The Big Affordability Question
It seems that each week brings a new article lamenting the prohibitive cost of housing in some U.S. city. This is hardly news for tenants in certain markets (e.g. New York and San Francisco) where prohibitive housing costs are a well-worn phenomenon. What’s more surprising is that the notion has gained traction in historically “affordable” markets like Denver, Salt Lake, and Wichita. Of course everyone wants cheaper houses and lower rent. But is there a reason the issue has recently gained broader attention? And are people even thinking about affordability in the right way?
In real estate terms, affordability is the ratio of rent to income. In this brief article we’ll discuss why the metric matters, how the affordability dynamic is playing out across the U.S. today, and how we try to apply the concept more intelligently in our investment process.
Why affordability matters
Investors tend to view affordability as a rough predictor of their ability to sustain or increase rents. We too believe affordability is an important metric. In fact, we think it’s one of the most important metrics when considering an apartment or other residential investment. In a previous blog post we described how we identify the factors that drive multifamily rent growth. Dynamics around affordability, at least based on our work, have historically been among the strongest predictors of relative rent growth.
Regardless of whether affordability is the single most important factor or simply one of several, it’s surprising that investors take such an inconsistent — even lazy — approach to such a widely cited metric. Getting affordability right (or wrong) can directly inform the likelihood that your rents have room to increase, or whether your operating income is at risk of being capped at current levels.
How is affordability calculated?
This seemingly basic number can be surprisingly difficult to pinpoint. The problem starts with the fact that there is no uniform definition of “affordability”. It is most commonly described as the ratio of gross rents to median household income. In our experience, the typical threshold for what’s considered healthy, or “affordable”, is a 30% rent-to-income ratio, meaning 30% or less of pre-tax income going to rent.
But as soon as you start to apply this concept to an actual investment opportunity, a number of questions arise. Where can I find reliable income data? And do I care about the entire local population, or just my tenants? Should I include rents across all my units, or just my 1-bedrooms? If I renovate units to a higher quality level, will I attract a different tenant base with different incomes?
Facing this added complexity, most investors default to oversimplifying. The U.S. Census provides median incomes down to the zip code level. Simply take property rents and divide by that median income number to get an affordability measure. But for multifamily investors, is this even a remotely useful output? Let’s use Boston as a high-level example: Overall incomes imply an affordability ratio of 20%. But that conclusion changes materially when we add just one critical distinction by separating owner and renter households. Thankfully, Census data makes this possible without much difficulty, and, as the graphs below illustrate, median incomes can vary widely between owners and renters. In fact, on average, owner household incomes are twice the level of those of renter households. When you compare owner and renter incomes in Boston, median owner incomes are $108k, 125% higher than median renter incomes of $48k. By keying in on the renter base specifically, Boston’s affordability ratio jumps from 20% to 29%, a full 45% worse than the initial high-level estimate.
Owner / Renter Median Household Income
Select MSA’s: Difference Between Owner and Renter Median Household Incomes ($ Amt)
What’s the reality for renters today?
It turns out that the press has picked up on a real phenomenon: rent growth across the U.S. has outpaced incomes since the financial crisis. So on average, people’s monthly rent check today feels more painful than is has historically. But that feeling is relative. In reality, much of the U.S. still falls comfortably below what we would consider healthy affordability levels (i.e. 30% rent to income). So yes, New Yorkers still have plenty of reason to complain. Renters in Wichita, however, may just need to adjust to the fact that they don’t have it quite as good as they used to.
U.S. Cumulative Rent vs. Income Growth
Importantly for investors, we do not see a widespread rent “bubble” where rents today are unsustainable relative to incomes (as was the case with U.S. home prices pre-financial crisis). Rather, we just see a shrinking list of markets that are likely to experience outsized rent growth going forward.
What’s my takeaway as an investor?
Takeaway #1: Affordability is a critical metric for understanding potential rent growth. Unfortunately, most real estate investors tend to oversimplify their affordability analysis or apply inconsistent data to support whatever opportunity is at hand.
Takeaway #2: Static metrics are helpful but totally insufficient. With respect to affordability, we believe that the evolution in affordability over time (especially going forward) is even more important than a snapshot of affordability today. Sure, New York is “unaffordable”, but is it less affordable than it used to be? And is it likely to get even more or less so in the future? If more affordable, is that due to rising incomes or falling rents? There are plenty of reasons New York should have persistently lower affordability than most other markets. What matters more is how that dynamic has evolved over time.
Applying what we know
Combining these takeaways, our basic strategy is as follows: Identify locations where 1) affordability today is relatively healthy for the actual renter base we’re serving, and 2) where affordability is likely to improve (or at least remain healthy) due to rising incomes. The below maps visualize these elements at a high level.
Our investment in Dallas is an example of this strategy at work. When we acquired the property, average affordability amongst our renter base was 24%. Incomes in that market had been rising faster than the national average, and both external forecasters and our internal assessment led us to conclude that trend would likely continue going forward. This alone doesn’t make for a successful outcome, but we do believe it’s an important tailwind when comparing that deal to similarly priced opportunities in other markets.
Median Rent as a % of Renter Household Income
On a national level, some interesting themes emerge. For example, areas like Seattle may actually become more affordable given the high expected pace of future wage growth. This possibility supports continued rent growth even in one of the country’s more expensive markets. For certain other metro areas, such as Atlanta and Houston, rising incomes are expected to support at least inflationary rent growth.
However, many cities may continue to see the proportion of rent to income increase, due mainly to weak income growth. The question for these cities is to what extent affordability can continue to deteriorate before rents flatten or even reverse. This consideration alone doesn’t negate the potential for good real estate investments in those markets, but investors should be making those investments fully aware of the potential affordability headwind. All else equal, our strong preference at Cadre is to pursue opportunities in markets where we can identify healthy affordability at the asset level, and project an income-driven tailwind in the years to come.