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Why Houston Multifamily

January 20, 2020

“Why Houston?” – Many people ask Kent and I this question when they find out we are two partners investing in Houston, one from California and another from New York. We feel very confident with our decision to focus on the Houston multifamily market and I would like to use this whitepaper to explain our investment thesis and provide the data to back it up.

I find it interesting that many Texas-focused investors I speak with tend to overlook the Houston market and instead, choose to focus on San Antonio, Austin, or Dallas-Fort Worth (“DFW”). We believe this provides us with a slight competitive advantage as we see less competition in Houston to purchase comparable assets with similar growth potential as assets in those other Texas markets. Notwithstanding the difference in competition, Houston, just like the rest of Texas, has performed extremely well throughout this current cycle, abetted by heightened investor demand for Texas assets, business-friendly taxes and laws, population growth, and job growth. We continue to see a lot of value in Houston, similar to Dallas and other strong Texas markets like Austin and San Antonio.

We find that we are often competing with local owners in Houston and aren’t battling as many national buyers in multiple rounds of Best and Final (don’t get me wrong, it’s still highly competitive). However, many of these local operators are long-time owners of multifamily and thus are jaded by the previously low price-per-door numbers which make it difficult for them to bid aggressively on new opportunities as prices continue to rise. For example, properties that used to be $20,000 per door a few cycles ago are now easily trading for $80,000 per door.

While most of the product on the market is frighteningly overpriced, there are still good buying opportunities for price-appreciated assets because rent growth has lagged just slightly behind price appreciation. We don’t allow our underwriting to be swayed by the outsized rent growth observed over the last cycle. For the most part, we are underwriting to 2.5% rent growth matched by 2.5% expense growth as well as 4% growth in property taxes (property taxes can be a wild card in Texas which many investors and operators overlook).

We believe this mix of assumptions, typically played out on a five-year pro forma, allows us to see if an investment can stand on its own two feet, without being buoyed by a booming market or cap rate compression. Our assumptions are very conservative compared Houston’s potential as well as to the many investors who are underwriting 3% rent growth coupled with 2% expense growth, compounded over a ten-year timeline (believe me, this makes a huge difference!). Despite the conservative rent-growth assumptions in our underwriting, we believe Houston’s growth prospects and long-term stability in the class B/C multifamily market make it an attractive place to focus our acquisition efforts.

Houston Highlights

Houston Stands Alone

Houston is the only market in the US which is currently in its recovery phase according to Integra Realty Resources’ 2019 report (image below). This means that all other US markets are either in the late stages of expansion or are already in oversupply. Meanwhile, Houston has a lot more room to grow and is projected to experience roughly 3% to 4% rent growth in 2019 while Freddie Mac’s 2019 Multifamily Outlook report, among other research reports, is projecting that most of the other hottest markets in the country will have slowing rent growth (Freddie Mac). Coupling this growth with a low level of completions, Houston should provide a great supply and demand dynamic for multifamily investment.

Two major reasons why Houston is so uniquely positioned as the only US market in recovery and with potentially a lot more room to grow in this current cycle is the 2015 oil crisis and Hurricane Harvey. Both of these events caused major economic shocks to the Houston employment and real estate market which set back its expansion cycle by two to three years. The oil crisis, caused by an oversupply of crude oil and a very strong dollar, halted job and rent growth in Houston and caused an isolated recession. The chart on the next page shows the flat job growth in 2015 and 2016. Houston’s 2015 recession is unlike the painfully scarring 1980s recession in Houston because the whole US was also sliding into recession at that time, caused by oil and real estate price declines. Houston used to be known as a boom/bust town, highly correlated to oil. However, Houston and its real estate market are slowly decoupling from the price of oil as more and more technology jobs move into Houston. We see tremendous value and stability in some of Houston’s stronger submarkets which are in notable school districts and are not energy-driven.

Hurricane Harvey destroyed roughly 135,000 homes and displaced many more, leading to a decline in vacancies and increased demand for workforce apartments. “The Category 4 Atlantic storm hit Houston in mid-2017 and accelerated a market that was already fighting to surpass its 2015-16 energy-related slump. The metro added 128,700 jobs in the 12 months ending in September, with mining, logging and construction accounting for more than a quarter of gains. Professional and business services and trade, transportation and utilities added 51,000 jobs combined. One of the largest infrastructure projects is the $815 million investment in State Highway 288, a critical north-south transit corridor. Thousands of workers are also on site at the $1.1 billion McNair medical campus, slated for completion in 2019. Moreover, roughly $4.5 billion in local and federal funds will be put into critical flood control projects, further boosting construction.” (Yardi Matrix Winter 2019 Report).

Natural disasters, while terrible for communities, spur investment by the government to remedy destruction which increases the number of jobs. For example, Houston residents recently passed a $2.5B flood bond, which will allow the “Harris County Flood Control District to build at least 230 projects over the next 10 to 15 years. It is also key to accessing more than $2 billion in matching federal dollars.” (Houston Chronicle). This sort of investment should benefit the multifamily market for years to come. As in the past, these storms will continue to reduce the housing stock (temporarily and permanently) and place upward pressure on multifamily demand and further benefit the affordable multifamily investment thesis. Apartments damaged by natural disasters will be rebuilt as class A or redeveloped as a different class (office/industrial) for highest and best use. Either way, B-/C+ multifamily cannot be rebuilt as the delta between pricing and replacement cost is extremely wide. In Houston, average pricing for class B/C assets is $75,000 per door while replacement cost is roughly $150,000 per door. Lastly, natural disasters dissuade home ownership, which benefits the rental market.

