest rates, a return to a healthier transactions market with better visibility on the part of both buyers and sellers, and operating metric comparisons which should also be more attractive.
2022 was a year of momentous change in the world of residential REITs and this change was widely influenced and shaped by external events impacting the global economy including war, the pandemic, an affordability crisis in housing, and central banks around the world working their best to manage through it all. While we like to believe that 2023 will usher in a period of calm and stability in markets and on Main Street, our thinking right now is that more change is ahead.
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