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November 16, 2021

2021 Casden Multifamily Forecast Report


Richard K. Green
Richard K. Green | Director, USC Lusk Center for Real Estate

Richard K. Green highlights data and analysis from the 201 Casden Multifamily Forecast Report. Before Green dives into forecasted rent, vacancies, and deliveries for Los Angeles, Inland Empire, Orange County, San Diego and Ventura submarkets, he offers an economic context for where Southern California stands. 

In the context discussion, Green delivers insights into what’s happening with the supply chain in the ports of Los Angeles and Long Beach, why cap rates are so low, and how unemployment and total employment impact the delivery of goods, including multifamily construction.

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Richard Green: Good afternoon. My name is Richard Green. I am director of the USC Lusk Center for Real Estate, and this is the fall 2021 Casden Multifamily Housing Forecast. Our agenda for today, is to talk about some things that are on many people's minds. We're thinking about the world of multifamily housing. Inflation, something we haven't talked about in quite some time that is now on everybody's lips. Interest rates, infrastructure, coastal markets, taxes, and maybe a little bit on the Federal Reserves before we get into the forecast. So there is pressure right now on the goods market, and the first reason for it is if we just look at how much income there is out there, it is considerable. This is real disposable per capita income in the US. What you can see is that it rose and then dropped and then rose and then dropped. The rises reflect those stimulus checks that we know about the three rounds of stimulus. But the really important thing to look at is if you look at the trend in real per capita personal income, disposable income is the upward trend. And again, this is adjusting for inflation was basically not interrupted by COVID. We are where we would have expected to be had COVID never happened right now take a look at that. And so people having, okay what are they spending it on? Well I think this is one of the reasons we're seeing inflationary pressures.

So in the immediate aftermath of COVID, we saw big decreases in spending on both services and goods, but bigger declines in services, then goods. And if you look, when it comes to service spending we're still not back to where we were before COVID. Whereas when we look at goods spending, we are well past where we were at the beginning of COVID, that's almost a 20% increase in goods spending. So what's going on? The people have this money, we showed you that, they're not spending it on services, what does that mean? It means they're not getting haircuts. They're not getting their nails done. They're not going to the doctor. Although there's been some catch up in that in the last year or so, but just think of all the services that you spend money on and how you're not spending money on them recently, because you're staying at home, right? You have to leave home in order to buy services. People have not been leaving home. So they have money, they're not spending the money on services. What are they gonna do? Well, people wanna spend their money. They have buy buttons on their computers, and so they're buying stuff. They're buying lots and lots and lots of stuff. And the thing about the manufacturing process and the supply chain process is it's not something that can be immediately expanded. So if you're close to capacity, then if you spend a lot more it's to show up in prices and not in output and goods unlike services, can't adjust quickly to this change in demand. So that's putting a lot of upward pressure on prices right there, okay. Will this go away any time soon? Well, I'm sort of doubtful. And here's the reason why is, despite the fact that we've been spending all this money on goods, we've also been saving a lot until quite recently relative to what we did in the past. Even if you look at this recent savings rate, other than the spike here in the immediate aftermath of the financial crisis, we're still saving more than we've saved at any time in the last 30 years, more or less. So what you could say is what's here is the unspent money that people have that could potentially go to new spending unless they get tired of buying stuff. And so this will continue to put inflationary pressure on the markets.

