Market Report_Q1 2023 MultiFamily

Apartment vacancy in the Sacramento market posted their seventh consecutive quarterly increase during the first three months of 2023, reaching 6.2% as of the end of Q1. The region had hit a low-water mark for vacancy levels in Q2 2021 when local vacancy hit its lowest point on record of just 3.1%.

From 2000 through 2007, the market added 22,700 new competitive apartment units, or an average of 2,838 annually (709 per quarter). When the Great Financial Crisis (GFC) hit in 2008, new development in the region dropped precipitously. From 2008 through 2011, the Sacramento region saw a total of 2,577 total new units added, or an average of just 644 annually (161 per quarter). But as economic recovery picked up steam, local apartment development did not. In fact, it would fall further.

From 2012 through 2017 just 3,625 new units came online, or an average of just 604 apartments annually (151 quarterly). At that time, much of the region’s foreclosed single-family home (SFR) inventory had been pivoted towards the rental market as banks and investors sought to buy time for the SFR market values to recover and eventually sell off this inventory. These strategies ultimately proved successful—the lion’s share of them eventually moved from the rental market back to home ownership opportunities for buyers during this period. The velocity at which this process occurred surprised most market watchers, but it is important to note that the region had also had virtually no SFR development in the years following the GFC. This lack of development across the spectrum, that by now had been occurring

for most of the previous decade, was about to translate into a regional housing shortage. Multifamily vacancy rates suddenly were falling again but even as developers sprung back into action, Sacramento’s apartment market was playing catch-up. The result was that by midyear 2021, vacancy levels were at an all-time low and rent growth in the region for three consecutive years placed the Sacramento region on top ten lists for all major US markets.

Sacramento Multifamily Market Average Asking Rent Per Unit vs. Vacancy

Sacramento Multifamily Market: Vacancy/Average Asking Rent Per Unit

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Since 2018, development levels have picked up considerably. Over the past 25 quarters (including Q1 2023), the region has since added 10,777 new multifamily units, with the pace of new development accelerating over the past two years. While this four-year period may be notable for driving some of the region’s strongest historical rent growth and lowest vacancies on record, the impact of recent development trends is starting to show. Overall vacancy levels have climbed from 4.0% to 6.2% over the past 12 months.

Current levels of new development were already likely to create headwinds for further rental rate growth, but the inflationary trend of the past 18 months has intensified downward pressure on rents for a substantial portion of the market.

A quick review of the statistics does not readily demonstrate this. Overall rental rates in the Sacramento market have increased 0.2% over the past 12 months. Clearly this reflects a sharp decline from the 8.8% growth rate one year earlier (2021) and the 8.0% increase the year before that (2020). But while this overall average remains in marginally positive territory, it masks the growing disparity in pricing between new construction and the market’s existing apartment stock. Since 2020 the market has added 7,706 new units, or roughly 5.0% of the current multifamily inventory. The average asking rent for these properties stands at $2,488 per month. This compares to the market-wide average of $1,691 per month. Until last year, rental rate growth was occurring across most apartment classes and submarkets. Now, the only reason this metric hasn’t turned negative is it is being propped up by newly delivered product while older properties are facing greater competitive pressures. This is, of course, without adjusting these totals for inflation. This said, though there are some clear patterns in the marketplace playing out universally, not every submarket has fared the same.

Submarket health check

Let us start by exploring the region’s three most expensive submarkets; Davis/Woodland, Roseville/Rocklin and Downtown.

In terms of rent growth over the past year, the Davis/Woodland market remains on firm territory, despite the fact that it already ranks among the most expensive of local submarkets in the region. The average asking rent here is currently $2,173 per month, up 7.3% from last year’s average rent of $2,025. There are two reasons for this market’s continued outsized performance. First, it is one of our smallest trade areas with just 88 projects totaling 7,773

housing units. But it also has one of the most dependable demand pipelines in the region due to the presence of UC Davis and its 32,000 students. While enrollment and on-campus attendance took hits during the pandemic, these have now returned to pre-pandemic norms. Approximately 15,000 UC Davis students live in on-campus housing, but the remainder live off campus, with a sizable contingent that opts for local market-rate multifamily housing. This also happens to be a trade area where development tends to be challenging; the market itself is land-constrained and the community itself has often proven to be outspoken against growth. The net result has been a lack of housing, higher pricing and a submarket where existing landlords have a strong upper hand in negotiations. Not surprisingly, Davis/Woodland has the region’s lowest submarket vacancy rate at just 1.6%. We suspect rental rate growth here will slow in the coming year, but it is likely to remain positive.

