High-Rise v. Garden-Style: Examining the Path to Prosperity
Modern times offer exciting opportunities for direct real estate investors. With properties across the spectrum realizing a significant growth trajectory, real estate investments can offer both attractive returns and diversification benefits. Specifically, apartments offer a long track record of favorable risk-adjusted returns, a higher dividend payout ratio and healthy growth of net operating income (NOI) relative to other property types. However, to determine the right strategy for apartment investing, investors have myriad factors to consider before deploying capital. All of the calculations, analysis and forecasting culminate into one overarching goal: to maximize returns and minimize risk.
Following the Great Financial Crisis, apartments have been a clear investment winner among real estate sectors due to declining homeownership rates, tighter mortgage standards, demographic trends and desire for flexible living. The apartment sector is comprised of several different property types, leaving investors to wonder which product type is the better bet. To determine the answer, this piece will analyze growth across rental rates and NOI, as well as dive into the components of total return to determine whether high-rise or garden-style apartments provide the most effective path to prosperity.
Key performance differences by property type
Higher effective rents – which drives NOI growth – is the foundation for real estate investment performance. Figure 1 illustrates that the clear winner for rent growth is high-rise apartments. Given the outperformance, it is not surprising that high-rise apartments also tend to produce superior NOI growth (see Figure 2). In fact, during the previous 15 years, NOI growth in high-rise apartments has exceeded garden-style apartments on average by 270 basis points (bps) per annum. However, superior NOI growth does not come without risk. High-rise apartments also experience more volatility. This might seem counterintuitive since high-rise apartments tend to be viewed as “recession proof” because they attract more renters by choice. But it is this very fact that belies the volatility: renters can come and go, especially if another more spectacular product comes to market. High-rise renters command the income to allow for such agility.
Where do garden-style apartments excel?
Since total returns incorporate both an income and appreciation component, it is important to note that garden-style apartments enjoy an income advantage. Figure 3 shows on average, garden-style apartments have maintained an income yield advantage of 73 bps on an annualized basis during the previous 15 years. More recently, that premium has expanded to roughly 124 bps as asset prices of high-rise apartments have been bid up.
Historical appreciation advantage belongs to high-rise apartments
Circling back to the correlation between NOI growth and valuation, high-rise apartments experience faster appreciation. Again, this is not surprising given the track record of stronger NOI growth. Historically, high-rise apartments have appreciated on average 103 bps faster on an annualized basis when compared to garden-style (see Figure 4). However, more recently, that trend has shifted in the favor of garden-style apartments. From 2nd quarter 2014 to 4th quarter 2014, results have swung in the opposite direction towards garden-style as some level of price fatigue sets in for investors of high-rise apartments. While it’s not clear if this is a blip or a trend, we’d be remiss by not mentioning it here.
Just give me the answer already!
Back to what you really want to know: If I invest in apartments, what product type should I pursue? Despite the pride of owning a high-rise apartment complex in a major metropolitan area, total returns between garden-style and high-rise apartments are almost identical on a national basis (see Figure 5). Furthermore, Figure 6 illustrates that risk-adjusted returns by the slightest of margins, tend to favor garden-style apartments, a fact that runs contrary to traditional thought.
Since garden-style apartments are typically associated with suburban areas, these results resemble a perception-realty gap. Said another way – the perception may be based on vanity (it’s more prestigious to own a high-rise) versus the value gap that has existed on a historical basis. Moving forward, the fact that the largest population of renters – Millennials – tend to prefer the live-work-play lifestyle that high-rises often afford, future results may very well look different. At least this appears to the thinking based on capital flows.
The changing landscape of institutional ownership
If all signals point to a slight advantage toward garden-style apartments, does private equity and institutional investments support these facts? The results are actually counter-intuitive. In reality, institutional ownership of high-rise apartments has been on a steady uptick. There are several possible explanations. First, institutional investors are risk-averse, and as such, they may be attracted to the liquidity aspect of high-rise apartments due to the sheer amount of capital chasing deals. Second, apartments were not embraced by institutional ownership until recently. For comparison, apartments comprised 16% of the NPI index by market value in 4th quarter 1999 compared to 25% today. As institutional capital flowed into apartments, it headed into the higher barrier-to-entry markets, which typically comprise of more high-rise apartments. Third, as institutional investors look to apartments as an effective way to allocate capital, they also tend to favor investing in newer product as a way to enhance their income return. And since apartment construction has shifted toward urban, infill, high-rise product, the institutional money followed suit. Finally, institutional investors who want to deploy a large amount of capital will naturally gravitate towards the most expensive product – in this case high-rise apartments. As a result, the composition of ownership has shifted from a heavy concentration of garden-style apartment units to nearly a 50/50 split, as seen in Figure 7.
If all signals point to a slight advantage toward garden-style apartments, does private equity and institutional investments support these facts? The results are actually counter-intuitive. In reality, institutional ownership of high-rise apartments has been on a steady uptick. There are several possible explanations. First, institutional investors are risk-averse, and as such, they may be attracted to the liquidity aspect of high-rise apartments due to the sheer amount of capital chasing deals. Second, apartments were not embraced by institutional ownership until recently. For comparison, apartments comprised 16% of the NPI index by market value in 4th quarter 1999 compared to 25% today. As institutional capital flowed into apartments, it headed into the higher barrier-to-entry markets, which typically comprise of more high-rise apartments. Third, as institutional investors look to apartments as an effective way to allocate capital, they also tend to favor investing in newer product as a way to enhance their income return. And since apartment construction has shifted toward urban, infill, high-rise product, the institutional money followed suit. Finally, institutional investors who want to deploy a large amount of capital will naturally gravitate towards the most expensive product – in this case high-rise apartments. As a result, the composition of ownership has shifted from a heavy concentration of garden-style apartment units to nearly a 50/50 split.
In conclusion, high-rise versus garden-style could be argued from many different viewpoints. The facts are garden-style apartments have historically provided a slightly more favorable risk-adjusted return over the past five, 10 and 15 years. However, institutional investors, developers and some tenants favor high-rise apartments, a fact which cannot be discounted. In the end, from a strategic investment perspective, the decision is based on your investment goals, objectives and risk tolerance.
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