The other thing is people do decide to leave home and do decide to spend more on services that could relieve pressure but in the absence of that, in the absence of people getting tired of buying goods or people deciding to spend their money on services again, there's no reason to think these inflationary pressures won't be with us for at least a while longer, okay? At the same time, the other place where there's a bottleneck is not as many people are working. And if you look at where we are in terms of total employment, where at about 2 million people still fewer people working now than was the case two years ago. And let me restate that. If you look at the share of the working age population that's working now, compared to two years ago, it's still about two percentage points lower. So this is the total number of people working divided by the population age between the ages of 15 and 64, which is what we consider to be the prime working age population. So fewer people working, harder to produce as much stuff, again it's going put some inflationary pressure on. At the same time, the number of people who are working age population is actually falling right now. This is not the share of the working age population, that is, which is falling. This is the total number of people who are of working age is falling, and it will continue to fall over the course of the next decade as the large number of baby boomers between the ages of 55 and 64, heading into that 65 to 74 year old age range at which they will likely at some point cease working. And one of the interesting things about COVID is after years and years and years, in which people have pushed back their retirement age, we have seen people at least state that they are retiring at a younger age than before, which will put even more pressure on the economy because we won't have these workers able to contribute to it unless we change immigration policy of course.

Okay, here's another indication of where we are relative to the past in terms of capacity. So 40% of the imports coming into the United States come through the ports of Los Angeles and Long Beach. And this is where Los Angeles is in terms of TEU's. So think of those containers that come through, moving through each month. And so the blue is a month for 2019. The yellow is a month for 2021. The red is 2020. Obviously we don't have the last three months of 2020 yet available in terms of, excuse me, 2021. But note this, in October, November, December of last year, far more stuff moving through than was the case in the previous year, we look at January not quite 2019, but February much more, March much more, April, May, June, little less in July, more in August, more in September, 2019 was a record year for stuff moving through the port of Los Angeles. And in nearly every month in the last 12, we've been moving more stuff through the port than we did in that record breaking year. So the question is, are we at capacity in terms of the port? Well it would appear so if you look at the number of ships sitting off in San Pedro right now. It would appear that more stuff can't move through, but interestingly we had Jaime Lee, who's the chair of the Port Commission at the Custard Event, and she said, the issue is not so much the port itself, it could have more stuff moved through it. It's the lack of truckers picking stuff up and moving it out. And she said that there is a shortage of 30,000 truckers go back to your labor, the labor supply at the moment, that are preventing us from having stuff picked up, which is causing a bottleneck at the port, which again, of course is inflationary.

It's important to remember that the impact of this is not been the same on everyone. If we look at unemployment rate based on race, if we look at it for white folks, I mean, everybody saw their unemployment rate rise dramatically at the beginning of COVID, but it rose more for black folks than white folks. And if you look at where we are now in terms of the difference between black unemployment and white unemployment and compare it to before COVID, that gap has expanded again. So as is often the case people who are sort of at, struggling most in our society are harmed most by these traumatic events, despite the government interventions that we have put into place in order to help.

Let's talk about interest rates. And this is something that I'm wondering about the sustainability of in the years to come, but it also explains why capitalization rates are as low as they are. This is the tip rate, or the tenure constant maturity inflation index interest rates. So let me explain how this works. Is currently, the real interest rate in the United States is -1%. So you can buy a security and it works like this. It says okay, you spend 100 bucks on it, what do you have in an year for a coupon? Well, you'll have -$1, so do you have to give the government $1? Well, we're not there yet. Plus the growth at CPI, which has been clicking along at between five and 6%. So what it would say is, a year from now you get a $4 coupon for that $100 that you invested today, right? The 5% nominal rate minus the 1% real rate that you're taking on. This is the relevant benchmark for capitalization rates, because what a cap rate is, is a rate of return minus a growth rate. Your total return on a property is your cap rate plus your growth rate. So rate of return minus your growth rate is your cap rate. And so if you look at the margin between capitalization rates and tip rates at the moment, they're actually pretty high by historical standards, which suggests that they are not overly compressed at the moment. Relative to relative benchmark, you are getting a good margin with cap rates, which makes again, apartments very appealing. And when you add to that the fact that apartment rents are rising more rapidly, in fact much more rapidly than inflation, it makes apartments even more appealing. Now the question is, will these rapid rises in rents continue to increase? And we'll talk about that when we get to the forecast.

