Rents Drop for First Time in Two Years After Climbing to Records
Updated: Feb 19
//Anthony Bourdain Voice:
“Disclaimer: I am known to go against the grain. Thankfully for that, I have created such an eclectic group of close friends. My tribe. My tribe is sacred. Behind the scenes, I have been looking for ways to succeed so that I could bring them along and help them succeed further. Just like a superhero of sorts.
This is my mission, and due to it I have made my success not by following trends, but from studying them and identifying opportunities. My bet is that when an opportunity appears, my odds are greatest to succeed. I feel that right now we’re at one of those opportunities. I’m going to dig into the headline and explain why I see a massive buying opportunity, which will not only protect my wealth, but to multiply it alongside every one in my tribe (family, friends, investors, general partners, friends, family).
//End Anthony Bourdain Voice.
I intend to outline here why we are so BULLISH on Tier II and Tier III markets, and why we are taking our whole investment thesis to these markets TODAY.
The Wall Street Journal just posted a report showing rents dropping for the first time in two years. Before we dive into the rent drops and negative absorption shown in Quarter 2 of 2022, we need to lay some foundations down. Let’s first explain what Real Estate Market Tiers are.
Investment companies use Real Estate Market Tiers to segment cities based on size and development. Real Estate Market Tiers categorize cities as Tier I, Tier II, or Tier III, depending on the stage of development of their real estate markets.
Each real estate tier has defining characteristics:
Tier I cities have a developed and established real estate market. These cities tend to be highly developed, with desirable schools, facilities, and businesses. These cities have the most expensive real estate.
Duamel Voice: You could think of them as Tier I represents your metros, your downtown, where you go to hang with your homies for drinks or dinner out with your lady.
Tier II cities are in the process of developing their real estate markets. These cities tend to be up-and-coming, and many companies have invested in these areas, but they haven't yet reached their peak. Real estate is usually relatively inexpensive here; however, if growth continues, prices will rise.
Duamel Voice: You could think of Tier II as probably where your parents live. Kind of suburby, not a ton of growth, but no one leaves. There are a lot of old friends there that just never left the city. Population is very steady and jobs are healthy.
Tier III cities have undeveloped or nonexistent real estate markets. Real estate in these cities tends to be cheap, and there is an opportunity for growth if real estate companies decide to invest in developing the area.
Duamel Voice: Tier III is probably where your abuela lives. You know it, it's super quiet, very similar to Tier II except that it’s older. It’s nice. We’ve all spent a summer there, but we’re not coming here on date night or vacation. However, similar to Tier II, no one really leaves and it’s where you could bounce back after a life set-back.
We play in Tier II and Tier III markets. Remember this. We’ll get back to it.
Nationwide, rents declined on a monthly basis in August 2022 amid new apartment construction and weaker consumer sentiment. Let’s dig under this rock. Remember the Tier system?
Tier I Cities are identified as having new development, led by multifamily apartment complexes. This is due in large part to the cost of construction. If you take notice, most new apartment complexes charge rents at record levels and they’re happening in large cities and metro areas. As such, the rents need to be set at a high minimum entrance price for the developers to make a profit. The price of construction of new apartment complexes compared to what they’re able to achieve for rents is a good metric for maximizing profits for developers. However, this also leads to a feeding frenzy and overbuilding, riding the cycle to a halt.
Tier II Cities are identified as seeing new development, however, this is mostly concentrated on retail and restaurants and not new multifamily apartment complexes. Remember what we mentioned above… the price of rents in this market is much lower than Tier I markets, therefore, there is rarely new multifamily housing developments in this Tier.
Tier III cities tend to be sleepy. There is probably some new neighborhoods here and there, but rarely any new commercial or multifamily apartment construction. This is because the cost of construction is relatively high compared to the rents afforded in the market.
