Large-scale moves away from expensive and dense gateway metros to spacious rural areas and more affordable non-gateway metros characterized the early days of the pandemic. Recent official U.S. Census data covering the first approximately 18 months of the pandemic clearly illustrates these two dynamics.

First, the rise of “Zoom towns” sparked images of remote workers taking up residence in small towns in more remote parts of the country (e.g., Bozeman, Mont.). It turns out this rush for cheaper space in idyllic parts of the country was a relatively concentrated phenomenon, as large swaths of cheap and rural areas in the Midwest and the South shrank. Simply having abundant affordable space was not enough; Zoom towns had to offer extraordinary natural beauty or easy access to outdoor activities as well.

Second, gateway metros (New York City, Chicago, San Francisco and Los Angeles) suffered significant population and real estate value declines, while non-gateway metros (Austin, Phoenix, Nashville, Raleigh-Durham and Denver) enjoyed population growth and a commensurate rise in investor interest.

This contrast between gateway and non-gateway markets is clear when looking at metro-level population statistics. Nationally, the United States saw 0.1 percent population growth over this period, much lower than the historic level of 0.6 percent to 0.8 percent seen during the previous decade. Gateway metros underperformed the U.S. average, with the gateways that we sampled shrinking over the period. Meanwhile, non-gateway metros generally grew, except Miami (which, one could argue should be classified as a gateway metro). Of note, Austin grew more than 3 percent, while Raleigh and Phoenix both grew more than 2 percent. This is an impressive level of population growth on its own, but particularly when the national growth rate was almost zero.

The impressive level of population growth fueled the narrative that all real estate was booming in these markets. That narrative is not entirely accurate. Office and retail have performed modestly, but apartment markets in non-gateway markets significantly outperformed gateway peers. Since the start of the pandemic, non-gateway markets saw an average quarterly total return of 2.3 percent in office and 2.2 percent in retail, outperforming gateway offices (1.6 percent) and retail (1.2 percent). But in apartments, non-gateway markets grew a stunning 8.4 percent since second quarter 2020 versus 3.4 percent in gateway markets. Apartment returns in gateway markets were high relative to other property types, but also within their historic range. This compares with apartment return in non-gateway markets, which outperformed other property types but were materially above any level of return these markets had delivered historically.

Outperformance on rent growth is partly responsible for higher returns in non-gateway markets than gateway markets. The cap rate risk premium compression, and its impact on the capital growth component of total return, is also striking.

When comparing market cap rates for major U.S. property types in gateway and non-gateway markets, statistics showed that, until the pandemic, non-gateway markets consistently offered a higher market cap rate to investors than gateway markets. In the pandemic, that risk premium compressed to the minimal levels — and, in the case of apartments, going negative, with non-gateway markets yielding less than gateway markets in our sample average. (This does not mean all gateway markets have cap rates higher than all non-gateway markets. Non-gateway markets saw consistent cap rate compression to relatively low levels, while cap rate changes and levels in gateway markets were more heterogeneous — for example, low-yielding San Francisco and high-yielding Chicago.)

SUN BELT BUILDING BOOM

The pandemic spurred changes in demographics and capital markets that upended our pre-pandemic assumptions. Investors are now considering which of the investment theses that emerged in the pandemic are here to stay and where excesses could have built up.

The main risk we see is potential apartment oversupply risk in non-gateway markets, particularly in the Sun Belt. Rent growth and apartment supply under construction, on its own, is not concerning, so long as demand for apartments can absorb the new supply. This is where we start to see risks. We assessed housing supply in the context of pre-pandemic population growth to understand what supply looked like outside of pandemic migration patterns. Specifically, we estimated the amount of total housing under construction expressed as how many years of normal population growth that pipeline could house.

We compared building in 2021 to 2013, which we selected to show a comparator year that was some distance from the 2008–2009 housing crash but also some distance from the pandemic. In 2013, both gateway and non-gateway markets were building enough residential product to house between one and two years of population growth. Moving to 2021, gateway markets were still developing housing suitable for one to two years’ population growth, but non-gateway markets had moved to developing for 2.5 years to 3.5 years’ normal population growth. Unless these non-gateway markets continue to get large above-national population growth outperformance, they may be at risk of supply overhang.

Oversupply may pose a risk for valuations in the short term. Our analysis suggests those markets that saw some of the largest valuation increases over the previous two years could see some of the slowest demand growth. Our analysis shows a positive relationship between lagging cap rate compression and leading jobs growth, meaning those markets that saw the greatest cap rate compression in basis-point terms have weaker job growth prospects than those markets that saw less compression. This dynamic could put apartment valuations at risk in markets with the biggest run-ups since the start of the pandemic.

DOES SUPPLY MAKE A MARKET?

We see supply risks in non-gateway U.S. apartment markets, particularly those in the Sun Belt. This stems from what we see as optimistic assumptions on demand growth versus the amount under construction for delivery in the short term, which in turn is a function of population flows and capital markets activity during the pandemic.

The good news for Sun Belt investors is that supply on its own does not make a market. Over the long term, attractive markets are those with strong demand fundamentals to meet growing supply. Many of these Sun Belt markets may offer attractive long-run demand growth, and the short-term supply overhang is likely to be absorbed over time. Much depends on investment time horizon. Still, in the short term, it is important to be cognizant of where risks have built up following the pandemic.

Brian Biggs is vice president, research, with Grosvenor, and Ashton Sein is a research analyst with the firm.