2023 Outlook: Build-to-rent remains resilient

How does the fastest growing asset class in real estate history weather its first macroeconomic headwinds? How well do so many new, untested relationships and networks among actors–operators, lenders, equity providers, design professionals, contractors, property managers, among many others–endure such times? Is there a broad pullback from the space, or do actors double down?

With eyes and ears on the ground in multiple regions of the United States, insight into the perspective of operators that run the spectrum from dabbling in BTR to approaching it with an institutional mindset, and having looked at over 75 projects last year alone, we believe there is reason for cautious optimism. So, let’s dive in.

2023 will be a year in which established actors in BTR entrench their positions and separate themselves from the pack in the wake of continued favorable macro trends for BTR. These established actors include the national homebuilders who developed an earlier presence in the space, to the more BTR-specific operators with an existing headstart.

As capital providers in particular–both debt and equity–seek reassurance in uncertain times, groups with an established track record and strong, pre-existing capital relationships will disproportionately benefit. These relationships are always important, of course, but their quality will be tested more than in less volatile times. The established actors will obtain markedly better terms on core project economics, like interest rates, preferred return hurdles, and promotes, while many less-established actors may struggle to gain traction with capital, whether it be equity commitments or loan approvals. This continued performance advantage will enable the established groups to shore up existing land positions, win new land pipeline, build during an anticipated correction in construction costs, and otherwise run up the score. But…

The traditional tradeoffs between friends and family capital networks versus institutional ones are well-known. Fundraising from family and friends can carry significant transaction costs on each and every project, particularly in terms of time spent and hand holding, but is often fairly lax when it comes to oversight and mandatory reporting. Institutional relationships, on the other hand, can take years to nurture, but once established, can be a much more efficient way to capitalize multiple projects and scale a true platform.

Current macroeconomic conditions have brought a less-appreciated “friends and family” advantage to the fore: ease and freedom of decision making. Family and friends networks, where everyone starts, are often and almost solely relationship-based. The pre-existing trust between the operator and the “family and friend” investor is what matters most and dwarfs other considerations. But family and friends investors rarely perform their own analyses or do their own diligence. In fairness, these investors have the benefit of investing their own capital and do not have fiduciary duties to upstream partners that primarily drive the thoroughness of institutional funds. They also use their trust in, and relationship with, the operator as a proxy for further diligence. These dynamics result in the operator having much stronger decision rights, both legally and practically, and more freedom to operate on their own instincts and analyses.

In contrast, institutional fund managers scrutinize an operator’s recommendations at every stage (and current market conditions have only increased that scrutiny). And across capital markets, the limited partners who invest in institutional funds have become significantly more active, bringing atypical and additional upstream scrutiny and second-guessing of institutional fund managers’ investment decisions.

In sum, even though institutional capital relationships are traditionally seen as a “goal” by many, operators who have strong family and friends capital networks (many of whom are the “less-established” actors) may end up having more success getting projects capitalized in a very advantageous time to build.

B and C projects in B and C markets will get squeezed. The senior lending market is the big bottleneck right now. The number of senior lenders willing and able to lend has dropped dramatically and only the best deals in the best locations with the best operators are getting financed. Operators also have to pay more for less leverage: while interest rates have increased, loan-to-cost ratios have decreased as lenders’ appetite for risk cools. This dynamic hammers project proformas, resulting in only the best deals making sense.

Over the last two years, historic rent increases have been the primary savior of many a project’s economics. Over these next two years, construction costs will play a similar role. The math is simple: even as interest rates rise, construction costs in many markets are going down and may go down in even greater magnitude than the countervailing increases in debt service costs. Construction cost decreases also impact more broadly: a percentage increase in debt costs applies only to the portion of overall construction costs that is levered, whereas a percentage decrease in construction costs applies to the entirety.

We won’t see a return to 18%+ year-over-year rent growth anytime soon, but BTR rents should hold steady this year and even see modest growth. Household formation, the main driver of rents, took a pause starting in mid-2022. Notably, college grads did not flood the tenant market in mid-summer the way they typically have, instead reacting to high rents and uncertain economic conditions by living with friends and family. On the other side, however, lease renewal rates are at near all-time highs. All to say, the mix of factors will buoy rents. And overall, we continue to push out demand and constrain supply, which could lead to historic demand in the next 18-24 months similar to what we saw over the past 2 years.

Many multifamily developers entering BTR have already begun to apply the multifamily “recipe book” in planning these communities. We expect these players to continue to iterate as they increasingly mix product types in BTR communities, with a focus on larger unit sizes, more elaborate elevations, and increased unit counts. We predict more multifamily developers will enter this space in 2023, bringing with them a new level of product sophistication and efficiency given their experience delivering rental homes to tenants. With more REITs and multifamily developers entering the market, we expect more institutional capital to play a part in the BTR industry.

BTR will continue to outperform traditional multifamily and generate “alpha”–a return that beats the market–this year. As it has over the past 12 months, BTR will carry a premium in key indicators such as per square foot rents, tenant quality, lease durations, and growth trends. Further, as experienced rental operators increasingly enter BTR and ramp up the overall sophistication of the asset class, more efficient community and architectural designs will lead to higher NOI for owners. And to the extent there is a drop in key project metrics, BTR will “bounce back” sooner and more quickly than traditional multifamily.

While homebuilders continue to buy down interest rates in an effort to keep their production flowing evenly, trades who have been through this before (see 2008) are diversifying their customer base in order to de-risk their reliance on the for-sale market. The consistency of unit deliveries, accelerated pace of construction, and simplicity of vertical construction plans is an attractive mix and is starting to draw the highest-performing trades to the BTR segment. GCs who can manage these factors while providing clear instructions, paying on time, and advocating for the trades’ best interests are winning trade capacity. These efforts result in a big win for BTR owners, as the residential subcontractor base offers the most efficient and cost-effective delivery method for this product type.