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When is a B better than an A?
When it comes to investments in housing, the highest quality asset doesn’t necessarily correlate to the highest return on investment. Class B apartments are a step below Class A in terms of amenities, location, building quality and renter incomes. But the Class B apartment subsector has outperformed Class A for the last decade. With its undersupply and resilient renter demand, we believe this subsector is poised for continued outperformance.
Class B rent remains in line with tenant income
The incomes of Class B apartment renters grew a cumulative 24% between March 2020 and December 2022, mainly due to the healthy job market. The increase was relatively in line with the 25% cumulative increase in Class B apartment rents over the same time period, keeping this cohort’s rent-to-income ratio unchanged despite record rent growth.
Meanwhile, due to above-average home price appreciation and rising interest rates, the mortgage payment for a midlevel home purchase increased 98% over the same time period, diverging from rent and income growth in the fall of 2021.
Potential buyers are now facing the most significantly skewed rent-vs-buy calculation in years, in favor of renting. This dynamic should further support demand for rental housing over the next few years, particularly for Class B apartments, which are more likely to be rented by necessity rather than choice.
Class B performance outshines Class A
New supply has largely been concentrated in the Class A market segment, an issue that is somewhat structural due to limited land availability and elevated construction costs. In this environment, constructing units that fetch higher rents can sometimes be the only way a developer can turn a profit. In past cycles, apartments have generally been a good inflation hedge, as the short-term nature of apartment leases provides the opportunity to pass along increased expenses in the form of rent increases. However, this is only the case where market conditions are favorable to rent growth. Across many of the largest U.S. apartment markets in 2022, the Class B segment largely maintained higher occupancies than the Class A segment.
The Class B segment has outperformed Class A on a total return basis throughout the last decade, according to our analysis of NCREIF data. Although the data cannot be queried by Class A versus Class B, using +/- 10 years of age provides a reasonable proxy for quality. Notably, we also found similar outperformance of garden-style apartments (often Class B) over high rise apartments (often class A).
Class B investment opportunities are compelling
While markets show some moderation of demand and rent growth, both are elevated relative to history and are simply down from record peaks. Elevated construction within the sector is likely to weigh a bit on fundamentals in the short term, although our base case remains for above-average rent growth over the next few years. We believe that rent growth and occupancy rates within the Class B subsector will be particularly resilient. Given the subsector’s healthy fundamentals and resilient demand, we believe there are compelling investment opportunities in Class B apartments.
In this issue
The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature.
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