Market Update: Inflation, War, and Rogers Park
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Doug Imber
President, Essex Realty Group and RPBG Director
I’ve had the privilege of working in the Rogers Park apartment industry for more than 30 years, yet each time I attempt to summarize the market, the analysis seems more complicated than it did before.
First and foremost, as I write this in early April, Russia’s invasion of Ukraine has had a rippling effect on the geopolitical landscape as profoundly as almost any event in my lifetime. While Rogers Park is 5,046 miles from Kyiv, the global economy seems to shrink this distance faster than Michael Glasser finds worthy causes to support. As a result, forecasting in our neighborhood now seems more influenced by someone else’s neighborhood far away.
Inflation has only an indirect effect on rents, which are instead driven by the forces of supply and demand. While inflation doesn’t directly affect rents, it mercilessly impacts expenses.
Despite the disturbing news in other parts of the world, the Rogers Park apartment market continues to recover from the trials of Covid. This recovery is occurring despite political leadership that placed many of the pandemic burdens squarely on the shoulders of housing providers. Other industries were not required to give away their products for free, to sell them on credit, or to delay collecting accounts due.
Similarly, this recovery is occurring despite an onslaught of ill-conceived regulations from policy makers who appear to have little understanding of how markets function. For example, in a city with a critical housing shortage, it may be politically popular to support a 20% affordability component for new apartment developments, but many in the City Council are oblivious to the fact that this requirement reduces supply. Instead, they believe restrictions rather than incentives will somehow yield more affordable housing. But collecting political capital often takes priority over problem solving.
The demand for rental housing is ballooning as the impacts of Covid wane.
One of these problems is the challenge of inflation, which is forecasted to reach 7.9% in 2022, on top of 2021’s 4.7% – far above the historic 2.0% Fed target rate. So, what does this mean for apartment owners? Contrary to popular belief, inflation has only an indirect effect on rents, which are instead driven by the forces of supply and demand. For example, if Rogers Park were 5,000 housing units oversupplied, rents would decline regardless of high inflation. Conversely, if Rogers Park were 5,000 units undersupplied, rents would increase, even in a time of low inflation. The reason inflation has an indirect effect on rents is that wage inflation allows renters to afford the rent increases of an undersupplied market. Yes, I’m hoping some of our policy makers are paying close attention to this last part.
While inflation doesn’t directly affect rents, it mercilessly impacts expenses. We are seeing this in the costs of taxes, insurance, utilities, labor and material – almost everything that is required to operate an apartment property. However, inflation also benefits borrowers of fixed rate debt. While the nominal amount of a mortgage may remain unchanged, the effective amount decreases commensurate with inflation. Per the above inflation levels, borrowers would receive a 12.6% reduction in effective debt in just two years, which is akin to debt forgiveness without the tax consequences.
Shockingly, during the Covid crisis, capitalization rates compressed rather than expanded.
Historically, the Fed’s primary defense against rising inflation has been interest rates, which are edging upwards in 2022. This begs the question as to whether rents can grow fast enough to keep pace with borrowing costs and skyrocketing expenses? So far, the answer appears to be yes.
But inflation isn’t the only force impacting the apartment market. The supply chain challenges over the past two years have made building new apartments and renovating older ones more difficult, on top of regulations that already disincentivize new supply. The volatility in raw material pricing and the delay in delivery schedules have resulted in fewer apartments being built or improved. Meanwhile, the demand for rental housing is ballooning, as the impacts of Covid wane, unemployment reaches an historic low and another class of Big 10 graduates prepare to descend on Chicago’s core neighborhoods.
Shockingly, during the Covid crisis, capitalization rates compressed rather than expanded, as many had expected. In Rogers Park, capitalization rates fell to 5.77% in 2021 from 2020’s 6.21%. It is worth noting that the capitalization rates in Lincoln Park/Lakeview during 2021 were 5.20%. Although capitalization rates are a measure of return, they are also a reflection of risk. This narrow delta of 57 basis points between the two areas indicates that the market perceives Rogers Park as having only nominally more risk than Lincoln Park/Lakeview, and that the market will accept similar return thresholds in either sub-market.
Interestingly, compared to most other major markets, capitalization rates in Chicago remain an incredible bargain, at least for the time being. In markets such as North Carolina, Texas, Colorado, Arizona, Florida and Georgia, capitalization rates for core or core-plus apartment properties are in the high-2% to low-3% range. For secondary locations, capitalization rates are in the mid-3% to low-4% range.
While those markets have experienced faster population growth, they also carry their own challenges, such as water shortages, new supply, intense and frequent weather patterns and strong upward pressures on property taxes, particularly for those states with no state income tax. As a result, after a few years of tapping the breaks on Chicago, institutional capital is now returning, viewing this market as providing better risk-adjusted returns, and potentially pushing capitalization rates down even further.
This decline in capitalization rates was certainly fueled by low interest rates, which fell during Covid to upper-2% borrowing rates, before expanding to their current 4.0% range. But the decline in capitalization rates has also been impacted by the supply of capital, not just the cheapness of capital. Twenty-five years ago, the US M2 money supply was less than $4 trillion. Today, US M2 is more than $22 trillion, having more than doubled in just the past 10 years.
While we know where the money came from (quantitative easing), the question is where does all that money go now? With strong fundamentals in the multi-family space compared to many other product types, capital continues to pour aggressively into apartment investments.
After a few years of tapping the breaks on Chicago, institutional capital is now returning, viewing this market as providing better risk-adjusted returns, and potentially pushing capitalization rates down even further.
If nothing else, the above reminds us that there are numerous factors that influence our marketplace. The complexities can be maddening, but there is also a simplicity that’s calming. Despite all the noise, Rogers Park’s fundamentals are incredibly strong. We have the unique amenities of Lake Michigan and its beaches; exceptional public transportation; and an extraordinary housing stock that services a broader array of residents than perhaps any other neighborhood. All this has led to a steady, albeit hard-earned, increase in the value of apartment investments, with price per units today nearly double what they were ten years ago.
Anthony Bourdain said, “Chicago is a town, a city that doesn't ever have to measure itself against any other city. Other places have to measure themselves against it. It’s big, it’s outgoing, it’s tough, it’s opinionated, and everybody’s got a story.” I have to believe he was standing in Rogers Park when he said that.
Please click here for Essex’ full 2021 Rogers Park Market Report.
