Rent Growth Assumptions

One of the first things I evaluate when considering a new multifamily investment is the organic rent growth assumptions. This is one of the most sensitive factors in the underwriting model, and no matter how skilled an operator or sponsor is, they won't be able to push rents beyond what the market can support without negatively impacting occupancy.

I recently looked at a deal (only briefly) that projected 5% rent growth in a Midwestern market with a 7-year hold period. While the operators had seen success in previous years, this assumption felt overly optimistic and seemed like they were trying to force the deal. That, combined with an aggressive exit cap rate quickly caused me to set the investment deck aside and move on before ever entering any kind of deep due diligence.

To illustrate this point, consider this example from Origin Investments, comparing the difference in value between 1% rent growth and 2% rent growth, at a 5% cap rate, for a 300-unit apartment complex.

This could be a make-or-break factor for your investment returns, and it really highlights how sensitive these assumptions are.

When evaluating investments, it's crucial to understand the market dynamics that could lead to rents either decreasing or not increasing as much as the underwriting predicts. Being aware of these potential risks helps ensure better decision-making.

Factors Influencing Multifamily Rent Growth

Several factors impact multifamily rent growth, and within these broad categories, there are numerous variables that can be difficult to predict. While no one has a crystal ball, understanding these factors will help you assess whether a sponsor's underwriting is grounded in reality.

These factors interact in complex ways, and can’t be considered in isolation.

New Supply Relative to Demand: We're witnessing this firsthand in Sunbelt markets. Thanks to the extremely cheap financing in 2021, developers were able to start building a large number of multifamily units. As a result, rents are either decreasing or remaining flat in many of these markets.

When evaluating a potential investment, it’s important to consider the development pipelines in the broader market, as well as within a 0-5 mile radius of the property you’re interested in.

• Economic Conditions: Factors like employment rates, inflation, and disposable income play a crucial role in renters' ability and willingness to pay. During recessions or periods of economic instability, rental demand can decrease as people lose jobs or face financial difficulties. This can result in higher vacancy rates, forcing landlords to reduce rents to attract tenants.

• Changes in Demographics: Shifts in population density, age distribution, or household size can significantly affect the demand for specific types of housing. Understanding these trends can help you gauge which property types will remain in demand.

• Emergence of Competing Locations: The development of new, appealing neighborhoods or suburban areas can attract renters away from established locations. This shift can reduce demand and potentially lead to rent declines in older areas.

  • Example: Urban to Suburban Migration: A clear example of this is the trend of urban residents moving to suburban areas, especially during the pandemic. Millions of Americans left major cities in search of more space and lower-density living. They were often drawn to the perceived benefits of suburban life, such as larger homes, better schools, and a stronger sense of community. This influx of people into suburban areas led to a spike in rental demand, driving up prices in these newly popular neighborhoods.

• Shifting Renter Preferences: Changes in what renters want, such as a growing preference for smaller units or a desire for more amenities, can impact the demand for certain types of multifamily housing, leading to potential price adjustments. Notably, rent declines tend to be more significant in smaller units like studios and one-bedroom apartments.

• Local Policies and Attitudes: Local policies and community attitudes toward new housing development can greatly influence rent affordability. Restrictive zoning laws, lengthy permitting processes, and resistance to multifamily housing from local communities can limit supply, ultimately driving up rents.

As investors, much of this is common sense to us. “Of course, rents grow faster when the economy is doing well and there is lack of supply.” The real challenge lies in understanding and forecasting rental growth rates for each market.

Fortunately, there are many resources available to help formulate hypotheses, gauge market consensus, and assess whether the deal you’re considering has a reasonable growth assumption—or if it was pulled out of a hat.

If a deal’s success relies on rent growth being 4% instead of 2%, I wouldn’t pursue it. Ensuring that projections are realistic is the goal. The following resources can help you stay on track:

Resources I Use:

• RealPage Market Analytics

• Yardi Matrix

• Freddie Mac Multifamily

• CoStar

• National Apartment Association

• John Burns Consulting