For the first time in over 10 years, Chicago passed the national average for year-over-year apartment rental growth as relatively mild construction has kept demand high, while a national pullback in rents caused by overbuilding has allowed it to leapfrog once-surging markets.

Over the past few years, growing tertiary and gateway multifamily markets in the Southern and Western regions of the United States were crushing the stalwarts of the Midwest and the Northeast with their double-digit rent growth returns. While Chicago was no slouch, at 8% rental growth, it couldn’t compete with the rental growth rates of such markets as Orlando and Phoenix, clocking in at 23% and 18%, respectively.

Yet those who placed their money on the stability of a Midwestern gateway market like Chicago’s believed that durable demand would be a safer bet than runaway returns. Those prudent bets on the Windy City have paid off. Although rental growth slowed in Chicago too, it wasn’t to the same extent as the rest of the nation. In addition, out of the country's 10 largest gateway markets, Chicago posted the largest multifamily rent growth. In fact, its year-over-year rental growth was 40%, or 120 basis points, more than second-place New York City’s growth rate of 3.2%.

“The underlying demand fundamentals of Chicago – diversity of economy, average rent as a percentage of household income, continued net positive absorption of units – lead us to believe Chicago will outperform other gateway markets in the coming quarters, dissipating past and future uncertainties,” Matthew Berry, managing director of investments at Chicago’s John Buck Co., said in an email to CoStar News.

Greater Demand Than Supply Keeps Apartment Rental Growth Climbing

It’s a common assumption that is usually backed up by the data: Recently built properties are a surefire way to boost overall residential starting rents. Yet this narrative hasn't always been true in Chicago over the past 12 months.

In fact, many of the market's cities and urban neighborhoods with the highest rental growth have seen minimal construction. For example, North DuPage County saw its multifamily inventory increase by just over 2% since 2019. Before that, no inventory expansions occurred here since 2005, yet the area is recording 9.4% year-over-year rental growth now.

This storyline does not always play out that neatly, though. The cities of Elgin and Dundee, on the other hand, registered an almost 10% rental growth rate since 2019 as inventory expanded by almost 20%.

Rising rents are simply a matter of supply. When the apartment supply is less than the market demands, regardless of recent inventory expansions, rents increase. The areas, generally, that saw the most rental increases were those that were not saturated with new supply. Or stated another way, the lack of new development in many of Chicago's suburban areas gave older, mid-priced properties a unique edge to raise asking rates.

For example, rental growth among mid-priced Class B properties grew by almost 12% in North DuPage County and 11% in Elgin and Dundee from the fourth quarter of 2021 to the fourth quarter of 2022, regardless of how high-end, Class A properties in the area were performing. In Elgin and Dundee, as much as the multifamily inventory expanded, it clearly didn't expand enough. Across Chicago, this correlation appears to be true.

From 2021 to 2022, rents in Class B apartment buildings grew 70%, or 230 basis points, more than in older Class C buildings, and 46%, or almost 180 basis points, more than in Class A buildings. The tight vacancy rates across Class B properties — registering at 5% by the end of 2022 — reveal the steady demand for them. So, despite the influx of new inventory entering the market over the past few years, Class B apartments are surpassing the rental growth of Class A and C properties for the first time in over 15 years.

As 2023 unfolds, demolitions are also likely for obsolete Class C apartment buildings, which should tighten the Class B property supply as they pick up those tenants forced to upgrade into available market-rent apartments.

Managing Expectations

Increasing rents is not just a matter of supply and demand fundamentals. Virtually every multifamily investor in Chicago knows future income projections are based on managing present and future expenses and calculating how market and government forces are expected to change in the coming years.

“Stabilized leveraged cash flow is everything,” Berry said.

When John Buck set out to develop its most recent award-winning project, the 586-unit Porte Apartments in the West Loop, it needed to underwrite overly conservative assumptions to reflect the tremendous uncertainty in the market about how the assessor would reevaluate commercial real estate in the most recent triennial cycle. It turned out, Cook County’s tax increases were more reasonable than the worst-case scenario that some in the market had feared.

Uncovering Opportunities

Multifamily speculators who are turning their gazes to Chicago's patchwork of residential enclaves would wisely look where vacancies are tight, whether populated by Class A or B apartments. But, serendipity, and higher rates of return, can be found in the city's overlooked districts.

“There are neighborhoods throughout Chicago that offer excellent returns for multifamily investors,” said Manny Regalado, a director at KW Commercial. “Clients think they need to invest in HUD properties to get the best cap rates and that just isn’t true,” he said.

Lower- and middle-market properties, ranging in size from 12 units to 40 units, can be had in the mid-7% capitalization-rate range for stabilized deals in the southwest of Chicago, like Archway Heights near Midway Airport.

“Although the Northwest Side multifamily cap rates are in the low-6% range, so are affordable housing properties offered within the South Shore Submarket,” Regalado said. In other words, traditional residential stock can still offer an attractive yield compared to HUD properties to their guarantors. In this instance, HUD properties are those where the financing is guaranteed by the Department of Housing and Urban Development and/or are those that are located in neighborhoods where Section 8 vouchers are commonly redeemed.

Excellent rent growth in the Chicago area is not necessarily tied to elevated or move-in figures, but rather where supply is relatively tight and steady demand is strong. Yet the severe rise in interest rates over the past 14 months eroded some of the market’s giddiness to multifamily development and procurement. Nevertheless, with rent growth still strong, market players remain bullish.

While crane sightings appear to fade across the national landscape, outside investors should be drawn to the stability of a mature market that’s been overlooked since the onset of the pandemic. Chicago, as a thriving economy and one the nation’s largest, should continue to draw attention from small private owners to large, institutional and foreign investors alike.

Source: www.CoStar.com