Apartment demand rebounded in the nation’s gateway markets in the 2nd quarter, after fundamentals in these regions suffered throughout much of the past year.
U.S. apartments saw a burst in renter demand in the 2nd quarter of 2021, logging higher absorption than the nation has seen since RealPage began tracking the market back in the early 1990s.
While the Sun Belt markets – areas that have proven resilient throughout much of the COVID-19 pandemic – accounted for a sizable portion of the nation’s recent demand comeback, gateway markets also logged notable apartment absorption. This recent performance in gateway markets countered the declines these more expensive markets saw throughout much of the past year when deep job losses and population declines resulted in rising vacancy rates and price-cutting measures.
Los Angeles/Orange County
The California market Los Angeles/Orange County absorbed over 12,000 apartments in the 2nd quarter, marking the second strongest showing in the nation, after only Dallas/Fort Worth. This quarterly tally accounted for roughly half of the annual demand volume of over 23,880 units, the nation’s third-best performance after Dallas/Fort Worth and South Florida. This recent performance in Los Angeles/Orange County was quite a turnaround after this region logged annual net move-outs in 2020’s 2nd and 3rd quarters, as the job base dwindled and residents left the area for less pricey locales. At the same time, construction levels remained elevated in this area, especially in the Los Angeles urban core.
Solid 2nd quarter demand made up for previous losses, pushing occupancy in Los Angeles/Orange County to 96.6% as of June, a rate that is back in line with the national average after falling to a low of 95% in June of last year. Apartment operators responded to rebounding occupancy by pushing rents by 3.5% in the year ending June. While still only rising at about half the level of the national norm, rent growth in Los Angeles/Orange County is quite a change from the price cuts that got as deep as 5.1% not long ago in October of 2020.
Chicago absorbed over 10,000 apartment units in the 2nd quarter, making up for some net move-outs seen earlier in the pandemic and taking annual demand to over 7,300 units. Apartment occupancy climbed 110 basis points (bps) in the past year to stand at 95.6% in June. While still behind the national norm, that is the strongest performance Chicago has seen since August of 2019. In the year ending June, effective asking rents grew 2.3%. While this performance was still well behind the national average, it was the first time Chicago saw the return of rent growth since annual price cuts started back in May 2020.
Washington, DC absorbed over 8,100 apartments in the 2nd quarter, accounting for most of the market’s annual demand volume of over 9,750 units. While apartment demand here never did fall into negative territory, it did fall well behind concurrent completion volumes, which are some of the most aggressive nationwide. Occupancy has rebounded slightly, hitting a few ticks ahead of the five-year average at 95.8% in June. While annual rent growth in Washington, DC seems insignificant at just 0.1%, this was the first time price increases returned after rent cuts were the norm for this market since May 2020.
The three Bay Area markets of San Francisco, San Jose, and Oakland logged sizable quarterly demand for 7,920 units, making up the bulk of annual demand of 8,380 units. The return to solid demand was especially significant for the Bay Area, which was one of the worst-suffering markets during the deepest declines of the COVID-19 pandemic. At its worst, annual net-move-outs in the Bay Area got as deep as 5,530 units in 2020’s 3rd quarter. The return of positive demand pushed occupancy up to 95.1% in the Bay Area in June. While that figure is a bit behind the region’s five-year average, it is well ahead of the low point of 93.6% logged as recently as February 2021. The Bay Area is one of only a handful of regions in the nation where rent change has not made it back to positive territory just yet. Prices were cut 5.9% year-over-year as of June, though that is notably better than the double-digit rent cuts the region was seeing just a few months ago.
New York – another expensive gateway market where apartment fundamentals were hard-hit by the COVID-19 pandemic – saw a significant rebound in demand in the 2nd quarter when over 7,000 apartment units were absorbed. While healthy quarterly demand made up for some of the net move-outs seen earlier in the pandemic, however, annual absorption remained negative, with a loss of over 25,000 units, on the net. While demand boosted occupancy to 95.9% as of June, well ahead of the low point from February, this rate was still 100 bps below the year earlier showing. Thus, New York is the only major market where occupancy is still down year-over-year. Rents are also still being cut on an annual basis as well, but cuts of 8.4% are much better than the annual declines that got as deep as 15% not long ago in March 2021.
In the April-June time frame, Seattle absorbed nearly 5,900 apartment units, accounting for a sizable portion of the 7,260 units of demand seen in the year-ending 2nd quarter. This annual showing was close to hitting the market’s five-year norm and nearly matched concurrent supply volumes for the first time since the 1st quarter of 2020. Seattle apartment occupancy climbed to 96.1% in June, notable progress from the recent low of 93.8% logged at the end of 2020. Seattle didn’t see rent cuts get as deep as what was seen in the Bay Area and New York in the COVID-19 era, but this market has also yet to pull itself out of price decline. As of June, effective asking rents were down a modest 0.3% year-over-year. This is the mildest annual decline this market has seen since operators turned to price cuts in July 2020.
