With each new real estate cycle, the information considered in underwriting real estate continues to evolve. No two cycles are alike, and with today’s more volatile inflation expectations and slower projected growth, we are looking at opportunities from a new perspective.

In this installment of ARA In Conversation, Eric Cannon and Britteni Lupe discuss how drilling down on details such as rent growth and tenant improvement expectations, combined with careful due diligence can lead to better investment decisions.

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Eric Cannon: Hello, and welcome to another segment of ARA In Conversation. I'm Eric Cannon, Deputy Portfolio Manager of ARA’s value-added strategy, and I'm very pleased to be joined here today in Los Angeles by Britteni Lupe from our Research and Strategy group. Britteni, thank you for joining me.

Britteni Lupe: Thank you for having me.

EC: It's fair to say it's been an interesting few years from an operating fundamental standpoint in the marketplace.

We've seen very strong rent growth in the apartment and industrial sectors – much higher than historical levels. I think investors are wondering: what is our outlook for rent growth moving forward?

BL: Well, Eric, there's no denying that the rent growth trajectory of the past four years has been quite unique, to say the least. But as they say, hindsight is 2020, and looking back, it's clear that those huge rent growth pops we saw in 2021 and 2022 were a product of pent-up demand and market disruptions caused by the pandemic lockdowns. But at ARA, we knew that those double-digit rent growth numbers that we were seeing were unsustainable in the long term. We knew that the market would have to normalize, and it was going to be due to one of two things, either one: tenants simply were not going to be able to continue to afford those higher and higher rent levels in perpetuity, or two: developers would see the hot demand, and they would respond by bringing new supply online, and that would temper that imbalance.

So while those double digit rent growth numbers might have been defensible in the past, they no longer are today. Today we're seeing that rent growth has slowed, or even moderately contracted in some markets. This leads us to the question that you just asked me, which is what is a defensible rent growth assumption?

And this is really an important question because it impacts what the next buyer's willing to pay for their building. If we're looking at the multifamily sector, we believe that the majority of markets will be in positive rent growth territory this year. But that band, that range of performance, it is going to vary quite a bit and be wider this year relative to others, simply because there are markets that are still working through that surplus of supply.

Rent growth is just one assumption in an entire underwriting model. There are so many other things that you have to consider. Eric, can you talk to me about the levels of concessions or tenant improvement packages we're seeing today relative to, let's say, three years ago?

EC: Well, as you alluded to, Britteni, we're seeing wide dispersion across markets, specifically in the residential sector.

In the more heavily supplied Sunbelt markets where we saw all that strong rental demand and there was a natural supply response to all that post pandemic-demand – think of Nashville, Phoenix, Austin – those markets are challenged right now. There's no doubt in certain cases, you're competing with three or four lease ups in renting out your apartment units, and so those markets have heavy concessions. In some cases, those concessions could be two months of free rent or more on a 12-month lease. Now, the good news is that we have seen construction starts plummet, and we do believe that supply will be absorbed and looking forward, as we look out a couple years, our expectation is for a rebound in rent growth.

If you look at the historical gateway markets or the non-Sunbelt markets, I think the Northeast, the Midwest, the West Coast markets, we're seeing much more stability and fundamentals in those markets. There obviously was not as much supply to meet that demand, but we're seeing strong occupancies and less concessions in those markets.

On the commercial side, office, industrial, and retail, there's no doubt that inflation has impacted the cost of commercial real estate tenant improvement buildouts. So we're seeing those costs remain elevated. Those pressures are subsiding a little bit, but we don't have the expectation of a material decline in costs moving forward. And it's interesting, the office sector in particular, you have this increased cost of leasing and building out space combined with a desire on the tenant part, the end customer, of shorter lease duration. So that sector we think is going to remain challenged from that standpoint.

BL: So I'm saying that we can't expect another big jump in rent growth in the near term, and you're saying that we have to be a bit more conservative in our underwriting assumptions going forward.

With all of this seemingly stacked against us, investors might be wondering: how are they penciling deals and placing capital? Can you let them know?

EC: It all comes down to being patient and disciplined. To use a baseball analogy, waiting for our pitch. We are very focused on creating new investments moving forward where we can generate high unlevered yields. And the reason is, we want to be less reliant on accommodative exit cap rates. We're using our direct sourcing channels, our relationships that we've developed in the marketplace over more than three decades to source interesting, often off-market opportunities where we can bring a particular skill to bear through active hands-on asset management to really drive income growth and operational efficiencies from an expense standpoint.

BL: You know, that's a really good thing to keep in mind this cycle. But Eric, it leads me to a thought, based on the trends we're seeing, do you think that there are going to be further changes in underwriting assumptions going forward? And if so, where?

EC: I think there's often an ebb and flow between greed and fear in terms of underwriting assumptions in the marketplace depending upon overall capital market conditions, the state of the overall economy, or local demand-supply characteristics of the particular asset class in the particular market. That being said, we've clearly shifted from late 2023, where in the first half of 2024, investors were looking at the forward curve and were really expecting a lot of rate cuts, and we felt as though they were pricing that into their underwriting assumptions as it relates to their underwritten exit cap rates.

At the same time, the moderation in fundamentals we're seeing have resulted in less rent growth. So we're much more constructive moving forward at deploying capital into new investments. If you think about it from an investor's perspective, you have more conservative underwritten rent growth combined with more conservative underwritten exit cap rates, we think that's a recipe for success in meeting underwritten returns or outperforming those returns moving forward.

BL: Absolutely. As you're implying, this isn't the first time that we've seen underwriting shifts, and it definitely won't be the last, and to me, that just goes to show the importance of having good managers throughout all cycles.

EC: It's critically important to have a hands-on manager who's been through multiple downturns and really knows how to underwrite with a view toward protecting capital on the downside.

BL: Yes.

EC: Britteni, I want to thank you for joining me and what I hope has been an informative segment for our viewers.

This transcript of the ARA In Conversation discussion has been edited for clarity.

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Disclaimer

The information in this video is as of March 1, 2025, unless specified otherwise and is for your informational and educational purposes only, is not intended to be relied in to make any investment decisions, and is neither an offer to sell nor a solicitation of an offer to buy any securities or financial instruments in any jurisdiction. This presentation expresses the views of American Realty Advisors, LLC (ARA) as of the date indicated and such views are subject to change without notice. The information in this video has been obtained or derived from sources believed by ARA to be reliable but ARA does not represent that this information is accurate or complete and has not independently verified the accuracy or completeness of such information or assumptions on which such information is based. Models used in any analysis may be proprietary, making the results difficult for any third party to reproduce. Past performance of any kind referenced in the information above in connection with any particular strategy should not be taken as an indicator of future results of such strategies. It is important to understand that investments of the type referenced in the information pose the potential for loss of capital over any time period. This video is proprietary to ARA and may not be copied, reproduced, republished, or posted in whole or in part, in any form and may not be circulated or redelivered to any person without the prior written consent of ARA.

Forward-Looking Statements

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