This article is republished with permission from REITCafe.

Supply is the name of the game with the apartment sector, which uncharacteristically underperformed through 2016. The sector, which has been a perennial leader in recent years, posted a flat 2.86 percent total return for the year, a stark contrast with its more than 50 percent rise during 2014 and 2015. Among the four major REIT sectors (along with retail, office, and health care), it is one of the most interest sensitive, and it appears the impact of rising rates canceled out any benefits that should have accrued from rising household income and expectations for inflation.

Though 2016 was disappointing, the outlook for the apartment sector remains positive: executives maintain that flattening supply growth will bolster returns. “[M]ultifamily will continue to be a favored asset class for commercial real estate investors,” says Kim Betancourt, director of economics and market research at Fannie Mae. “A combination of . . . a healthy spread between cap rates and U.S. Treasury rates, continued job growth, and demand for multifamily rentals from millennials, coupled with low homeownership rates, present a positive scenario for multifamily fundamentals over the next 12 months.” The apartment sector also shows resilience to the movements of the broader equity markets; in some cases countercyclical results can even be seen: Falling or flat income encourages potential homebuyers to hold off until income growth returns.

The underlying health of the apartment market tightly correlates with the balance of supply and demand; that balance drives occupancy and effective rent growth, which has slowed considerably since peaking in 2015. The current housing supply is at historically low levels, but the crowd-sourced content service Seeking Alpha reports that multifamily construction has returned to pre-recession levels and will remain elevated through mid- to late 2017. New supply growth is expected to fall to more moderate levels soon afterward.

Overall, rising interest rates and oversupply in key markets took a toll on the apartment sector in 2016. The future looks relatively positive, and the sector may be a haven for investors expecting uncertainty in the equity markets. Some investors might even encounter great returns because the sector is poised for success in an inflationary environment with stronger income growth.

* TREPP-i Survey Loan Spreads levels are based on a survey of balance sheet lenders. For more information, visit Trepp.com. 

** – 10 yr. Treasury Yield as of 1/13/2017.