Northern New Jersey
Newark absorbed 5,100 units in the 2nd quarter, just missing out on a top 10 national performance. This recent boost pushed annual demand to nearly 9,570 units, the market’s best showing since the 3rd quarter of 2018. Furthermore, demand is back to pacing close to annual apartment supply, which has been at some of the nation’s strongest in the past year. Occupancy has rebounded in recent months, climbing to 96.7% in June, quite an improvement from the low point of 95.8% seen in March 2021. As a result, annual rent growth returned, albeit at mild amounts at 0.5% in the year ending June. Just a few months ago, when Northern New Jersey was at its worst, rents were being cut by 3.3% on an annual basis.
In Boston, apartment demand hit a solid 4,930 units in the April-June time frame, also just missing out on a top 10 national rate. This recent performance made up about half of Boston’s annual absorption of 9,430 units, the market’s strongest annual demand performance in at least a decade. Recent demand pushed occupancy up to 96.4% in June, pacing well ahead of Boston’s five-year average. Boston was another gateway market that saw the return of annual rent growth in June. Prices were up by 1.3% year-over-year after deep cuts were instituted throughout much of 2020.
Multifamily rents rose nationally in April indicating ongoing recovery from the pandemic, according to the latest Yardi Matrix Multifamily National Report.
Overall, markets saw positive performance indicators for the first time in months, including a 1.6% year-over-year increase in rents — good news for owners and investors.
Matrix analysts said this is the largest increase they’ve seen since the start of the pandemic.
All of the top 30 markets analyzed had positive month-over-month rent growth, the first time this has happened since March 2020. Monthly rents increased by $10 in April to $1,417, the largest year-over-year increase by dollar amount since June 2015, according to the report.
Twenty-four of the 30 markets Matrix analyzed had month-over-month rent growth of more than 0.5%.
Chicago showed strong gains with a 0.5% rent growth rate on a trailing three-month basis.
Analysts said they expect these gains to strengthen as summer begins.
CoStar’s US Multifamily Analysis Finds Increasing Rent Growth Across the Country
National apartment rents aren’t just recovering — they’re growing at a pace that would equate to the strongest apartment rent gains this century if maintained throughout the year, according to a CoStar Group analysis.
One-bedroom apartment rents have grown by just under 4% since the beginning of the year, according to CoStar. Typically, analysts would expect apartment rents to be up roughly 1.7% through April, making this year’s rent growth more than double the normal seasonal trend, according to the analysis.
“If this rate of outperformance continues, rents will rise by about 9% in 2021 — easily the strongest gains this century,” John Affleck, vice president of market analytics with CoStar Group, said in a video presentation of the data.
Apartment rents in the suburbs and in urban cores are gaining strong momentum after more than a year of uncertainty during the health crisis that squeezed the nation’s multifamily sector, particularly the densely populated downtown areas, the analysis found.
Suburban areas, led by regions outside Phoenix, Salt Lake City, and Atlanta, are posting the strongest gains as more renters bolster the trend jump-started by the pandemic: flocking to cheaper, more spacious multifamily options. “In fact, had COVID never happened, suburban rents would probably be 2 percentage points lower,” Affleck said.
Downtown rent growth is being led by Chicago this year, with rents in the Windy City’s downtown core up almost 10% so far this year, according to CoStar. Rents in downtown Boston, San Francisco, Denver, and Seattle are also growing, after posting some of the worst rent losses in 2020.
Some U.S. cities are still posting weak gains or outright losses this year, including Detroit, Milwaukee, St. Louis, and New York City. But overall, national demand seems to be up as search activity on CoStar’s rental listing website Apartments.com grew even ahead of its surge in April.
“More Americans than ever before are looking for a new apartment, for a host of reasons: to save money or to escape roommates; to prepare for a return to the office or hunker down for permanent work at home; to relocate to a new city or to return home after riding out the pandemic,” Affleck said.
Home loan interest rates have inched up about half of one percentage point since the beginning of 2021, and analysts say that rise is beginning to squeeze young buyers out of the market.
On April 1, benchmark 30-year fixed mortgage rates averaged 3.18 percent nationwide, up from 3.17 percent a week earlier, reported Freddie Mac’s Primary Mortgage Market Survey.
What is more important, rates have risen 0.53 percent – more than half a percentage point – since setting a modern-day record low of 2.65 percent on January 7, 2021. The rock bottom 2.65 percent benchmark is the lowest rate in the Freddie Mac survey’s history that dates back to 1971. A year ago, lenders were charging an average of 3.33 percent for 30-year fixed loans.
