Afford a Bull Market: Let’s Talk about Underwriting Rent Growth…

Rent Growth… another core element of CF Capital’s underwriting process.  In this article we discuss why rent growth is important, how we factor in the metric, and what it means for other critical parts of underwriting.

First, let’s just establish that rent growth is a metric and is commonly shown as a percentage.  Like the other metrics we have already discussed in previous posts (Vacancy Rates, Bad Debt, Cap Rates, and Interest Rates), we approach things from the top-down and then really dive into the fundamentals of properties.  

By top-down, we mean starting at the “big picture” national level and working our way down to individual multifamily properties.  

Rent growth is important to our process because it can make or break the decision to pursue a submarket and/or a specific property.  This decision of course isn’t solely determined by this metric.  We have to consider supply and demand dynamics (market absorption and expected future supply, for example) while synthesizing the market’s preferences and behavior.

From that point, we can make an informed and conservative decision to pass an opportunity or continue to pursue.  Our proprietary business plans for those acquisition targets which we choose to pursue account for potential adaptations we might have to make if the market were to experience any radical change at some point during our hold period. 

Nevertheless, let’s walk through how this is taken into account throughout  our underwriting process.  

We begin by gathering historical and current US rent growth data.  From this information we can establish baselines for comparisons in our next steps of the process.  These comparisons will allow us to identify things like: 1) the submarkets than contain properties that are attractive on a rent growth basis; and 2) any anomalies that make a submarket or property more interesting.    

This top-down approach allows us to compare where the broader nation is in its macro cycle compared to the data we gather at the local submarket and property level.

If you were curious, the current national rent growth is -0.6%, slightly below the long-term historical average for the US multifamily market, ~2.6%.

With that said, our next step is gathering that same rent growth data of specific submarkets.  After analyzing the current and historical numbers we can identify how a market’s historical return compares to that of the national average rent growth.  While not a requirement, it would be ideal to invest in a submarket with rent price increasing at a rate higher than 2.4%.

However, this trait should not be considered alone because the behavior of rental price increases are different in every type of submarket.  As a result, it is very important for us to dive deeper into historical data and establish where the submarket is in its cycle.  If rent growth continues to show evidence of acceleration, it will help us to assume that a particular submarket is early enough in its cycle for us to be able to capture a longer part of “the market upswing.”

After we finish this step, we move on by gathering this same data for individual properties within the same submarket.  We compare our findings to the broader submarket and seek out any anomalies that require deeper research.  

Because rent growth can vary greatly across submarkets and across different properties within a submarket, it is critical that we understand the underlying “why.”  Fundamental market forces driven by tenant preferences and behavior are a big part of this equation.  If we understand the market and its innerworkings, we can be more precise in our projections.

It’s important to note that Our models can have a wide variety of outcomes if rent growth is adjusted even the slightest bit.  With that in mind, our conservative philosophy will add a margin of safety and maximize our ability to protect our and our investor’s capital.  If long-term rent growth is 2.6%, we might run through a worst-case scenario in our models where long-term average rent growth goes down to 1.6%.

We are aware that we are in extraordinary and continuously evolving times.  And we believe that our diligent and conservative nature will serve us well both in the short-term as well as over time allowing us to outperform over our hold period.

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If you’d like to learn more about CF Capital, please check out our Company Overview.

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