A normalization of value appreciation in apartments is usually related to a projection of flatness in net operating income (NOI). Historically, flatness of NOI is anticipated when two primary drivers occur: rent softness (meaning rents are not growing well) and anticipated interest rate increases. The current market seems to have both of these factors. Current rent softness comes from years of rent growth and a large supply of new construction units being delivered and a large supply of new construction units being delivered. Interest rates in Q4 2018 are higher than Q4 2017, and more increases are forecasted for 2019. Locally in Chicago, the third factor for NOI flatness is property tax increases, as city, county and state government continually raise taxes to increase revenue.
Focus On Fundamentals
For apartment investing, that’s the bad news. The good news is that if you focus on the fundamentals and invest for the long term, apartments are still the most compelling product type in commercial real estate. The key reason for this is simple, if trite: People always need a place to live. For investing in apartment buildings, remember three fundamental factors of location, value-add and underwriting.
Location is the primary factor for any real estate investment, but what makes a location good varies by product type (residential, industrial, office, apartment, retail, etc.). For apartments, good location usually means easy access to centers for employment and transportation (e.g., public or highway access).
Hone Investment Strategy
Value-add means ways to increase the value of your property. Increasing the NOI of the property despite the market in general projecting flatness for NOI is one of the best ways. The obvious is making physical improvements that result in higher rent (i.e., new kitchen cabinets). The less obvious maybe how to decrease expenses or create better operational efficiencies. Other ways to add value may have to do with overall returns over the lifespan of the investment. A trend right now for achieving this is investing in Opportunity Zones. These investments reduce or eliminate your capital gains, thus significantly increasing your overall returns.
Underwriting means carefully analyzing all of the income and expense related to an investment, including a conservative proforma of the changes expected, looking at financing options and determining what your return on investment will be at the purchase price being contemplated. Set a threshold you have to achieve and hold yourself to it. If your target is 10%, underwrite honestly and conservatively and do not invest if you cannot get the numbers to cross that minimum threshold.
Apartments remain a solid commercial real estate investment class — if not still the golden child. Getting back to the fundamentals described above should result in a long-term appreciating asset and a meaningful return on investment.