“Although mortgage rates remain low, we are beginning to see a pullback by those looking to enter the housing market,” said Sam Khater, Freddie Mac’s chief economist. “Home buyer demand has gone from 25 percent above pre-COVID levels at the start of the year, when mortgage rates hit record lows, to 8 percent above pre-COVID levels today.”
Khater noted that purchase demand is diminished today as compared with late May and early June of 2020, when mortgage rates were the same level.
“This is confirmation that while purchase demand remains strong, the marginal buyer is feeling the affordability squeeze resulting from the increases in mortgage rates and home prices we’ve experienced in recent months,” said Khater (left).
The Freddie Mac survey is focused on conventional, conforming, fully amortizing home purchase loans for borrowers who put 20 percent down and have excellent credit.
In 2020, mortgage interest rates set new record lows an amazing 16 times, and thousands of first-time home buyers moved across the threshold into new and existing housing. However, the party may be over for a while.
Analysts said long-term mortgage rates are creeping higher because of rising interest rates on 10-year Treasury notes, which have recently skyrocketed to 1.74 percent from a shockingly low 0.54 percent during the depths of the pandemic.
Optimism about future economic growth, success of the COVID-19 vaccine, and worries about a rise in inflation after the federal government pumped another $1.9 trillion in stimulus funds into the economy also are pushing bond rates higher, experts say.
Light at end of tunnel?
Despite the upward creep in home loan rates, and a shortage of listings, housing experts say there is light at the end of the tunnel.
John Chang, Senior Vice President of Marcus & Millichap, noted that home sales have surged nationwide in recent months, with sales activity in February coming in 9.1 percent higher than in February 2020.
Meanwhile, home prices skyrocketed 16.2 percent year-over-year nationwide to a median price of $334,500, a record high. Chang said sales activity would likely be even greater, but the number of homes for sale on the market has dropped to a record low.
Typically, new-home construction ramps up to meet demand, said Chang (right), but new-home starts tapered last month to about one million units, a figure that represents 55 percent of construction levels during the housing boom of 2006.
Slower housing starts are probably the result of harsh weather conditions in February, and rising material costs, which Marcus & Millichap pegs at 11.4 percent higher than last year. Builders report that rising lumber costs have added $24,000 to the cost of the average new home.
According to Chang, the biggest driver of first-time home sales is the “aging millennial generation.” There are currently 45 million people between the ages of 30 and 40 years in the United States. That’s three million more than five years ago.
The median age of first-time home buyers is 33 years, and over the next five years the number of people in that age group is expected to climb by another two million, forecasts Marcus & Millichap, which is predicting 2.5 million more households being formed each year in 2021 and 2022.
A recent survey of Gen Z renters conducted by the National Apartment Association in partnership with Statisfacts/Apartment Ratings late last year shows a sharp contrast in preferences compared to other cohorts.
Compared to pre-pandemic millennials who embraced both migration and dense urban cores, more than half of Gen Zers surveyed said they’ll stay put after graduating from college, with 44% saying they prefer a vibrant suburb over city life. And 43% say they want to rent single-family detached properties after graduating.
The Mid-Atlantic and Pacific regions are the top for retention and migration combined among those surveyed. And interestingly, 24% of respondents plan to work in health care after graduating from college, with markets in Arizona, Colorado, Alaska, and Idaho standing out as the most in-demand markets for health care workers.
Gen Z renters also believe that buying a home makes more financial sense than renting, with 58% saying that renting “feels like throwing their money away,” according to a NAA report on the survey’s findings. Nearly all of those surveyed said homeownership provides a greater degree of control and privacy over renting, and 69% expressed confidence that they’ll be able to afford to own a home at some point in their lives.
Current Gen Z renters value guaranteed parking, Wi-Fi enabled communities and security and access control features above all community amenities, the NAA report notes. Onsite retail, car charging, and business centers were less in-demand.
“Gen Z renters are savvy yet practical consumers who additionally value a functional living space with upgraded features,” the report notes. “The majority of participants said that strong internet speeds, spacious floor plans and premium features such as a washer/dryer, walk-in closets, balconies and hardwood floors are key factors in their decision-making. However, keyless apartment entry, smart-home controls and a dedicated office/workspace are not critical features.”
Gen Z renters are the fastest-growing active segment of the renter market in the US, according to a recent RentCafe study, and they’re flocking to small towns in the heartland. The top trending markets for Gen Z renters included Greenville, N.C. (with a 35% share of Gen Z renters); Little Rock, Ark. (34% share); North Little Rock, Ark. (31% share); Norfolk, Va. (30% share); and Lake Charles, La (33% share). Of the roughly 3 million rental applications RentCafe analyzed, 22% of applicants were born after 1997, and Gen Z renters comprised the second-largest share of the rental market.