Okay, logistics. If we're thinking about the cities that will succeed going forward, they are going to be the ones that have the best logistics. And so it's worth spending a minute to talk about the context in which Southern California sits. A very important logistics for getting people and goods in and out of a place is, do you have a runway? Do you have an airport with four parallel runways? So the thing about having four parallel runways is even bad weather has minimal impacts on the outflow and inflow of air traffic at such an airport. You have two runways with planes leaving, you have two runways with planes arriving. You don't have planes interfering with each other and airspace as a result of this. And so you could get very efficient flows. This is a list of all the airports in the United States with four or more parallel runways. Atlanta, Denver, Dallas, Detroit, Los Angeles, Orlando and Chicago. It's no accident that many of these have been fast growth cities going back 50 years. Chicago not so much and of course Detroit not so much, but it still is something that gives all of them an advantage relative to other cities. Now, for those of you who fly through SFO, you know that the weather there will cause delays and cancellations very easily, very quickly and that's because their four runways intersect with each other. They're like a hashtag instead of in parallel. And so this is an important advantage LA has, and explains why before COVID it was the number one origin and destination airport. The world, which is to say, if you remove the people changing planes it had more air traffic than any other airport in the world. Why it was the number two commercial airport period in the United States and why it was the number two cargo airport in the United States. The two main cargo airports in the US of course are Memphis, which is FedEx's hub and Louisville, which was UPS's. And they have only three and two parallel runways respectively, but they have very little passenger traffic. So that's adequate for their purposes.

Where LA doesn't do so well, is roads California. So we need to get stuff in and out of the ports. And I know roads are things that people tend to not like very much nowadays you read people complaining that we should have fewer of them, not more of them. If that's the case then California is in good shape, because California, for all of our reputation of being a freeway place, has amongst the fewest lane miles per capita of any state in the country. Okay, so what does that mean? It even takes to account the fact that LA freeways are eight lanes across, 10 lanes across et cetera, we don't have that much road capacity relative to the number of people who live here. Now, the other thing is if you compare, one of those states states, one of the places with less, New Jersey, Hawaii, and District of Columbia, those are very small, very dense places. And California of course has a lot of density, but there's a lot of places that are not so dense. It's an enormous state. So those are places where you would expect there to be less in terms of roads per capita. And if you go to the far right, you wanna ignore, far left excuse me, you wanna ignore these places, North Dakota, South Dakota, Montana, they don't have people and they have roads that cross the entire state, which we do have a national system of highways, you need roads to get all the way across them. So you would get this very large amount of capacity relative to the number of people. So that's not really particularly relevant, but it is interesting to look at places that we consider our competitors like Texas. And I would argue Washington State, have considerably more road capacity than California does. And it's just something to think about as we're thinking about the importance of moving stuff through the supply chain and Los Angeles' role in that.

Some other things to consider is coastal markets in general and LA market in particular, in terms of performance, going back 43 years. And there's a good news, bad news aspect of the story but the way to look at this is we're looking at just average CPI growth per year in residential rent. And you see Los Angeles has rent growth of 4% per year, highest of any market in the country over that period of time. San Francisco is number two at about 3.7, 3.8%. Houston is under three, Atlantis under 2 1/2. Dallas is a little under three. From the standpoint of an investor of course, this is great, it means the cap rates should be lower in these markets because you would expect rent to grow. And there's a reason we're not building much stuff here. And so that makes sense, of course from the standpoint of housing affordability, this is terrible and explains why LA is amongst the worst, if not the worst place in the country when it comes to housing affordability. The other thing I want you to look at is the volatility of that growth. So the orange bar is the standard deviation of rent growth in these various markets. And what you could see is LA, while it has the highest rent growth. It does not have the highest volatility. I find it interesting that Atlanta has the highest rent volatility in a sense Atlanta, a place that has bloomed as an economy over the last 23 years has not been a particularly great place, at least based on these metrics for investing in apartments. I divide return by the standard deviation to get what's called a modified Sharpe Ratio. It's not exactly the same thing, but the idea is how much return you get in exchange for unit of risk. And as you can see by that metric, Atlanta does the worst of any of these cities. Chicago does the best of any of these cities. You haven't had a lot of rent growth, but there's very little raw volatility, just sort of reliable. Lead goes up by a little more than inflation year after year after year. But by this measure again, the higher the silver bar the better LA is pretty good. Not quite as good as New York, not as good as Chicago, but better than all of the other metropolitan areas listed in this. And so people sometimes wonder okay, why do people invest in LA? And sometimes people say, oh, I'm not investing in LA because they, I don't like the progressive's there. There's a CEO of a very large who actually said that, at the end of the day, from an investor stand point, the performance in LA has outpaced the rest of the country. But also again, from a resident's standpoint, from an affordability standpoint, it's kind of been a nightmare.

