For Multifamily Investors, Sun Appears To Be Setting on Sun Belt Markets

Article originally posted on CoStar on February 10, 2023

Sun Belt’s Share of Multifamily Sales Decreased Last Year for the First Time Since 2015

After a decade in the making, the shift in commercial real estate investment away from the major gateway markets to faster-growing areas in the South and West has stalled and even begun to reverse course.

U.S. cities in the Sun Belt have led major market demographic growth for over two decades, with total households in the region growing by a cumulative 43% since 2000, far above the cumulative growth of 24% across all major 54 U.S. markets. There are many reasons for the outperformance, though the driving force appears to be the cost of living. In gateway markets, which boast higher incomes but also higher tax structures for households and businesses, apartment rent-to-income ratios were significantly higher throughout the last two decades, even after accounting for higher average incomes.

Multifamily investors, looking to capitalize on the recent demographic growth, had been shifting capital into the Sun Belt and away from the gateway metropolitan areas like New York and San Francisco. The share of multifamily investment volume to Sun Belt markets investment grew from an average of 35.6% in 2010 to 56% by the end of 2022, almost purely at the expense of gateway market share.

However, those trends of multifamily volume favoring the Sun Belt are starting to change. For the first time since 2015 Sun Belt multifamily transaction volume was lower at the end of the year in 2022 than at the start, as concerns of oversupply and a slowing economy weighed on investors.

While the share of multifamily sales volume in Sun Belt markets is still significantly higher than pre-pandemic, the abrupt reversal in trend is notable. Construction has been a particular concern for Sun Belt markets, where a historically high 7% of inventory is underway, 2.5 percentage points higher than construction levels in gateway markets, which are also experiencing historically high construction.

The record construction levels in the Sun Belt are not without reason. Rent growth in Sun Belt markets has boomed, peaking at 18% year over year in the fourth quarter of 2022, compared with 10% in gateway markets. By the end of 2021, the Sun Belt average rent was 19% higher than its pre-pandemic level, while the average rent in gateway markets was just 5% above its pre-pandemic high. But as the economy shifted, so did rent growth, and 2023 is projected to be the first year that apartment rents increase slower in Sun Belt locations than in the major gateway markets since 2011.

While new construction is certainly weighing on rents in the Sun Belt, a slowdown in demand is also partly to blame. High-interest rates are freezing in place homeowners who took advantage of low-interest rates in the last several years, and migration trends tend to decelerate in economic slowdowns, all of which can reduce demand growth from the in-migration-reliant South.

Additionally, the amount of rent that residents are paying as a percentage of income is increasing in Sun Belt markets. The ratio of rent-to-median household income, where median household incomes include both homeowners and renters, in Sun Belt markets was 19.2% at the end of 2022, 1.2 percentage points higher than in 2019, which is not far off from the pre-pandemic average of 19.3% from 2010-2019 for the region.

However, the average gateway market rent-to-income ratio is 1.3 percentage points lower than its 2019 level, and three percentage points below its pre-pandemic average, as average incomes in the gateway market have seen just as strong growth as the Sun Belt since 2020, coupled with somewhat weaker rent growth.

Rents in the Sun Belt are still cheaper relative to incomes, but the gap between the gateway and Sun Belt markets is at its narrowest in over a decade. Slowing rent growth, the shrinking affordability gap, and supply concerns in the Sun Belt have begun to affect pricing, with multifamily capitalization rates rising faster in the Sun Belt than in gateway markets since June 2022.

At their nadir, Sun Belt market cap rates were roughly 54 basis points lower than gateway market cap rates, and the timing roughly coincides with the Federal Reserve beginning to hike rates to fight inflation. The Fed’s change in tone was quick by the central bank’s standards, and that relatively swift change in economic and interest rate expectations likely explains at least some of the change in fortunes for Sun Belt markets in 2022 and 2023.

Increased construction activity and rapidly falling cap rates relative to gateway markets was predicated on expectations of a stronger economic outlook in the near term driving continued migration and corporate expansions in the Sun Belt region, which appears far less likely as of early 2023. And while few market participants may have thought rent growth would continue at 2021 levels, even fewer expected rent declines were on the horizon. That means the markets with the lowest multifamily cap rates, including Jacksonville, Phoenix, and Raleigh, also have some of the lowest expected rent growth as a large amount of new supply hits at a time when renter demand is waning.

While the near-term outlook for Sun Belt apartments is for continued slow growth, that outlook is based mostly on cyclical factors. For example, Sun Belt household growth is still expected to grow 80% faster than gateway markets over the next three years, even as the economy weakens.

The structural factors that have driven Sun Belt growth, including easier development mixed with low taxes and an overall lower cost of living, remain favorable, although the affordability gap has narrowed. Sun Belt markets have had some of the highest increases in educated residents, and therefore higher-income workers, and many of the recent corporate expansions and relocations to the South are likely permanent.

For longer-term investors, a decline in multifamily property values in the Sun Belt could provide an opportunity to invest where U.S. demographic growth is projected to be the strongest.