As the only metro in recovery due to Hurricane Harvey and the 2015 oil recession, Houston has a lot more room to run regarding job growth, wage growth, and rent growth. This market position should also bode well for Houston in the event a national recession does occur, since it is only three years away from its most recent bottom. However, Houston’s prospects remain strong and are primarily driven by job growth.

Jobs, Jobs, Jobs

Houston is the nation’s leader in job growth in absolute terms and is also rapidly growing on a percentage basis. “Houston is expected to lead the nation in job creation for a second consecutive year in 2019 as the economy bounces back from a slowdown in the oil and gas industry.” (Marcus & Millichap). Houston’s GMP is also estimated to grow by 6.5% in 2019 (HIS Markit).

Furthermore, the data shows that many of these new jobs in Houston are tech-focused, providing further robustness and long-term sustainability to the job market. 80% of tech leaders in Houston are expecting to add to their teams in the first half of 2019. Houston leads the country in this metric with Charlotte and Phoenix in 2nd and 3rd place, respectively (PR Newswire). Technology is the future of jobs and more tech jobs means higher wages. Houston pays tech employees 5% more than Austin does yet it is a more affordable city (Bisnow). As the cost of living continues to rise, especially in technology hubs like the San Francisco Bay Area, more people will be flocking to more affordable metros that still provide the diversity of employment and amenities of a major city. Houston satisfies the requirement of not having any one employment sector making up more than 20% of total jobs (see chart below).

Houston is relatively affordable compared to other major markets and employment centers similar to its size in GMP. According to a report by the Council for Community and Economic Research, Houston is one of the most affordable major metros in the United States. This helps mitigate the negative repercussions of a recession since during a recession people tend to move to more affordable job centers. In all, Houston’s combination of affordability and job growth should keep its population growing, leading to a very favorable supply and demand dynamic for multifamily investments.

Supply/Demand

Demand continues to outpace supply in the US multifamily market. Nowhere is that truer than in Houston as it led the nation in net absorption as a percentage of new supply in 2018 (CBRE Q3 2018 Report). Houston’s construction pipeline has been active over the last few years but 2019’s completions are predicted to fall to one-third of 2018 completions (Marcus & Millichap). Houston is only anticipated to have completions equaling 1% of total current stock while a similarly hot Texas market, Dallas, is expected to experience completions equal to 3% of total inventory in 2019 (Yardi Matrix). Furthermore, these completions and future supply brought to market are concentrated on the core central business districts and other class A locales.

Even if completions weren’t slowing down, there are plenty of other positives on the demand side. The gap between home ownership and the cost of renting continues to grow and should remain wide enough to discourage home ownership for a disproportionately greater percentage of the population for the foreseeable future. Demand should continue to outpace supply, especially for class B/C units. Many B properties are being value-added to appeal to a more A demographic, which worries some investors who believe the new supply of A properties will make value-added B product uncompetitive and thus unable to achieve underwritten rent premiums. However, the rent gap between A and B rents in better submarkets is such that most renters in the B/C pool will not be moving up to A apartments any time soon. We see the best mix of opportunity and downside protection in the C+/B- product.

Submarkets

We are bullish on the Northwest and West Houston areas for a few reasons. The northwest Houston area is proximate to downtown and many blue-collar job providers such as an Amazon distribution center. Also in this area, and near one of our recent acquisitions, Cranbrook Forest, is a new $250MM Coca-Cola distribution center that is scheduled to break ground in 2019. Coca-Cola previously had five different plants, warehouses, and distribution centers all around Houston and has decided to close those up and build one massive 1 million square-foot plant at Beltway 8 and Interstate 45 very close to our property Cranbrook Forest, as well as other assets we are targeting for acquisition. We see similar job/population growth heading north to south in the path of progress towards Greenspoint. West Houston, near the Energy Corridor, has many attractive suburban markets which are stable and positioned to perform well even in a downturn.

Here is a list of the top 20 submarkets in Houston, according to Transwestern’s 2018 report. Ignoring downtown and other class A areas and energy-driven submarkets, most of these submarkets are west. We particularly like submarkets in the Spring Branch school district.

We love the Houston multifamily market because we believe it offers an attractive opportunity set of acquisitions and is the only market in the recovery phase of the cycle according Integra Realty Resources. While all markets and investments are primarily influenced and affected by the economic cycle (fiscal/monetary policy), the real estate cycle (occupancy and rents) of each individual market offers unique opportunities. We believe assets purchased with solid business plans in Houston will do well operationally even in a national recession. According to Marcus & Millichap’s 2019 Multifamily Investment Forecast, Houston rent growth is expected to be up 3% in 2019 and Houston is expected to lead the nation in job creation for a second consecutive year (120,000 jobs created in 2018; 110,000 expected in 2019). For these reasons as well as those discussed throughout this paper, we believe Houston provides one of the most attractive large- scale multifamily investment opportunities in the United states.

References