Okay, this is a little bit about taxes. I mean, we're in the middle now of continuing negotiations of the build back better plan. I don't know what's gonna happen, but people are worried about what happens if like-kind exchanges go away or if step up basis at the time of inheritance goes away. So the way it works right now is if you have a property that says a basis of $1 million and it's worth $10 million, if you were to sell it, you pay capital gains tax on the difference. But if you die and your heirs inherit it, the basis steps up to 10 million until they could sell at 10 million and not pay capital gains tax. I'm sure everybody who's watching this does about like kind of exchanges, the way to defer a capital gains event is if you wanna sell a building, instead of selling it for cash you exchange it for another building, and you defer to the point when you sell that building, unless you die before that building is sold. And again, it steps up in basis. You either aren't putting off your taxes or again, if someone else inheritance, perhaps eliminating that tax liability at all. So I looked at the effective tax rate on this particular deal, and this is just federal income tax rate. It's in California, apartment 5% cap rate, entry and exit maybe it should be lower than that. Building to value ratio so what you can depreciate at 50%, 2% annual NOI growth, maybe it should be higher than that. 60% loan to value ratio, interest only loan at 3%, all in ordinary income tax rate of 50 and all in capital gains tax rate of 33. So this is, excuse me I said federal before this takes in to account California, Texas as well. All right, so what is your all in tax? Without any preferences? It would be 27% if, what the like kind exchanged does is reduces that effective rate 25% and what the step-up in basis death, is reduce it 24%. So is there an impact that these things go away? Absolutely. Is it an enormous? Well I guess you could think about it at, it's about a 10% tax increase. You can decide for yourself whether that's an enormous impact or not on the property markets, okay.

To the forecast. So before we get into the forecast for this six month period, and this here, I do wanna hold myself accountable for what we did last spring and our forecast did not do particularly well last spring. This is what I call my wall of shame. What did we forecast and what actually happened? And long answer short, rents went up everywhere faster than we said that they were going to go up. My only excuse if you can call it that is, I don't think anyone was seeing that Irvine would have a 19.2% increase in rent over a six month period. If somebody did out there I'd love to hear about it and how you figured that out. We didn't do that badly if we sort of look regionally, the place we thought would be weakness were kind of weakest. The places we thought would be strongest were kind of strongest, but this increase in rent was quite extraordinary. And it was driven by the fact that vacancy rates already low, dropped even further over the period of time that we studied. And so that's gonna be, so remember, if you look and see what we wrote last spring, when we were forecasting rent increase in the Inland Empire of Inglewood, rent increases of 10%, we were writing, man we are, I don't know, this may not make sense. And if you look you got, this is again in six months, for Palm Springs 6%, West Riverside County about 10, Rancho Cucamonga again nine, again those are six month increases in rent. So considerably more than we were expecting. So again with trepidation, let me show you what we think is going to happen in the year to come.