“The economic and public health consequences of the COVID-19 pandemic have likely influenced Gen Zer’s preferences for less populated, more affordable cities/towns in Mid-America and outside of the large southern metro areas e.g. Atlanta, D.C., Charlotte, Houston, than millennials,” Ronnie Dunn, Associate Professor of Urban Studies at Cleveland State University, told RentCafé.
The markets that saw the fastest declines in 2020 are starting to experience the most significant jumps in 2021.
Apartment rents continue to rebound across the country, according to the latest data from Apartment List.
In March, Apartment List’s national index jumped by 1.1%, which was its largest monthly increase going back to the beginning of 2017. That doubled historical growth in the month. In the previous three years, March’s year-over-year rent growth was 0.6%. In addition, the rent growth in March knocks out COVID’s declines in Apartment List’s index.
Recently, Apartment List’s index started growing ahead of seasonal trends. It saw improvement in both pricey coastal markets and smaller cities that have grown popular through the pandemic. The markets that saw the fastest declines in 2020 are starting to experience the most significant jumps in 2021.
While San Francisco is still down 23.2% percent year-over-year, it experienced the largest increase in the country, 3.4%. Rents in the city have now increased by 4.8% over the past two months after falling by an average of 3.4% each month from April through December 2020.
Additionally, Apartment List says that nine of the 10 cities with the sharpest year-over-year declines have had two consecutive months of rising rents. Boston, San Jose, and Washington, DC have experienced rent increases for three consecutive months. Boston grew 2.9% in March, followed by Chicago (2.5%), Seattle (2.2%), New York (0.9%), Washington DC (0.6%).
Even with a rebound in coastal markets, mid-sized markets that have surged during the pandemic continue to hum along. Boise, maybe the poster child for pandemic rent increases, saw prices jump 3.4% this month. Rents are now up by 16.1% year-over-year in the city, which places it in the top spot nationally.
Apartment List says the 10 cities with the fastest year-over-year rent growth all saw prices continue to increase this month. After Boise, Fresno (12%), Greensboro, NC (9%), Gilbert, Az. (9%), Riverside, Calif. (9%), Albuquerque, NM (9%), Tucson, Az. (9%) and Memphis, Tenn. (9%) saw the largest year-over-year rent increases.
Other data sources show some differences. A recent report from Yardi Matrix shows The Inland Empire and Sacramento as the top gainers, with rents up 7.6% and 6.4%, respectively. It shows the markets are also among the top three for occupancy growth year-over-year, with occupancy in the Inland Empire ticking up 2.2% in January and Sacramento showing a 1.2% increase.
Meanwhile, rents in New York, San Jose, and San Francisco remain seriously compressed year-over-year, though their monthly declines have slowed from the summer and fall of 2020. And in cities like Seattle, which showed a 7.7% decline in rent year over year, the struggle continued as tight COVID-19 restrictions dragged on, and tech workers remained decamped elsewhere.
With the federal ban on evictions set to expire in two days, the Centers for Disease Control and Prevention has once again extended the eviction moratorium, this time through June 30. This marks the third time an extension has been granted. The CDC first put the order into effect in September 2020 and was set to conclude at the end of the year. In December, it was then extended for a second time through Jan. 31. Once President Joe Biden went into the office, one of the first acts he made was calling the CDC to extend the moratorium on evictions for non-payment of rent through March 31.
However, many of those in the multifamily industry expressed concern over this decision. In a joint statement from the National Multifamily Housing Council and the National Apartment Association, the groups once again expressed disappointment, much like they did previously back in January. The groups mentioned that housing providers have hit the end of their resources after dealing with eviction moratoriums for more than a year, in addition to the financial distressed brought upon by the pandemic.
“Another extension only serves to exacerbate the challenges facing the rental housing industry and does not address the underlying financial stress of apartment residents, instead of forcing households to accumulate insurmountable levels of debt,” the statement said.
Earlier this month, NMHC released the results of its rent collections report, stating that 80.4 percent of U.S. rental households have made rent payments as of March 6. The report came the same week as the $1.9 trillion COVID-19 relief bill was approved and signed into law by President Biden.
The groups stated that direct financial assistance has shown to be the most effective when it comes to keeping residents safe and securely housed. The almost $50 billion allocated for rental assistance “will prove critical in helping those in need as the country emerges from the pandemic, and we must shift focus from legally uncertain federal eviction moratoriums to swift distribution and continued rental assistance funding,” according to the statement.
Many states and local governments are turning to software, emergency management firms, and advisory services to assist in dispersing billions of dollars in federal funding through the Emergency Rental Assistance Program.
An argument can be made for downward pressure on cap rates for popular assets like industrial and multifamily and recovery types like senior housing and retail.
Rising interest rates are unlikely to push cap rates up this year, counter to what many investors may believe, according to a new analysis from Marcus & Millichap.
