Solving for Housing Supply Shortages Through Value-Add InvestingSolvingforHousingSupplyShortagesThroughValue-AddInvesting

The lower volatility in vacancy is mirrored in affordable housing rent growth. Over most time periods, affordable housing rent growth matches or lags only slightly behind market-rate. Rent growth lags market-rate during boom periods, such as the post-GFC period and, notably, the post-2020 frenzy. That underperformance is partially offset by steady growth during weaker market-rate performance, such as the subdued growth in the economically lackluster mid-2010s, and more recently in the brief demand collapse in 2020. We now expect affordable housing rents to continue to grow over the next two years, even as the temporary increase in multifamily supply constrains or potentially depresses market rent growth.

The combination of stable rent growth and low vacancies has drawn increased institutional investment into regulated affordable housing. According to Real Capital Analytics, transactions volumes have grown over the past decade to a peak of just under $55 billion in 2022, before the recent slowdown in all real estate transactions activity. 

Despite that increased investment, cap rates for subsidized sales have tracked closely with broader multifamily markets. In most periods, there is a premium to compensate investors for the lack of upside during strong market rent growth periods. However, the series occasionally converge during periods when market rent growth decelerates, such the late 2000s, the mid-2010s, and today.

Investing in regulated affordable housing is not without risk. The sector limits the risk of falling property incomes, since rents are usually set well below market rates – even during periods when market rents fall, regulated affordable rent growth usually remains positive.² The risk in the sector is that legally allowed rent increases are insufficient to offset rising operating and capital expenses. This risk can be mitigated, but not entirely abated, by consistently raising rents by the maximum allowed.

Building Market-Rate Rental Housing

What does market-rate housing, sometimes including non-essential amenities like modern fitness studios and saltwater swimming pools, have to do with affordable housing? While counter-intuitive, construction of luxury multifamily units makes existing rental units more affordable than they would have been without new supply additions. This second-order effect means that building new market-rate housing can improve housing affordability alongside providing regulated-affordable housing.

The need for new housing increases in metropolitan areas that have a growing number of households, rising household incomes, and supply constraints that raise the cost and limit the density of new housing. What is less obvious is that housing can become unaffordable even in places that don’t have all three of these things happening at the same time. 

The most important housing demand driver is, by definition, household growth. This is closely related to population growth, which is in part due to a combination of domestic and international migration. Over the past two decades, domestic migration flows have generally been from the Northeast, Midwest and California towards the Sunbelt. Developers in those Sunbelt markets have historically been able to accommodate that growth, and therefore rent growth has been only slightly higher than slower-growing Non-Sunbelt markets since 2010, as shown in the chart below. However, the COVID-era surge in Sunbelt migration was too much and too fast to add enough new housing, causing rents to soar at an average rate of over 20% per year at the beginning of 2022.

A pause in net migration to these Sunbelt markets combined with a supply surge has caused rents to decline slightly since late-2023. Nevertheless, relief for renters will be temporary, assuming migration returns to its historically normal pace. Construction has largely shut down, setting the stage for a further tightening in rental housing markets in 2025 and beyond. New market-rate housing will be needed for those who will continue to move to these high population growth Sunbelt markets.

Meanwhile, despite weak population growth and migration flows, many Northeast and California markets have highly unaffordable housing markets. This is where income growth – and income distribution – factors in. Over at least the past 50 years, household expenses have accounted for an increasing share of personal consumption expenses. Put differently, as household incomes rise, demand for housing increases even faster.

Areas such as the Northeast and California also have a disproportionate share of the highest-earning households in the country. This further contributes to affordability challenges. Areas with the highest level of inequality, as measured by a Gini coefficient, are typically less affordable for average renters. This is because higher-earning households consume a disproportionate share of housing, not only because they prefer larger units, but also because they are more likely to have smaller households (i.e., fewer roommates). 

Finally, and perhaps most importantly, physical and regulatory³ supply constraints that limit the supply of housing will cause affordability to deteriorate as long as housing demand is growing. Supply constraints are typically highest in areas that historically have high income growth. This supply inelasticity means that in metropolitan areas such as San Francisco and New York, even small increases in household formations can push housing costs up. 

Those supply constraints limit competition for new housing that does get built. While demand shocks can cause housing rents to decline during recessions in places like San Francisco, those downturns are likely to be short-lived given the limited pace of building even during economic boom periods. In short, places where it is hardest to develop new housing also offer high returns to those who can build it.