The allure of trophy assets and high-profile office complexes can be difficult for an institutional investor to resist when allocating capital to real estate. Often overlooked are less flashy multifamily housing developments, which can be a more consistent source of long-term returns.
An institution’s decision to favor office buildings is largely because of the profile of its tenant base. Office buildings can attract large, well-known companies that sign expensive, multiyear leases, whereas apartment buildings rely on numerous shorter-term tenants who may only commit to occupy the space for months at a time.
On paper, this longer duration bestows a sense of stability and creditworthiness to office buildings that multifamily projects appear to lack. But a closer look at the numbers reveals a different reality. Research from the National Council of Real Estate Investment Fiduciaries shows that unleveraged average returns from multifamily housing units have outpaced those of office buildings in four of the past five years — at times by more than 600 basis points. Why is this?
The most important reason multifamily developments frequently outperform their office counterparts is quite simple: consistent demand. Regardless of macroeconomic conditions, people always need a place to live.
In a thriving economy, people can afford to live on their own and quickly fill housing that meets individual needs and brings them closer to jobs. During a down economy, renting may grow more attractive than buying for a variety of reasons: People lack the ability to save for a downpayment on a house, which may free them from ongoing home maintenance costs, and the short-term nature of renting provides location flexibility. These factors produce a reliable and stable revenue stream.
The same cannot be said of office developments. When times are good, office rent is consistent. However, during times of economic distress, businesses close, and those long-term leases, which looked so attractive on paper, can be broken or restructured. Empty offices are more difficult to lease as fewer businesses are launched or looking to move. The result: fewer tenants, less revenue.
Additionally, the fundamental nature of office space may be subject to disruptions with the advent of telecommuting and preferences for open floor plans or campuslike environments. Offices built just 15 or 20 years ago can struggle to fit the needs of today’s companies, which want more creative and flexible spaces, rather than just private offices, conference rooms and cubicles. However, the functional, physical characteristics of homes have not changed: walls, roofs, living areas, bathrooms and kitchens.
A new office complex can have a dramatic impact on the local market. Just as a big buyer or seller of a thinly traded stock moves a company’s share price up or down, the addition of hundreds of thousands — sometimes millions — of square feet of new office space can upset pricing as the market struggles to absorb new capacity. Conversely, the introduction of even the largest multifamily developments creates minimal disruption.
Ironically, it is precisely the makeup of the multifamily tenant base — lower-priced short-term leases, which institutional investors perceive as a negative — that may be its greatest strength. Unlike office buildings, multifamily developments are nimble enough to employ dynamic pricing models, much as airlines do when selling tickets for seats. Leasing prices in multifamily developments can be adjusted on a daily basis, up or down, depending on current demand and the available supply of units.
Office buildings are loath to adjust prices downward, especially when they are part of a publicly traded vehicle like a real estate investment trust, which can affect a stock price and produce inordinate consequences on commercial leases throughout the local market. The long duration of office leases can also hurt returns when buildings find themselves locked into agreements that were consummated at the bottom of the cycle, thereby depriving them of the ability to capture a market upswing.
Last, the costs of putting a new, large tenant into an office space far exceed those of a new apartment renter because tenant improvements for offices are customized to the company and its aesthetic. Apartment renters may only expect fresh paint. As a result, multifamily developments can keep vacancy rates to a minimum, again ensuring a steady revenue stream.
Multifamily developments have another advantage for investors exiting a property. When office buildings are completed during down markets, investors suffer for two reasons: First, the value of for-sale assets will be considerably lower than original projections, which may have been calculated during more optimistic times. Second, properties built to be leased and held struggle to attract tenants, and lease terms will be set below originally anticipated prices.
By contrast, constant demand for multifamily housing and its use of dynamic pricing models mean that builders can ride out a downturn by continuing to rent the units and generate revenue. Assuming that the project is not overleveraged, developers can hold the property, keeping it leased and generating cash flow, and sell when market conditions improve. This generates a more favorable sale price and increased returns.
Institutional investors by nature are long-term stewards of capital interested in generating consistent returns that meet the needs of their current and future obligations. To use a baseball analogy, institutions want a steady stream of singles and doubles and do not view themselves as home-run hitters, who also tend to strike out a lot. This long-term mandate to preserve and enhance capital philosophically matches up with the core characteristics of the multifamily asset class, which similarly seeks consistent performance with less volatility. Multifamily delivers that because of constant demand and the flexibility to quickly adjust pricing. This is a critical, yet often overlooked, consideration for institutional investors.
Ultimately, although multifamily developments may lack the superficial appeal of office buildings, the asset class warrants serious consideration for institutional investors deciding where to allocate capital within real estate.
Sean Burton is the president of CityView, a Los Angeles–headquartered developer and investment management firm focused on urban residential real estate in the western U.S.