The interest rate on ten-year Treasuries has nearly tripled since the end of July when it was at an all-time low near 50 basis points. But rates remain near historical lows, a good sign for investors, according to John Chang, Senior Vice President and Director of Research Services at Marcus & Millichap.
It’s true, Chang says, that there’s been upward pressure on rates for the last six months, and some economists have increased 2021 forecasts to the 8% range.
And “normally that kind of growth—especially when fueled by trillions in stimulus—will put upward pressure on inflation, and of course, the counterbalance on inflation is to push interest rates up,” he says. “But that said, inflation remains exceptionally low,” at a “tame” 1.3%. Generally, the Fed wants to see inflation in the 2% range, according to Chang.
So why exactly are rates rising? “Falling uncertainty and expectations of growth,” Chang said. “Because we can see the light at the end of the pandemic tunnel and the investor market expects growth to be strong in 2021, money is flowing out of safe havens like bonds and Treasuries and into growth investments like the stock market and yes, real estate. That flow of money is putting upward pressure on interest rates”
Chang also challenges the commonly-held investor beliefs that cap rates move with interest rates. “Historically, that’s not true,” he said. “Yes, over decades both have trended together. But when you look at the year to year movement the spread narrows and expands.”
For example, in pre-recession 2007, the yield spread narrowed to just 200 bps, while it opened to 580 bps during the Great Financial Crisis when interest rates went down and cap rates went up.
The current spread is 480 bps, Chang said. “Economists have a bullish outlook for 2021,” he noted. “Liquidity is good and rates low. Investors are increasingly less fearful of the pandemic.”
Chang posits that even if rates rise, they probably won’t push the caps rate up. He says an argument can be made for downward pressure on cap rates for popular assets like industrial and multifamily and recovery types like senior housing and retail.
“I encourage every investor to set aside the idea that interest rates and cap rates will move together,” Chang said. “Focus instead on the outlook for each asset. What’s on the horizon for demand driers and supply risks? That combination can put the long-term context of an asset into a much better perspective.”
Multifamily permits got quite a boost in January, surging to the highest level in nearly five years.
Building permits for the construction of multifamily projects hit an annual level of 557,000 units in January 2021, according to the U.S. Census Bureau’s monthly building permits survey. That is the highest annual permitting level since June 2015 and represents a 28% increase from December’s annual rate. Compared to last year, multifamily permitting was up by 7.9%. Increased apartment, condo, and townhome construction is contributing to the housing industry’s resurgence, with the January permitting total far outpacing the 12-month average of 419,000 units.
Meanwhile, multifamily starts were up 16.3% from last month to 402,000 units. Annually, however, that total was still down by 35.1%. Factors accounting for the differing growth rates between multifamily permitting and starts could include higher costs for lumber, construction, and labor as well as regulatory delays.
Single-family construction is still setting a torrid pace with annual permits reaching roughly 1.3 million units through January 2021. That was 3.8% ahead of the 15-year peak reached in December, and almost 30% greater than the levels permitted last year. The last time single-family permits were this high was in August 2006.
As with multifamily starts, single-family starts did not keep pace with permits, declining 12.2% from December to an annual rate of 1.2 million units. However, that was still a 17.5% increase from last January. Adding to the headwinds for multifamily starts are bitterly cold weather conditions around the country that will hamper starts in February as well.
The annual rate for multifamily completions were down 28.3% month-over-month and 23.9% annually, falling to 296,000 units. On the other hand, single-family completions were up 10% from December and 14.3% year-over-year, increasing to 1 million units.
With a strong performance for both single-family and multifamily permitting, total U.S. residential building permits were up 10.4% from December and up 22.5% from last January. With the recent surge in multifamily permits and the continuing increases in single-family permitting, total residential permits exceeded 1.8 million units for the first time since the waning days of the housing bubble.
Annual Multifamily permitting was down or flat in two of the four regions, with a decline of 23.9% in the Midwest (to 54,000 units) and -1% in the Northeast (to 100,000 units). The West region jumped 23.5% from last year’s pace to 173,000 units, while the South region experienced an increase of 12.8% to 229,000 units. Compared to the previous month, only the Midwest had a decrease in their annual permitting rate (-17.2%), while the Northeast saw a jump of 77.4% from December and the West and South were up between 20% to 36%.
Regional annual multifamily starts were down in three regions compared to January 2020. The Midwest region had a 72.4% increase in annual multifamily starts to 53,000 units while the South and West regions each had declines of about 30%, to 183,000 and 117,000 units, respectively. The small Northeast region had a decrease in annual multifamily permits of 67.3% from last January to 49,000 units but that reflects the annual rate from one year ago was unusually high at 150,000 units.