Okay, so Inland Empire, again, one of the things that's going on here crazy little bit gutsy. So the vacancy rate at which rents neither raised or fall on an inflation are just basis is about 5%. We think vacancies which have dropped to are gonna stay there. And the reason for that is the Inland Empire has a very strong economy. Employment growth has been very good. And at the same time, we don't see a lot of deliveries coming online in part because of COVID phenomenon and a supply chain phenomenon. So when you have vacancy that's very low, what do you expect? You expect rents to increase quite rapidly as we do. And we think in two years, rents in the Inland Empire will be well above $2,000 a month, to put this in some perspective for rent to be considered affordable, you need to be making $80,000 a year in income if you're at 2000 a month. Will there be people in the Inland Empire who can afford this? Well, if you have two people working in Amazon Warehouse at $20 an hour, sharing an apartment, yeah that gets you to about 80,000 a year. But the key is doubling up. If somebody's on one income, I think this is pretty hard for people to afford. And the Inland Empire used to be the place that we would say go if you're looking for affordability, okay. Well, a big reason for this again, is we don't expect deliveries to be particularly strong. And a lot of this reflects the fact that COVID has done a couple of things. One is it just slowed down the construction process. So deliveries are taking longer even for starts. But the other thing is because of the supply chain issues, materials are becoming so much more expensive because labor is becoming so much more expensive. Developers are looking at stuff that's permitted and they're saying wow, we need to get really high incomes in order to justify this construction costs. And so they have delayed beginning new construction, hoping against hope that some of these construction costs come down. Now the interesting thing is talking to some developers in the last couple of weeks because of these strong rents, they're thinking they're gonna go forward anyway, which suggest that maybe deliveries will be a little better than we're suggesting here.

We look at Los Angeles County. Similar sort of story, vacancies came down much more than we were expecting in the second quarter, as you can see we are at above 5% vacancy in COVID and that's why we thought we'd basically not see rent growth in most of LA County over the last six months, but stuff got absorbed quite rapidly. People have been coming back to Southern California after living in their parents' house for awhile. And what, we expect that to continue. And again, deliveries are not gonna start to have an impact on those vacancy rates until about two years out from now. And again, as a result of that, we expect to see very strong increases in rent. In percentage terms, not as strong as the rest of the region, but nevertheless quite strong. And again deliveries, we do think when we look at permitted stuff that there will be some stuff coming online toward the end of the second year of our forecast, which again that's what's driving those higher vacancy statistics.

When we look at Orange County, again very similar story to LA County, only a little more so they could see a little lower to begin with some deliveries coming online leading to somewhat higher vacancy. Again, still well below that 5%. So we expect rent growth every quarter in the next two years. And again, a pretty strong increase, a really substantially increase. Orange County again, very strong economy, very desirable place, not enough stuff coming online. So for LA County, for Orange County excuse me, to make a dent in its housing issues. It needs to be building more like, eight, 9,000 units a year, and it's building fewer than 4,000 a year. And so we expect the rents to continue to go up.

San Diego again, the pattern is very similar. If you look at these vacancy patterns for Orange County, for Los Angeles County, little higher but you can see that sort of a U-shape to it. Again, rent very strong increase the same reasons. Here's your deliveries, more in the shorter term than a longer term. But we will start to see having an impact on vacancy we think. And then finally Ventura. Very similar story again, rents again rising quite rapidly. Delivery's not so great.

Now, one of the things about Ventura is you're looking at these very low levels of delivery and you're wondering okay, how can those vacancy rates be going up? Well first of all Ventura County is just a much smaller county than these others is, as you know LA County is 10 million, Orange County is three. The Inland Empire is 4 1/2 million, San Diego county as well over three. Ventura County's about 800,000 people. And so you don't need as many units built at Ventura to have an impact. But the other thing, and this is an artifact of the model because Ventura hasn't built very much as you can see, we haven't seen a lot of people move into Ventura. There hasn't been a lot of absorption there because there's been nothing to absorb. And so our forecast absorption is pretty low. That might be a problem with the model and maybe you'll see more, in which case these vacancy rates will be lower in Ventura and rents will go up even more.

So that's a very quick overview of what we expect to see here in Southern California in the next year. My name's Richard Green. My email is I welcome any comments or questions. Thank you for watching.