The HLC Equity investment team takes a deep dive beyond the hype and noise about microunits, and offers an overview of how this niche product sizes up as an investment
Micro units have garnered much investor and developer attention over the past decade as the product type has become more prevalent. At HLC Equity, we seek superior risk-adjusted returns for our investors and identifying unique & emerging product types, such as microunits, is one strategy we employ to achieve this objective. For purposes of this article, we’ll define “microunits” as a unit that is less than 400 sq ft.
The Cost Structure & Investment Diversification
While microunits typically cost more to build and operate on a “per square foot” basis relative to a traditionally sized unit – after all, the cost of a refrigerator remains the same whether it’s in a 300 sq ft or 800 sq ft apartment – there are several characteristics which make the risk/rewards of investing in microunits quite attractive. These include portfolio and product diversification, cost savings to the resident, higher returns to landlords, energy efficiency, among other benefits.
Diversification insulates one’s portfolio from risk. As we identify new investment opportunities, we assess multiple variables to determine whether we should deploy capital or not. Investing in a property with microunits is one diversification strategy which can insulate our properties from risk. For one, microunits is a very small percentage of the total housing stock, providing scarcity value. Second, landlords will typically charge less monthly rent for these types of units (as they’re smaller than a traditional unit) which increases the population of people who can afford the unit – a critical factor, as some statistics suggest over half of renters in the US are cost burdened. Third, the presence of microunits within a property drives increased variability and choice for a potential consumer, which allows landlords to stratify the price points of the apartments within the property. Fourth, given tight local zoning laws, it’s difficult to build entire buildings of microunits which limit the supply of the unit typology.
Meeting Customer Needs & Solving the Housing Affordability Crisis
While some may view living in a microunit as “sacrificing” square footage, there’s much to be gained by living in a microunit, especially if it’s designed appropriately. As referenced above, we face a housing and affordability crisis in the US and microunits allow landlords to charge less monthly rent, thereby offering a “savings” to renters. In general, renters typically want to spend as little as possible on monthly rent and the emergence of microunits allow renters to achieve this objective. By some estimates, renters typically save 20-30% on monthly rent versus an alternative traditionally sized apartment. Additionally, during the pandemic, it appears as though the lower monthly rents (and therefore “savings” to the consumer) has translated into better performance in properties which contain micro units. According to a Cushman & Wakefield report, rents declined 9.4% from March to August vs comparable studio apartments dropping 11.7%, and apartment owners are also reporting ~70 bps stronger delinquencies as well.
Achieving Risk Adjusted Returns
Microunits can drive higher returns on capital given their unique value proposition within the marketplace. Despite the lower ‘monthly’ rent they typically command from renters, a microunit is more expensive on a ‘per square foot’ basis. For example, assuming a traditional 500 sq ft studio costs $2,500/mo, the landlord achieves $60/ft annually on that unit. By contrast, a 300 sq ft microstudio and charging $2,000/mo (a 20% discount vs the ‘traditional’ studio), the landlord earns $80/ft. In this example, despite charging $500/mo less for the microstudio, the landlord earns $80/ft (a 33% increase). The enhanced marketability of the unit given its lower price point and much higher return is difficult to ignore.
Microunits can also be described as high-density units. Density can provide environmental benefits via reducing a building’s per capita carbon footprint. As residential buildings are a top culprit of carbon emissions, the presence of microunits in a property can reduce per person demand for heating and cooling, thereby driving energy efficiency and benefitting the environment.