At the metro level, all the top 10 permitting markets in January returned to the list from December, but several changed places. New York, which is still the leading permitting metro in the nation with about 33,500 units permitted, has slowed from a pace of almost 40,000 units from one year ago. Houston and Austin remain at #2 and #3 with more than 18,500 multifamily units permitted each, although Houston is down 8% for the year while Austin is up 13%.
Filling the same slots as lost month were Phoenix, Los Angeles, Seattle, and Minneapolis-St. Paul, with each permitting between roughly 12,000 and 14,000 units. Dallas has begun to move back up in the national standings, jumping from #10 in December to #8 this month with 11,464 units permitted. Washington, DC stayed in the #9 spot with 11,174 multifamily units permitted, while Nashville slipped to the #10 spot with 10,858 units, after being displaced by Dallas.
Seven of the top permitting places had annual decreases, with cutbacks ranging from 1,300 units (Minneapolis-St. Paul) to more than 6,000 units (New York). Dallas had a solid month in January, bringing their annual total above 11,000 units for the first time in five months, although their annual permitting pace is still almost 5,400 units less than one year ago.
Significant slowing in annual multifamily permitting also occurred in Fort Worth (-5,275 units), Atlanta (-4,478 units), Portland, OR (-3,923 units), Chicago (-3,673 units) and Tampa (-3,128 units).
The only annual increases in multifamily permitting among the top 10 were in Phoenix (+2,796 units), Nashville (+2,747 units), and Austin (+2,195 units).
Other markets that saw significant year-over-year increases in annual multifamily permitting in the year-ending January were San Diego (+1,681 units), Columbus, OH (+1,490 units), Sacramento (+1,390 units), Tacoma (+1,288 units), Greenville/Spartanburg, SC (+1,275 units), Lubbock, TX (+1,233 units) and Baltimore (+1,057 units).
Six of the top 10 permit markets had fewer annual multifamily permits than the previous month, with Houston experiencing a 5% decline from December’s annual rate, and the remainder declining about 3% or less. Annual multifamily permitting in Dallas shot up 10.8% from last month, while Seattle had a 7.8% increase.
The annual total of multifamily permits issued in the top 10 metros – 154,691 units – was 7.4% less than the 167,062 units issued in the previous 12 months. The total number of permits issued in the top 10 metros was almost equal to the number of permits issued for the #11 through #41 ranked metros.
All but one of last month’s top 10 permit-issuing places returned to this month’s list with several changing places. The list of top individual permitting places (cities, towns, boroughs, and unincorporated counties) generally includes the principal city of some of the most active metro areas.
The city of Austin remained #1 in January with more than 13,100 units permitted, while the city of Los Angeles leaped over Houston and Nashville to the #2 spot, displacing them each to #3 and #4. Each municipality permitted between 9,200 and 9,700 units for the 12-months ending in January.
The city of Phoenix edged out the borough of Brooklyn for the #5 spot but each garnered about 6,300 units apiece. The city of Seattle moved up from #9 last month to #7 in January with about 5,800 units permitted as last month’s #7 (Queens) fell off the top 10 list entirely. The Bronx replaced Queens on the list, moving into the #8 spot with an annual total of 5,385 units.
The smaller metro of Columbus, OH remained on the top 10 list but fell from #8 to #10 with a still-impressive 4,979 units permitted. Houston’s Unincorporated Harris County again had about 5,000 units permitted for the year and ranked #9 on this month’s top 10 list.
All but three of the top 10 permitting places had moderate decreases in their annual multifamily permitting totals compared to last month. While the cities or boroughs of Los Angeles, Seattle, and the Bronx increased by about 500 units each, the remaining top permitting places declined by an average of about 350 units each.
Understanding the cash on cash return in commercial real estate is important when you are evaluating investment real estate transactions. What is the cash on cash return and how do you calculate it for acommercial property? What are the nuances and limitations of the cash on cash return? In this article, we’ll tackle these questions in-depth and also provide some detailed examples along the way.
Cash on Cash Return Formula
Before diving into some cash on cash return examples, it is important to have a sound understanding of exactly what the term means. So, let’s start with the basics. First, here’s the cash on cash return formula as it is commonly used:
As shown in the cash on cash equation above, the cash on cash return is defined as cash flow before tax divided by the initial equity investment. The cash flow before tax figure used in the formula is calculated on the real estate proforma. The total cash invested figure used in the above equation is the initial equity investment, which is the total purchase price of the property less any loan proceeds, plus any additional equity required.
Note that this is the cash on cash return formula as it is typically used. However, it is not uncommon to see variations on this definition. For example, the cash flow figure in the numerator of the equation above could be calculated using cash flow before tax as shown, but it could also be calculated using cash flow after-tax, or it might be based on cash flow with leverage (debt) or without leverage. This is why it is important to clarify how terms are being defined, and most importantly, to make sure measures are consistent when making comparisons.
