Although residential real estate has seen an increase in supply that has tempered rent growth and impacted valuations, we believe the fundamentals of the sector remain strong. In the latest installment of “In Conversation,” ARA CEO Stanley Iezman and Managing Director of Research and Strategy Sabrina Unger discuss the factors driving demand and identify potential emerging opportunities we see in the current market.

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Stanley Iezman: 2023 was a really interesting year in housing. Tell us about the factors that made it interesting and what we’re seeing in the market.

Sabrina Unger: Interesting is exactly the right word. I think anybody that tried to buy a house in 2023 maybe recognized how limited the options were.

If we look back, the number of existing home sales that occurred in 2023 were the lowest in 30 years – even lower than the number of sales that occurred during the subprime loan crisis. So it’s the lowest full year of sales since 1995. Now, normally if you're a homeowner and you hear that stat, you might think, “Oh my gosh, that's terrible that so few homes are being sold.”

But the reality is, this is not a demand issue. This is really a supply issue, and a lot of it is being driven by what's happening with interest rates. Effectively what we saw is the rate on a 30-year mortgage jump up considerably. If you're an existing owner and you have a mortgage in place, you might think, “Wow, my home appreciated 30 percent in the last five years, I should sell out of this house, take that money and go buy a newer house down the street.”

But then you start to look at it and you'd say, “Well, now I have to buy at today's much higher prices.” On top of that, the 3.5 percent interest rate that you locked in a few years ago, now it would jump to 7-plus percent.

That doesn't sound terribly appealing. And so even if you could find a home that was priced the same as what you were selling your current one for, which we know is not likely, the difference in interest rates would make your monthly payment increase something like 19 percent.

For a lot of people, that math just doesn't make sense. Effectively, it's keeping people in their existing homes and mortgages longer and keeping resale inventory incredibly low and the market very, very tight. So that's what sort of happened in 2023. For 2024, I think there's an expectation that the market will start to unlock a little bit, but even so, I think we do not anticipate that prices are going to come down considerably.

So even if you have an improvement on the interest rate side, the absolute price you're paying for a home, because of that supply-demand mismatch, it's still not going to be terribly accessible for a lot of people.

SI: The Fed has suggested that it will be dropping rates this year. Would that stimulate more people to buy single-family homes? 

SU: I think if you take the Fed at their word, they are anticipating a couple cuts in 2024. The timing of that could be in the latter half of the year, given what we have seen in the most recent inflation prints and in the fourth quarter of 2023, the strength of GDP growth. Let's assume that you have three cuts of 25 basis points each. The 30-year mortgage rate, which is what a lot of buyers will use, has already come down from peak when it was pressing up against 8 percent in October of 2023 – depending on the day, they're about 100 basis points lower now.

Those drops have been stimulating a little more activity on the for-sale side, but again, 90 percent of Americans with a mortgage have an interest rate below 6 percent. So even though we're now below 7 percent, we would need to see it drop at least another 100 basis points just to be essentially at par with where 90 percent of people have their mortgages today, and the majority is actually below 5 percent.

What that says is, you really need a 200-basis point drop to make the interest rate part of the equation of selling your home more justifiable or interesting to homeowners, and I don't think any of us anticipate that occurring. Certainly not this year. And there would need to be something much more dramatic happening in the economy, even heading into 2025, where we would be at that low of an interest rate.

So don't anticipate that. A lot of people that are in that lock-in effect are not going to suddenly become incentivized to sell their homes because interest rates dropped 25 or 50 basis points.

SI: As an anecdote, when I bought my first home, I was paying 13 percent and I thought it was a godsend when it dropped down to 11 percent and I refinanced a year later. Then I was even more shocked when it dropped to nine and I did it again.

Then it was always nine, then it dropped to seven and then it dropped to six. And now we're talking about that the norm should be less than six. The interesting thing is, when that happens, is that going to stimulate more demand, and is it a stable type of demand?

SU: Let's play out this hypothetical a little bit, if we were to see rates drop below 6 percent. I think you would see a surge of people come off the sidelines that have been wanting to buy and have been priced out, or the interest rates scared them away.

Or some of that resale activity might come back in. The challenge is that all of that pent-up demand is going to have an effect on prices. There are two parts to the lever when it comes to what you're going to pay on your mortgage. It's the price you're going to pay for the home and the interest rate on that loan.

So even if the interest rate part comes down, that releases a lot of demand into the market. You're going to see prices continue to increase. And so net-net, you're probably still going to be paying quite a bit for a mortgage. And I still think that's going to make it very challenging for today's renter to be able to break into that market.

What I think that does from a safety valve perspective though, is that it does sort of ensure that somebody that maybe could afford a mortgage if the rate was 5.9% but not 6.1% or they could afford the house at $350,000, but not at $400,000 - that’s more fragile demand. So while it's difficult for people to recognize they still can't buy a home, I think it gives us a little bit of a safety valve in terms of the quality of people that would be able to transact in that market.

SI: Since we happen to be a big buyer at American Realty Advisors of build-to-rent properties and residential for-rent properties, why don't we pivot to what the opportunity set is there, given what is happening in the cost of single-family homes today and the inaccessibility that exists?

SU: Absolutely. And you said it perfectly. We really participate in the rental market in effectively two pillars: the traditional multifamily apartment complex, and then we are also very active in this purpose-built single-family rental space. And what I really like about that is we are being additive to the stock.

We're not competing with Joe and Jane down the street who are trying to buy their first home and buying up the scattered homes in the community. We're actually adding stock, and we're giving people an alternative style of living without the burden of having come up with that down payment and deal with the interest rate equation.

