Our Love Affair with Apartments
The apartment sector has cemented a privileged position atop the commercial real estate investment hierarchy. Across a broad swatch of the nation’s markets, declining vacancy rates and accelerating rent growth have converged with low-cost financing to foment a sustained rebound in investment flows and a recovery in pricing unmatched in its geographic balance. Distinguished even further from other income-producing property types, the apartment sector has recorded a small but observable increase in development activity and has been the only sector to show a net increase in regional and community bank lending.
The apartment sector’s proponents argue that recent gains reflect a structural shift in the housing landscape, with millions of young American families now disabused of the notion that homeownership is always preferable to renting, and embodied in a long-term policy retrenchment from mortgage subsidies and market-making. In support of this thesis, advocates can point to data showing a surge in rental households and a corresponding decline in the homeownership rate. Between early 2006 and late 2010, the renter pool in the United States increased by more than 10 percent, at a faster pace than household formation or rental supply.
The descriptors of the apartment rebound offer a compelling but ultimately incomplete picture of an exceptionally mutable housing market. There is no doubt that national apartment trends are outdistancing an ownership market that remains mired in its own localized recession. Still, investors must proceed deliberately, remaining cognizant of risks to their baseline expectations. While conditions in the apartment sector warrant a sanguine assessment, investors and lenders alike must guard against the potential for unabated enthusiasm to inflate prices and erode lending standards to the detriment of long-term stability.
A Cyclical or Structural Shift in Demand
Underpinning apartment investment gains, fundamentals have improved markedly from their lows during the depths of the recession. Axiometrics reported last month that effective rents increased by 0.8 percent between February and March, 5 percent higher than a year earlier. Driving rent growth, occupancy has tightened across the country, reaching 93.5 percent in the March report. Major markets – New York, Long Island, San Francisco and Boston among them – each now enjoy occupancy rates above 95 percent.
The fundamentals gains in the apartment sector are a function of exceptional growth in the number of renter households and a relative paucity of new inventory. In some markets where the shadow inventory of condos for rent or reconversions might have threatened a sharp expansion of the supply curve, rising demand has nonetheless resulted in positive net absorption. Miami is a case in point, where Axiometrics reports a vacancy rate below 4 percent, while Las Vegas and Phoenix attest to the more basic intuition, with condos undermining the apartment sector.
With the exception of a few markets where particularly weak employment trends and the weight of the housing market have limited household formation, apartment markets are performing well even if removed from the coasts. Will the current tightness in rental outcomes persist, justifying further increases in prices? On one side of the equation, there is little question that supply will respond to rising cash flow; an increase in development, however small, is already a factor in the apartment market. As new units come online, some of the upward pressure on rentswill ease. The potential for overbuilding may be kept in check by more cautious bank lenders and by their regulators, who will invariably point to still-record high default rates on banks’ construction loans.
While the supply response lags the market, the demand side of the fundamentals equation is the more challenging source of uncertainty. Rental demand has been very strong as compared to the rate of job growth during the recovery. But charting its forward path introduces a degree of forecasting error. At the heart of the projection, housing tenure bias involves a complex interaction between the availability of credit and equity, expectations of relative rental and ownership costs,
and behavioral factors. While a complete discussion of tenure choice is outside the scope of this column, suffice it to say that households will tend towards renting if there is an expectation that real house prices will decline in future periods, as has been the case in recent years.
Whether the relative bias in favor of renting will persist once house prices normalize will depend in large part on the availability and cost of mortgage credit and the behavioral characteristics of younger households on the cusp of ownership. The former is in the realm of policy; the latter, a dimension of the American psyche that economists will struggle to forecast. While housing finance reform suggests that homeownership will become a more costly proposition in the coming years, investors must also concede a cyclical element to the current strength of renter demand.
In a continuation from this week’s column, next week’s Lead Indicator will address the implications of housing finance reform for the apartment outlook.
Sam Chandan, Ph.D., is global chief economist of Real Capital Analytics and an adjunct professor at the Wharton School.