Cash on Cash Return Example
Next, let’s take a simple example to illustrate the cash on cash return. Suppose you are evaluating an office building with an estimated Year 1 Cash Flow Before Tax of $60,000. Also, assume that the negotiated purchase price of the property is $1,200,000 and you are able to secure a loan for $900,000 (75% Loan to Value). What’s your cash on cash return for year 1?
The calculation itself is pretty simple – your cash on cash return for year 1 would be the Year 1 cash flow divided by your total cash out of pocket, which equals 20%. So what does this cash-on-cash return mean? Using only the figures above, the cash on cash return tells you that your year 1 return on investment is 20%.
Cash on Cash Return Limitations
The cash on cash return is a simple measure of investment performance that is quick and easy. It can be a good starting point for quickly filtering out potential investment properties. But don’t be fooled by the many limitations of the cash on cash return.
Consider the following series of cash flows:
The year 1 cash on cash return in the levered example above shows a 3% cash on cash return. To find this simply take the end of the year (EOY) 1 cash flow of $15,805 and divide it by the initial equity investment of $515,000.
But as you can see in the table above, the internal rate of return (IRR)is 10.71%. This suggests that according to adiscounted cash flow analysis, the investment is actually much better (almost 4x better) than what’s indicated by the cash on cash return. If you were only using the cash on cash return as an investment filter, then you’d pass up this opportunity to earn nearly 11%.
The reason why the cash on cash return is so much lower than the IRR in the example above is that the cash on cash return ignores the other 9 years of operating cash flows in the holding period. Plus, it also ignores the reversion cash flow at the end of year 10 that comes from the sale of the asset. Without taking into account these additional cash flows that occur over the holding period, it’s impossible for the cash on cash return to accurately reflect the return characteristics of the property.
The same is true when looking at the unlevered example above. The cash on cash return in the unlevered series of cash flows above is 6.2% ($95,000 divided by $1,515,000), and the IRR is 7.51%. This series of cash flows doesn’t produce as big of a gap as in the levered example, but it’s still a difference. Without taking into account all cash flows over the holding period, the gap between the cash on cash return and the IRR will be unknown.
Keep in mind that this can work in reverse too. In the above examples, the IRR was higher than the cash on cash return because operating cash flows grow over the holding period and the sales proceeds of the asset are favorable. But it could also be the case that many leases will expire a few years after the acquisition, causing operating cash flow to decline and the final reversion cash flow to be lower. This could produce the opposite result where the cash on cash return ends up being more favorable than the IRR.
Cash on Cash Return vs IRR
As mentioned in the section above, the cash on cash return and internal rate of return (IRR) are two different measures of investment performance. The biggest difference between the cash on cash return and IRR is that the cash on cash return only takes into account cash flow from a single year, whereas the IRR takes into account all cash flows during the entire holding period.
Since the cash on cash return and the IRR are two different measures, which one is better? As always, that depends on your investment objectives. That’s why it’s useful to look at a variety of metrics for a property in order to make an informed decision.
Let’s take a look at an example that shows why using both the cash on cash return and the internal rate of return can be helpful. Consider the following two sets of cash flows:
In the top left example, you can see that the cash on cash return is 10% in each year of the holding period. This is calculated by taking the cash flow of $10,000 in each year of the holding period and dividing it by the initial investment of $100,000.
The top right example, on the other hand, has a 0% cash on cash return each year because it doesn’t produce any cash flow until the asset is sold at the end of the holding period.
But notice that both investments have a 10% internal rate of return. So, which investment is better? This ultimately comes down to your investment objectives.
Investment #1 produces stable, predictable, and perhaps taxable cash flows in each year of the holding period. Investment #2 produces no cash flow until the sale of the asset at the end of year 5.
As you can see, using the cash on cash return in addition to the internal rate of return can help quantify these differences to inform your decisions. Other metrics can also help paint the picture and show you the nuance of an investment. These metrics include the internal rate of return, net present value, gross rent multiplier, cap rate, operating expense ratio, equity multiple, and more.
Cash on Cash Return vs ROI
What’s the difference between the cash on cash return and return on investment (ROI)? In order to understand this difference, it’s first important to clarify what ROI means. ROI is a common term used in business and investment. But the term “return on investment”, or “ROI”, can also be defined in various ways which sometimes makes it confusing to understand.
One way return on investment or ROI can be defined is that it’s the total gain of an investment divided by the total cost of the investment:
For example, suppose an investor purchased a parcel of land for $1,000,000, sold parking access each year during a large event to break even on all operating costs, and then after 2 years sold the investment and received net sales proceeds of $2,000,000. Using this method of calculating ROI you would end up with a return on investment that looks like this:
($2,000,000 – $1,000,000)/ $1,000,000 = 1 or 100%
Of course, if this is how you are using ROI, then the cash on cash return would not be the same. The reason why is because the above ROI formula uses total gain and cost over the entire life of the investment, whereas the cash on cash return only measures the return from a single period’s operating cash flow.
