Market Report_Q2 2023 Multifamily

Q2 23

STABLE Q2; DEVELOPMENT WAVE ON THE WAY

As of the close of Q2 2023, multifamily vacancy in the Sacramento market stood unchanged from last quarter’s recorded level of 5.8%. While this metric remained steady in Q2, vacancy has been trending upwards over the past two years.

In Q2 2021, vacancy fell to a record low of just 3.1%. But long before market availability grew that tight, a limited availability of space and a decade of underbuilding had already translated into extremely robust rental rate growth for the Sacramento market. By 2021, Sacramento was leading all US markets for rental rate growth in national surveys from data firms as diverse as Costar, Realtor.com and Yardi Matrix.

Attractive metrics, of course, unleashed a muchneeded wave of new development in the region. Since Q2 2021, approximately 6,800 new multifamily units have been built in the Sacramento region. Though net absorption has consistently remained in positive territory over the past two years, it has been surpassed by new deliveries in seven of the past eight quarters—sending vacancy levels creeping upward.

In Q2, the Sacramento market recorded positive net absorption of 639 units, while a total of 651

4.5%

Sacramento Multifamily Market Average Asking Rent Per Unit vs. Vacancy Q2 2023

Multifamily Market: Vacancy/Average Asking Rent Per Unit

new multifamily units were delivered. With demand (net absorption) and supply (new construction) keeping pace with one another, overall vacancy remained stable at 5.8%.

Sacramento’s average asking rent currently stands at $1,721 per unit (across all classes of multifamily). This metric stands exactly where it did a year ago. But while the region’s overall numbers appear to have been remarkably stable this past quarter, they mask some underlying shifts that are evident when breaking out market performance by class and submarket. Those shifts, incidentally, are likely to become far more pronounced over the final half of 2023, as a robust construction pipeline ramps up Over the first half of 2023, developers added a total of 829 new multifamily housing units to the local inventory. We are currently tracking another 4,961 multifamily units under construction across the region. The lion’s share of these, or 3,040 units, are scheduled to be delivered over the final half of this year (the remainder are slated for completion in 2024). If developers can keep to their timetables, this means that we will close 2023 with 4,012 new multifamily units—the most we have recorded in our survey since 2000.

Sacramento’s housing market (both single-family and multifamily) is far from overbuilt. According to the California Apartment Association, Sacramento needs at least 8,000 to 10,000 new units annually just to keep up with population growth. But the timing of these deliveries may prove to be challenging depending on how the economy shakes out over the final half of 2023.

So far, the economy has proven to be far more resilient than expected both to consumer spending and to a labor market that keeps outperforming. However, after two years of high inflation, consumer spending has been coming back to earth in recent months. Meanwhile, though a solid 209,000 jobs were created in June—this was the lowest level of employment growth the US has recorded since December 2020. The reality is there is a considerable lag time that occurs before the impact of interest rate hikes fully hits the economy. The Federal Reserve’s current campaign to tame inflation is not just the most aggressive we have seen in 40 years; it is also the fastest—with the effective funds rate having been raised a full five percentage points in one year. We have not felt the full impacts yet—which raises the risk that the Fed will overdo it (assuming they return to rate hikes again) or that they may already have. Either way, expect elevated vacancy and greater downward pressure on rents ahead, with new projects facing longer lease-up times amidst greater competition and weaker economic fundamentals.

CLASS A: THE EMERGENCE OF SACRAMENTO’S DOWNTOWN LUXURY MARKET

The greatest concentrations of Class A product in the Sacramento region are in the Roseville/Rocklin (3,481 units), Natomas/North Sacramento (3,263 units), Folsom (2,857 units), Downtown (2,602 units), Elk Grove submarkets (1,911 units), and El Dorado Hills (1,018 units) submarkets. Historically, Class A product has primarily been clustered in the region’s higher income suburban submarkets, but downtown has increasingly become the focus of new development over the past two years.

Class A vacancy currently stands at 9.1%. This is down from Q1 2023’s reading of 10.6% and reflects positive net absorption of 583 units in Q2. The trade areas posting the greatest occupancy gains in Q2 were Natomas/North Sacramento (+249), Downtown (+142) and Folsom (+111). Vacancy for Class A properties peaked at 11.4% in Q4 2022, following last year’s delivery of 966 Class A units.

The current average asking rent for Class A multifamily is $2,210 per unit (though in most new construction we are seeing those asking rates start above the $2,500 range). Over the past 12 months, this metric has fallen by -3.3% ($2,286 per month).