They get that single-family home experience at a much lower cost. So we like that space – and the demand is there. If you can't buy a home in this environment, whether it's price, interest rate, down payment, whatever combination of factors is keeping you out of that market, those people still need a place to live.

If you can't own your home, there are only a couple of options. You can live with your parents, maybe if they own their home, but likely you're going to be in the rental market. And so given structural tightness, we're talking about that lock-in effect of so many people having really low mortgage rates and home prices just being really unaffordable. I think we're going to continue to see this demand for residential hold up over the next 3 to 5 years at the minimum, because there are just so many people that cannot afford to get into the for-sale market.

What I think is interesting is what you're seeing in fundamentals on apartments today is that they are becoming a little weaker just because of the amount of supply that got delivered in 2023 and what's expected to deliver this year.

But it's doing something interesting from a market perspective. If you think about some of the winners of this most recent cycle: Phoenix, Austin, Atlanta, Miami, Orlando – part of the reason that they were winning and having so much rent growth was because people were moving en masse because it was affordable.

Well, then what happened is all these people move in, they're coming from the coast, they have higher incomes, the rents shot up, in some instances, 15 or 20 percent or more year-over-year, and that shrunk the affordability gap between a place like Austin and a market in California. And so when it becomes less affordable, the inflow of people may stall out a little bit.

Well, now what we're seeing is all this supply. While it's not great from a short-term operating perspective, you may have to be a little more competitive in those markets. But it has refilled the affordability gap for those markets relative to the coast, and I think that will reinvigorate the flow of people that go into those markets. In the long term, I think it's actually a positive for the demand outlook there.

SI: You and I have spent a lot of time talking in investment committee about the opportunity in multifamily and for-rent residential. I think that we're convicted that there is a great opportunity as a result of the great reset in pricing today. Can you just talk a little bit about that?

SU: Yes. We start by thinking about where the potential distress is from the debt side. It hasn't materialized in distress yet, but there were a lot of very creative things happening in multifamily financing. There were a lot of syndicators who maybe hadn't lived through an entire financing cycle, and now they're facing much higher rates and are also facing a more challenging lease-up environment.

So there are going to be some great assets that are brand new, in locations where people want to live. And they're going to come to us at an attractive basis. We know that when we look back to past downturns, whether it was economic downturn or real estate downturn – the years coming out of it, there are some good vintage year buys.

I think 2024 is going to be a year that, when we look back on it in two, three, five years, we’re going to say “We had some incredible acquisition activity in the multifamily space because we had a targeted geographic approach, we knew who our renter was, we knew how to operate these things through cycles, and we got them [at that time] at a great deal.”

SI: One of the things we focus on here at American Realty Advisors is a submarket selection process. Walk us through the identification of some of those key submarkets. What are the drivers that we focus on, and how do we forecast outperformance on a revenue growth basis and an occupancy basis – and thus a value basis?

SU: There are a lot of things happening in real estate research and real estate in general – it’s very technical with predictive analytics and algorithms, and all of those things are exciting, and they certainly help us do our work. But at the end of the day, it really does come down to what drives demand for space.

When we're talking about housing, what drives demand for rentals? It’s people. Where do people want to be? We can look at historical data and projected data, things like population growth and employment growth. Obviously, people have to move where they have a job, writ large, though remote work has shifted that a little bit.

But overall rental demand is going to align with where the businesses are. [We look at] what are the factors that have driven businesses to be centered in a certain market? And are those factors changing or appearing in other places? I'll use two examples, coming out of the pandemic, if you looked at a place like New York early in the pandemic, all the headlines said “the city is dead. No one is moving back. This is terrible.”

Well, basically within the flip of a switch, people started moving back. This was before their businesses called them back into the office. There was something about New York that brought people back, and the demand for apartments surged, and we had some really strong rent growth.

On the other side, I look at a market like Boise, which for a couple years was screening really well, especially during the pandemic. A lot of people from the Bay area, some from Seattle and Portland, got to work from home, and Boise was cheaper and had a nice lifestyle element. There was a flood of capital to get into that market. Everybody said, “I don't want to miss the next Austin. I'm going to go build a bunch of apartments in Boise.” And while I think the first movers probably made money, the reality is that others just got caught up in a wave. I just saw at the end of 2023, the Yardi matrix said Boise was the 120th market for rent growth out of 121 markets.

The idea of chasing momentum in a market can be really challenging. To go back to the question: how do we identify the markets and submarkets that we want to be in? You have to look at whether the drivers that are bringing people in are sticky and resilient.

In New York, it has taken decades to have the presence of industries and the dynamic employment market, and these things don't tend to leave quickly. It takes a long time to get that critical mass. It takes a long time for it to go away. Boise was missing some of those elements. It was really an affordability play, but it lacks connectivity.

The diversity of its local economy and the job base is not as dynamic. So its success has been a little bit fleeting.

This transcript of the ARA In Conversation discussion has been edited for clarity.

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Disclaimer

The information in this video is as of March 1, 2024, and is for your informational and educational purposes only, is not intended to be relied on to make any investment decisions and is neither an offer to sell nor a solicitation of an offer to buy any securities or financial instruments in any jurisdiction. This video expresses the views of the author as of the date indicated and such views are subject to change without notice. The information in this video has been obtained or derived from sources believed by ARA to be reliable but ARA does not represent that this information is accurate or complete and has not independently verified the accuracy or completeness of such information or assumptions on which such information is based. Any opinions or estimates contained in this video represent the judgment of ARA at the time this video was prepared and are subject to change without notice. This video is proprietary to ARA and may not be copied, reproduced, republished, or posted in whole or in part, in any form and may not be circulated or redelivered to any person without the prior written consent of ARA.

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