Another common way ROI is defined is that it’s net income in a particular year divided by the cost of the investment:
For instance, suppose we have the same example above where an investor buys a land parcel for $1,000,000, operates at breakeven, and then receives net sale proceeds for $2,000,000 at the end of year 2. If we were to use this net income based variation of the ROI calculation, then we could calculate our ROI for year 1 like this:
$0/ $1,000,000 = 0 or 0%
In other words, our year 1 ROI is 0%. This is the same result we’d get with a cash on cash return calculation for year one and is subject to the same limitations discussed above.
At a high level, return on investment simply measures cost versus benefit. However, as discussed above, how “cost” and how “benefit” are defined will impact the results you get from an ROI calculation. That’s why it’s best to clarify terms and definitions so you can be sure you are speaking the same language and ultimately comparing apples to apples.
Cash on Cash Return vs Cap Rate
What’s the difference between the cash on cash return and the capitalization rate? The cash on cash return and the cap rate are two different measures of investment performance. While both the cash on cash return and the cap rate are based on cash flow for a single year, each ratio uses a different measure of cash flow, and therefore the cash on cash return and the cap rate measure two different things.
The cash on cash return uses the cash flow before tax line item on a proforma, which is then divided by the initial equity invested. The cap rate, on the other hand, uses the net operating income (NOI) line item on a proforma, which is then divided by the purchase price.
In other words, the cash on cash return is the return to the equity owners because it takes the cash flow available to equity holders and divides it by the total equity invested.
The cap rate, on the other hand, is the return on the property itself because it takes the net operating income from the property and divides it by the purchase price.
Although the cash on cash return and the cap rate measure different things, the cash on cash return is commonly used by appraisers to calculate a cap rate.
This is accomplished by using what’s known as the band of investment method. The band of investment method takes a cash on cash return and a mortgage constant and then uses these factors to build up to a cap rate.
This is particularly useful when there is no market data available for comparable sales, which is common in secondary or tertiary markets, or when a market crash causes transaction volume to freeze up.
To calculate a cap rate using the band of investment method, appraisers will survey local investors and ask them what their required cash on cash return would be to invest in the subject property. Then the appraiser will survey local lenders and ask them what terms they would be willing to lend on for the subject property, which can be used to calculate a mortgage constant.
Using this survey data, the appraiser can then create a weighted average between the cash on cash return and the mortgage constant in order to calculate a cap rate.
For example, suppose we survey local lenders to find out their current loan terms for a property similar to the one we are evaluating. We learn that we can get a loan at a 75% loan to value ratio, amortized over 20 years, at a rate of 6%. We can now use this loan information to calculate amortgage constant of 0.085972.
We also survey local investors and find out that they would on average need an 11% cash on cash return to consider investing in a property like the one we are evaluating.
Now we have everything we need in order to calculate a capitalization rate using the band of investment method. To do this we simply take a weighted average of the return to the typical lender and the return to the typical investor. In this case it is (75% * 0.085972) + (25% * 11%), which equals 0.06448 + .02750, or 9.20%. This is our market-based cap rate using the band of investment method.
Does Cash on Cash Return Include Principal?
The cash on cash return is based on the cash flow before tax line item on a real estate proforma. The cash flow before tax is calculated after deducting the loan’s debt service and in this sense, it does take into account both the principal and interest payments from a loan.
However, the cash on cash return does not take into account any principal paydown that occurs over the term of a loan. For example, if you have a $1,000,000 loan at a 5% interest rate amortized over 20 years, then your annual debt service would be $79,194. And your loan balance after 10 years would be $622,215. That means you would have paid down the principal balance on your loan by $377,784 over 10 years ($1,000,000 – $622,215). Since the cash on cash return is based on a single year’s operating cash flow, it does not take into account this principal paydown over the term of the loan.
The advantage of using the internal rate of return is that the IRR does take into account this principal paydown in the form of your net sale proceeds. The net sales proceeds is simply the selling price of the asset, minus any transaction costs, minus any remaining loan balance.
This doesn’t mean the cash on cash return should be ignored. It just means that it shouldn’t be the only factor considered. Using the cash on cash return along with other metrics will help show the nuance of the opportunity.
In this article, we discussed the cash on cash return in depth. We defined the term cash on cash return, including how the formula can vary in different situations. Then, we discussed some limitations of the cash on cash return and reviewed how the cash on cash return compares to the internal rate of return, capitalization rate, and return on investment. Finally, we discussed whether or not the cash on cash return calculation includes loan principal. The cash on cash return is a commonly used metric in commercial real estate, but it is not a silver bullet. As such it is important to consider its limitations and nuances as discussed in this article.