The next most expensive apartment market in the region is Roseville/Rocklin. We track 98 competitive complexes in this submarket that account for 15,272 apartment units. Vacancy here has crept up slightly over the past year from 4.6% to 5.1% and it is likely to creep higher in the next few months with 375 units currently in the development pipeline. The current average asking rent per unit is now at $2,024 compared to $2,106 one year ago, reflecting a decline of -3.9%. It is critical to note this same metric a year ago stood at 9.8% and at 12.9% two years ago making this the highest rental rate growth trade area in the region for 2021 and

Source:GallelliRealEstate;CostarGroup

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2022. But here is where we are seeing the impact of inflation starting to price out tenants and set the ceiling for rents in the area. What remains to be seen is whether the actions of the Federal Reserve to tame inflation (the numbers have been consistently falling) can do so, without plunging us into a downturn. Regardless, we anticipate rental growth in this trade area to be negative to flat through the remainder of the year.

The region’s emerging Downtown market is facing a similar situation; here 103 competitive projects account for 9,468 total apartment units. The past ten years have seen development here pick up substantially, though the pandemic temporarily derailed the city’s continued efforts to convert Downtown Sacramento into an 18-hour city. Ten years ago there were 6,139 apartment units Downtown (please note, we only track competitive apartment projects with 25 units or above so these numbers do not include fourplexes, section 8, etc.). The stock of quality Downtown apartment housing units has grown by 54.2% in a decade. Additionally, there are another 1,707 units currently being developed, with delivery times slated through late next year. No other trade area comes close to these development levels. We anticipate this will ultimately lead to a much stronger Downtown retail and office market as well as the further flourishing of Sacramento’s arts, culture and dining scene. But in the near-term, vacancy levels will be going up, perhaps substantially. Current vacancy is already 13.5%, we anticipate it to cross the 16.0% threshold later this year and for an already competitive leasing marketplace to become even more so. Rental rate growth Downtown has only turned negative recently; as of Q1 2023 the average asking rent of $1,820 per unit was down -0.8% from the $1,835 rate of a year ago. It is likely that this metric will fall further as more supply comes online at a time where there are macroeconomic headwinds despite the fact that activity in the Downtown core has the greatest potential to be transformative to the city as a whole.

Out of our three most expensive apartment submarkets, all are experiencing upticks in vacancy likely due to renters being priced out combined with new construction. Two are already reflecting negative rent growth, while the other—which is uniquely buffered from market forces due to the presence of UC Davis and continued under-development—is still posting gains.

On the flip side of that equation, let’s explore the region’s four most affordable submarkets; Arden Arcade, South Sacramento, West Sacramento and Carmichael/Citrus Heights.

Sacramento Multifamily Market Average Asking Rent Per Unit Vs. Annual Rental Rate Growth

While the Arden Arcade submarket currently has the lowest average asking rent in the region at $1,412 per unit, it actually reported the second highest rental rate growth in the region (behind Davis/Woodland) at 2.8% over the past year. While still positive, this compares to asking rent growth of 9.4% the year prior. In contrast to Davis/Woodland, this is one of the region’s larger trade areas with 194 complexes totaling 16,813 units. While we anticipate rental rate will continue to slow here, we also see the potential for stronger demand from tenants that may have already been challenged by the region’s price increases of the past few years, with the cumulative impact of inflationary pressures.

In South Sacramento, the current average asking rent per unit is $1,496 per unit, up 3.0% annually. Like virtually all other local submarket this is a considerable slowing from the 9.9% (2022) and 5.9% (2021) of the past two years but it places it within the six of 12 local trade areas that are still recording growth, nearly all of which are lower priced markets where the average asking rent has not crossed the $1,600 per unit threshold. There are 945 units under development here, slated for deliveries through the middle of 2024. Current vacancy stands at 6.2% and will almost certainly climb into the low 7.0% range by early 2024, which is likely going to flatten rent growth here in the near future.

Meanwhile, West Sacramento currently has a 3.8% vacancy rate and its average asking rent per unit now stands at $1,543, compared to $1,521 a year ago. While this still reflects a modest 1.5% gain, this compares to 10.9% (2022) and 6.0% (2021) in previous years. Given its proximity to the urban core and local city government support for new development, the apartment development pipeline in West Sacramento is among the strongest in the region; there are currently five major new projects

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underway that will add an additional 703 apartment homes to this submarket over the next 18 months. As elsewhere, we will see vacancy rates tick up here though West Sacramento today is still a tight leasing market. We think it is likely this submarket hits 5.0% vacancy by year end as new projects come online and rent growth trends flatten.

Near-term outlook

After multiple years of underbuilding, record low vacancies and outsized rental rate growth, the Sacramento region’s multifamily market is in the midst of a rebalancing period. The return of development to the region alone would have likely slowed rent growth in most markets simply because they would have eased the incredibly tight vacancy levels the region had been experiencing. However, it is doubtful that this alone would have flattened or reversed rent growth. That said, two consecutive years in which growth was at or nearing double digits is typically not a growth rate that is sustainable unless incomes are also rising.

They have been, but not at the pace of overall inflation over the past 18 months, hence, we are seeing a ceiling in rents increasingly emerge for now. This is why rents have shown the weakest growth (Davis/ Woodland excepted) in what have been the region’s most desirable and expensive submarkets. It is also why we have continued to see growth, albeit sharply slowing, in the region’s most affordable housing markets.