"I learned working with the negatives can make for better pictures." - Drake
Lack of new development in Tier II and Tier III markets is often seen as a negative metric by institutional investors as well as large funds and lenders. The thing is, the epicenter of real estate finances is Manhattan, New York City. There is nothing else in the nation that compares to NYC, however, this is the barometer many institutions follow. That’s why they focus on Tier I markets across the nation, since it is the next closest thing in regard to skyrocketing housing prices.
Lack of new development in Tier II and Tier III markets is what makes them so POWERFUL. It is also what makes them RECESSION RESILIENT. The only available housing is already built, and tends to be maxed out.
Hello, demand, is that you?
Not all data is created equal. Let’s talk about the population growth metrics. In the Tier I markets, growth is volatile, much like the stock market. As much as a whirlwind there is of people moving in, there could be an equal whirlwind of people moving out. This is due to the pricing of the housing market (home purchases and market rents).
As the new developers price their rents, they are constantly moving the needle on how much they can get. For them, a 100% occupied property is seen as a negative. This means that they are leaving money on the table. However, as we have begun to see, all things are cyclical, and when rents get pushed to their breaking points, potential residents begin to move back out to Tier II and Tier III markets.
As we mentioned earlier in the Tier descriptions, population growth has been a sexy trend. Mainstream investors are copycats, which means they do as the large institutions do, and therefore flocking to the same exact markets that the institutions are playing in. What this does is drive property prices up into a frenzy in Tier I markets, regardless of size. We’re seeing under-100 unit properties in Orlando, Clearwater, Volusia, our markets for example, where the sales price does no support the rents. These properties will have NEGATIVE CASH FLOW for years! And that’s the gift this frenzied rush to Tier I markets is giving us; overpriced properties because the rents will take several years to reach cash flowing, if at all.
IMPORTANT DISCLAIMER: Commercial real estate is valued by the amount of income it generates. Anything above that is what is called “speculation.” We’ve reached the point of the economic cycle, typically demonstrative of the top, where speculative investors are throwing money into negative-cash-flowing deals. All with the hopes that in the next 3-5 years, they are cash flowing and can either refinance or sell for a future profit to another speculative buyer.
Corporate Greed? There is no doubt that multifamily real estate has been the hottest commercial real estate product over the last decade. Seeing rental demand continue to skyrocket, especially since the 2008 housing crisis, developers started to go all-in fully since 2012 on multifamily development. The developers focused on Tier I markets, since at the time, that was the only Tier that the big institutions were willing to invest in.
This started the current development trend in our big cities. Again, this trend was focused on Tier I markets. In 2022, there are over 300,000 units projected to come on-line, meaning, available to new residents. In case you are wondering, that is the highest national amount on record since the early 1980’s. As of July 2022, over 700,000 units being built (CoStar data).
Negative Absorption for First Time Since 2001. The July 2022 Yardi Matrix, which is a market report, showed that from June to July the rental prices only increased $10. This represents a 7% growth and is a stark contrast to the 15% to 25% that was seen for these Tier I markets. Quite simply, oversupply is pumping the brakes on the rent growths.
Because of the news, we are seeing fewer buyers, a reduction in offer prices and increased selectivity from the institutions. This is going to have a big effect on the Tier I as a market softener. CBRE reported in their Q2 2022 US Capital Markets Figures that institutions and REITs have pulled back, by more than 5%. Further, REITs have become net-sellers. Again, all of the news, all of the noise and all of this action is contained within Tier I markets.
The most important takeaway.
In conclusion, it was my intent to illustrate with the above that Tier II and Tier III markets are not only safe, they are less prone to the market volatilities and shifts you see on mainstream media. While they may not be sexy looking, the cash flow is real sexy direct deposited in your bank account.
Our team at Ten15 Capital believes steadfastly that the opportunities to protect wealth and massively grow it will be found in these markets, and as such our entire philosophy is based on scouring these markets for buying opportunities. Right now.
If you want to not only protect your wealth and net-worth, but grow it also, consider investing alongside us.
Mainstream investors are copycats, which means they do as the large institutions do. This also means they are overlooking amazing opportunities in our markets. We gobble up these opportunities. - Duamel Vellon
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