Q2 2023 is the fourth consecutive quarter in which the area’s Class A asking rents recorded flat or negative growth. However, this comes following the region’s unprecedented rental rate growth of the past decade. Until recently, Class A rents had recorded gains in every quarter since Q1 2011.

After the outsized growth of the last few years, further local rental rate growth is increasingly limited by affordability issues. Those have only been amplified by the inflationary environment of the past year. As much as Class A rents are already facing headwinds due to greater economic uncertainty, the pricing environment is about to become more challenging for landlords—at least in some key local submarkets where deliveries of new product are about to surge.

Through the first half of 2023, development levels for Class A product have remained constrained. There were two major new Class A projects delivered to the market in Q2, totaling 351 total units. In April 2023, USA Properties Funds delivered the 111-unit Sage at Folsom project in the Broadstone neighborhood of Folsom. This was followed in May with the Stamas Corporation’s completion of the 240-unit Arena Senior Apartments complex in the Natomas/North Sacramento submarket. While both new projects helped to contribute to Q2’s net absorption totals, we are increasingly seeing longer lease-up times for new Class A product. Most of Q2’s occupancy growth did not occur in brand new developments, but in projects that came online 12 to 24 months ago.

There are 1,595 units Class A units currently under construction in the region. Six projects, totaling 1,014 units, are slated for delivery over the final half of this year. Four of those projects are in Downtown Sacramento—the other two are in West Sacramento. These include Anthem Properties’ 153-unit midrise project Envoy at 1010 11th Street, The A.J., a 345-unit midrise complex at the heart of the new Railyards redevelopment, the 51-unit Luella Lofts at 1218 Q Street and Ary Place, a 159-unit midrise project at 1717 S Street. In West Sacramento, the 200-unit 805 Riverfront and the 106-unit Four40 West at 440 Sixth Street will be delivered in Q4.

Looking ahead, though the sheer amount of new Class A product coming online will drive overall vacancy levels higher, most submarkets will not be impacted. But rental rate growth will remain challenged across the board by economic uncertainty and the still looming potential of a

downturn. Those challenges will be particularly acute in the epicenter of current Class A development activity—Downtown. It is conceivable that this submarket’s current 21.0% vacancy rate could approach 40.0% with the addition of so much new space, particularly if economic conditions weaken and slow leasing activity over the final half of 2023. That said, while the new Downtown product will face near-term challenges in terms of competition and lease-up periods, the longterm transformative impact of this current wave of development will be an incredibly positive one for the city. For decades, Sacramento has sought to transform itself into a premier 18-hour city, but the missing component Downtown has been housing.

CLASS B: DELIVERIES RAMPING UP ACROSS MOST SUBMARKETS

Class B vacancy currently stands at 5.8%. This is down slightly from the 5.9% rate recorded in Q1, though since hitting a record low of 2.9% in Q2 2021, the general trend has been one of rising vacancy. The market absorbed 312 units in Q2, with the Folsom (115), Natomas/ North Sacramento (74), South Sacramento (60) and Elk Grove (50) submarkets leading all other trade areas in terms of positive net absorption. The Carmichael/Citrus Heights (-36) and Arden Arcade (-23) submarkets recorded modest negative net absorption in Q2.

Only two new projects, totaling 300 units, were delivered in Q2; in April, Artemis Real Estate Partners delivered The Celeste—a 225-unit project at 3820 Chiles Road in Davis. That same month, St. Anton

completed the 75-unit Bidwell Place project in Folsom. Through the first half of 2023 a total of four new projects featuring 478 new multifamily units have been delivered in the Sacramento region. However, deliveries are about to ramp up substantially for Class B product throughout the region.

There are currently 20 projects under construction throughout the region that, upon completion, will add an additional 3,366 units to the local inventory. This is the most robust Class B development pipeline that we have tracked since Q1 2000 when there were 3,641 units under construction.

There are twelve projects (totaling 1,801 new apartment units) slated for delivery over the final half of 2023, with the remainder of projects currently under construction scheduled for completion in 2024. Assuming that the projects currently underway are not delayed, Sacramento will close this year having added 2,279 Class B units.

Among the projects that will come online over the final half of the year are the 281-unit Track 281 project in the River District of Downtown, the 270-unit Zeta Luxury Apartments at 3701 E. Commerce Way in the Natomas/North Sacramento submarket and the 266-unit Solasta Luxury Apartments in the Pocket neighborhood of South Sacramento. Seven of the region’s 12 multifamily trade areas currently have new projects under construction.