These metrics will create headwinds through the remainder of 2023 even in a best case scenario (I.E. the Fed succeeds in driving inflation towards the 4.0% they have stated as their goal for the year, without driving the entire economy into a recession by having raised interest rates too aggressively). Clearly, this has had a major impact on commercial real estate investment activity.

But those are still separate issues than the bigger picture longterm multifamily leasing fundamentals that are in play. The current population of the greater region is estimated at 2,215,000 people, up 1.3% from last year. In 2022 the growth rate was 1.4% and it stood at 1.5% in 2021. For most of the previous decade it stood between 0.6% and 0.9%. The Sacramento region has acted as a housing pressure valve for its pricier neighbors by the Bay for the better part of the last 40 years. This in-migration has come in multiple significant waves; in the early 1990s as the initial tech boom ramped up, in the early 2000s as the second tech boom arrived and, most recently, with the pandemic and its aftermath. This latest wave is now moderating, though Sacramento’s standing as the most affordable large city in California will continue to be a magnet for in-migration.

Meanwhile, interest rates on the typical 30-year home loan have effectively doubled from where they stood a year ago, resulting in a sharp slowdown in the SFR market and price resets that are playing out nationally. According to RedFin, the median home price in the United States stood at $400,706 in March 2023, down 3.3% annually.

In California, this has translated to a 7.8% drop as the statewide average median price has fallen to $743,200. Their data suggests an even sharper pullback in Sacramento; a current median sale price of $455,000, down 12% annually. This metric stood at $380,000 in March 2020 and peaked at $525,000 in April 2022. During this peak pricing runup period, Sacramento’s SFR market recorded record-setting (and unsustainable) pricing growth of 37.7% in just 25 months. Even with the current ongoing reset, the region’s SFR market values are still up from pre-pandemic levels by 16.5%.

Here is the key; if as the Federal Reserve has telegraphed most recently that there may only be one more interest rate hike this year, and providing the proverbial soft-landing of the economy, we may be nearing the end of this reset. Conversely, if the greater economy does fall into recession, the question will be if the Fed reverses course and slashes rates will that be enough to bolster housing even in a negative economic growth scenario. Either way, the likelihood of any sort of housing reset akin to the GFC is virtually zero, barring some immense black swan event, because so much of that was driven by toxic loan product that had infected every level of the mortgage markets. The outsized gains of the immediate post-pandemic years mean that most home owners still have more equity even in the midst of today’s faltering prices than they did before. There is very little exposure to adjustable rate mortgages—unlike in 2008, which means that recent buyers that find themselves upside down likely won’t face deep challenges unless they have to sell or move. SFR values are resetting downward, but they are not likely to crash.

Meanwhile, a return to near zero interest rates is also highly unlikely. SFR pricing resets may help some renters on the cusp make the jump to first-time home ownership, but do not expect much movement there. For the most part, the ability to move from being a renter to homeowner in the near and immediate term is going to be significantly strained. Most renters are going to remain renters. In the long run this still points towards continued strength for multifamily product, even if there are currently headwinds. That these are occurring at a time of elevated development levels simply means that we are in for a year or two of elevated vacancy levels and continued downward pressure on rents, starting at the top.

Sacramento Multifamily Market Average Sale Price Per Unit Vs. Average Cap Rate

Sacramento Multifamily Market: Average Sales Price Per Unit Average Cap Rate

Investment

Given the sharp rise in interest rates which has created both pricing and lending pressures, sales activity for multifamily has plummeted. Would-be buyers are holding off in hopes of price erosion, would-be sellers aren’t bringing product to market unless they have to. Meanwhile, the gap between bids and asking prices remains substantial. Anecdotally we have seen and heard of disparities anywhere from 5% to 25%.

Current market fundamentals do not help the situation. The recent run up in lease rates means it is harder to find apartment product with rental rate growth potential. This is certainly true at the top of the scale, though there may be some value-add opportunities hidden away within the Class B and Class C marketplace. But even that may be a challenge given recent multifamily investment pricing and the existing gap between buyers and sellers. Until multifamily prices reset, it is going to be a challenge for buyers to find properties where they can unlock hidden value to boost returns on investment. That is not to say we won’t continue to see activity from long-term players looking to park their money and willing to hold the properties they buy until market fundamentals return to supporting rent growth. This may not be as far away as many fear—greater economic clarity over the course of 2023 could change this landscape quickly. But for now, we expect activity to remain challenged.

MULTIFAMILY MARKET STATISTICS: Criteria based on: 25+ Existing, Proposed, Under Construction, Final Planning Units, Market Rate & Market/Affordable

Gallelli Real Estate is a private firm that specializes in commercial real estate services and property management. We believe that as a boutique firm whose understanding of the business runs as deep as our core values, our advantage is large. We take pride in our unique approach to offer more individual solutions that address the ever changing needs of our clients and the industry. After all, our success is measured by the success of our clients and the strength and longevity of our relationships.

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