With all the information that is available and availed in the development of real estate, there still seems to be no way to avoid overbuilding a hot property type. Perhaps it is because too much information exists to be used. Perhaps it is because decisions on what and when to build are ultimately still made by humans. Whatever the cause, overheating almost always occurs when one category of real estate heats up.
For the past couple of years the hottest category of construction has been the multi-family apartment complex. Like all property types, apartments have a history of boom and bust. The relevant question in mid-2013 seems to be: when will this boom end?
It’s pretty clear that 2013 won’t be the answer to that question. The fundamentals of the apartment market remain strong. National vacancy rates for multi-family at the end of the first quarter were 5.9 percent, well below the 8.2 percent peak prior to the recession. Occupancy is 0.6 points higher than the 15-year average. Rents are still growing – although at a slower rate – and are now 3.6 percent above the pre-recession levels. Moreover, the influx of Echo Boomers into the market has increased demand and raised the bar on the kind of apartment expected.
Improved demographic support and great supply/demand fundamentals have created a target renter who rents by choice and is able to pay a premium rent for high-quality space.
The roots of the apartment boom are similar to what drove past apartment booms, albeit with a slight twist this time. Demographics are the biggest driver of apartment demand. This was the case in the early 1980’s boom as well. A weak economy or tight credit makes buying a home more difficult than renting. A shift in culture can trigger a change in preference about where most people want to live. All of these factors were at work when the current boom in multi-family development began in 2010. In 2010, there was another factor that raised the heat on apartment development and that was the availability of money
After the dust settled on the financial crisis, it was clear that the housing market was going to look different for a while. Higher unemployment, foreclosures, lower incomes, and a deep aversion to residential lending risk were but some of the factors that were driving people who formerly owned homes to rent instead.
At the same time the government’s response to the crisis ensured that fixed income investors were going to get limited returns from cash and Treasury bonds for an extended period. Investors who needed yields – like insurance companies or retirement funds – had to find someplace safe to put money. With economics that favored renters – and further encouragement from favorable financing from Fannie Mae, Freddie Mac and HUD – investors began looking for apartment projects. If you wanted to develop in 2010 or 2011, the easiest path was to build apartments.
Investor appeal with apartments has been the rent growth, of course. In 2011, effective rents climbed five percent, which was the highest growth rate in a generation. Comparing that growth rate to a 10-Year Treasury bond that was under two percent made apartments attractive. Even the effective growth rates of 4.05 percent in 2012 and the 3.4 percent rate of first quarter 2013 were beyond safe bond yields but the gap is shrinking. In fact, as the benchmark 10-Year bond yield has risen to 2.2 percent, rent growth has declined to just above three percent. If this decline becomes a trend – and it’s hard to argue that is hasn’t – you can expect to see REIT’s and other large institutional investors further shift assets to other property types.
Financing capacity will be diminished as well, although multi-family will likely still be the most sought-after category for investors. As part of the plan to clean up the assets of Fannie and Freddie, Congress mandated that the market share of the two agencies had to shrink. At the start of 2013 the federal agency charged with overseeing the government sponsored enterprises – the Federal Housing Finance Agency– ordered that Fannie and Freddie must cut back their volume of multi-family lending by ten percent.
The National Association of Homebuilders’ May multi-family builder surveys show that the perception of vacancy is rising, a sentiment that should cool off construction of new apartments. Cooling sentiment would actually be a good thing. The averages in April and May were for 321,000 units to start this year. CoStar forecasts that roughly half of those will be added to the inventory, which is a 40 percent increase over the 15-year average. The increased volume of starts in 2013 should add even more to the inventory in 2014, as supply begins to outstrip demand. Assuming that word of a softening market gets out, many planned projects might go on the shelf rather than exacerbating the growing inventory of apartments. Markets generally don’t get the word in time to stop a boom, however, so overbuilding is likely.
The final straw for the multi-family boom may come from the recovery in home ownership. Single-family construction is rising again, with forecasts of new homes crossing the million-unit threshold in 2014. An improving economy, even one that is growing slowly, will swing the residential pendulum back towards home ownership again.
“As the economy improves and more people enter the housing market, more will choose single-family homes over multi-family,” predicts Paul Griffith, vice president and managing director of Integra Realty Resources. “People chose to stay out of the market because of jobs or credit or other economic concerns but as they come back they will choose single-family again.”