The current average asking rent for Class B product in the Sacramento region is $1,824 per unit—the same rate recorded exactly one year ago. As is the case with Class A product, Class B rents will be facing the dual headwinds of economic uncertainty and an influx of new competitive product.

CLASS C: INFLATION IMPACTING RENTERS ON THE EDGE

Class C multifamily vacancy stood at 5.0% as of the close of Q2—an increase from the 4.7% reading of three months ago. One year ago, local vacancy stood at just 3.0%, but this metric has been climbing now for four consecutive quarters.

Sacramento recorded negative net absorption to the tune of -257 units in Q2. Year-to-date net absorption now stands at -708 units. While some of this occupancy loss may be attributable to tenants trading up, given the inflationary pressures of the past year we think it more likely that the local trend of negative net absorption for Class C space is due to some tenants on the fringes being priced out or doubling up (taking on roommates, moving in with family, etc.).

Despite modest occupancy declines, there are no local submarkets where Class C vacancy is more than 6.2% (Carmichael/Citrus Heights). While Class A rents have declined 3.3% over the past year,

and Class B rates have remained stable, the current average asking rent of $1,484 for Class C units is up modestly (1.5%) from where it stood a year ago.

INVESTMENT ACTIVITY REMAINS IN LIMBO

The impact of the Federal Reserve’s sharp interest rate hikes over the past year has had a profound impact on the local multifamily investment market. In the face of both greater pricing and lending pressures, deal activity has simply paused. No major multifamily transactions (projects of at least 25 units) closed in Q2 and we are aware of only one deal that occurred in Q1. This trend is playing out nationally—according to Yardi only $23 billion in multifamily investment sales had been completed through mid-June, a drop of 70% from where deal volume was one year ago.

The increase in capital costs, as well as heightened economic uncertainty have made it extremely difficult to complete any commercial real estate investment transactions. One of the greatest challenges has been the rapid and steep decline in property values stemming from the increase in interest rates and slowing rent growth. The 4.0% to 5.0% cap rates for quality multifamily product that were common just 15 months ago simply no longer make sense now that mortgage rates have climbed from the 3.0% - 5.0% range to the 6.0% to 10.0% range. Sellers still largely want yesterday’s pricing and buyers are holding out for discounts. As a result, there has been little movement in the gap between bid and ask. We continue to see disparities here of anywhere from 5% to 25%. Because of this, unless sellers have a compelling or urgent reason to sell, most are playing the waiting game.

Current market fundamentals do not help the situation. The run up in lease rates of the last few years 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 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.

Sacramento Multifamily Market Average Sale Price Per Unit Vs. Average Cap Rate Q2 2023

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

That is not to say we will not 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—greater economic clarity emerging over the final half of 2023 could change this landscape quickly. But for now, we expect activity to remain challenged.

DEFINITIONS

We are proud to announce that we have revamped and expanded our tracking of the Sacramento region’s multifamily market to include detailed statistics by class, as well as by submarket. Our quarterly market survey includes competitive multifamily complexes of at least 25 units or more throughout the Sacramento region. Our survey does not include residential condominiums or co-ops. All told, our survey includes 1,296 apartment communities accounting for 152,672 housing units.

Class A product accounts for a total of 90 local projects and 17,745 housing units, or 11.6% of the market’s total inventory. Class A properties are typically less than 10 years old and are upscale, luxury apartments. They are in the most desirable geographic areas with top-of-the-market rents. Their tenant base tends to be white collar workers that choose to rent by choice.

Sacramento’s Class B multifamily market consists of 410 apartment communities accounting for 62,288 multifamily units, or 40.8% of the region’s total inventory. Class B properties are defined as typically being 10 to 25 years old and well-maintained. They tend to have a middle-class tenant base, consisting of both white and blue-collar workers. Some are renters by choice, most are by necessity.

There are 796 projects accounting for 72,639 housing units that we classify as Class C properties, or 47.8% of the region’s total inventory. Class C construction is typically 25 to 40 years old. The tenant base for Class C properties is typically low-to-moderate income. Most tenants are renters “for life,” though Class C tenancy also often includes young people just starting out in their careers.

Pat Ronan Vice President pat@gallellire.com

Adam Rainey Associate Vice President arainey@gallellire.com

Kannon Kuhn Associate kkuhn@gallellire.com

Brandon Sessions Senior Vice President bsessions@gallellire.com

Robb Osborne Partner rosborne@gallellire.com