On today’s show we’re talking about a new report from Freddie Mac on the state of the multi-family market nationwide. But the purpose of today’s show isn’t just to share information. It’s about what you do with the information.
When you prepare a financial pro-forma for investors and lenders, the numbers you choose for that financial model should not be arbitrary. They should be based on widely accepted principles and practices.
For example, no financial model should assume zero vacancy when the market vacancy is in fact much higher. Which number should you choose? Do you arbitrarily choose 10%, 5%, 8%. How do you justify your choice of that vacancy factor?
On today’s show Freddie Mac’s economics team has issued some guidance that could be particularly useful in forecasting and modelling.
The first thing we see is that despite the recent surge in new construction, there continues to be a modest shortage of housing on a national basis as household demand outpaces total supply.
We all know that national numbers are meaningless because real estate is a hyper local business. Within the average there can be a shortage in one market and a surplus in another. But still, on a national basis the folks at Freddie Mac are seeing continued demand. Total housing completions over the past three years have averaged 1.1 million housing units each year. During that same time, total households have increased on average 1.4 million each year.
The second noteworthy item in their report was rent growth and occupancy. The federal government has been telling us that inflation is low, worryingly low in fact. But Freddie Mac is stating clearly that rents grew an average of 5.1% in 2018 and vacancy rates closed the year at 4.8%.
It is interesting to note that housing makes about about 40% of the consumer price index in most markets. The government Bureau of Labor and Statistics reported that inflation was 2.44% for 2018. But if rents increased by 5.1% and housing makes up 40% of the CPI, then what they’re saying is that the only thing that went up in price in 2018 was rent. Everything else remained flat. Something isn’t adding for me.
But here’s the thing that I found interesting in the report. Freddie is reporting that rent growth will remain healthy but at more modest levels compared with the robust growth seen in 2018. They are expecting rent growth of around 4% in 2019 and 3.6% in 2020.
Now here’s where things get interesting for me. When I’m modelling the rent growth for a project, I typically use a very conservative number, typically the rate of inflation. So if the CPI is 2%, I model 2% rent growth year over year for, say, a 10 year hold period of a project.
But now we have Freddie Mac clearly saying that rent growth was 5.1% in 2018, and will be 4% in 2019 and 3.6% in 2020. All those numbers are a long way from 2% that has been the conventional wisdom for a number of years.
Now the Freddie report did have some local data that I think is quite useful. They provided a forecast for local market vacancies and new construction starts for 47 markets. This gives a rough graphical view of whether vacancies will be trending upwards or downwards in a given market.
They also gave a view of rent growth compared with historical averages for those same 47 markets.
So what should you use when you model rent growth for the next few years? Should you use 2%, like the conventional wisdom? Should you use the Freddie Mac numbers averaged at, say 4%, and back up your assertion with the Freddie Mac report? The difference in valuation for a project between a 2% rental growth rate and 4% is dramatic.