Multifamily Fundamentals: Rent Growth Impacted as New Supply Hits Market

The US apartment market has been making headlines of late. After peaking in 2015 with rent growth in excess of 5% and occupancies tightening to above 95%, recent data is starting to show some weakness as large waves of new supply hit the market.

The US has seen spikes in apartment construction in the 70’s, 80’s and 00’s, however there is a key difference in this cycle: developers are focused on building in urban cores.  The thinking that urban areas provide barriers to entry for developing is antiquated.  Instead, cities like Nashville, Austin, and Denver are fully embracing the live/work/play model to boost their local economies.  Major markets like New York and San Francisco have also seen a large increase in new supply.

The impact of this new supply is starting to emerge with rent growth slowing to around 4%^[1] for the year ending June 30, 2016.  Headwinds will persist because of the following reasons:

• There are approximately 600,000 units that are currently under construction. This will be coming on the heels of two consecutive years where 200,000+ units per year were delivered in 2014 and 2015. Occupancy rates are expected to decrease below 95% and landlords will likely need to offer concessions (free rent) and reduce rents in order to stabilize these properties.
• Affordability is a big concern as wage growth remains muted. Increases in land and construction costs are pushing developers to build high-end apartments that demand premium rents. According to CoStar, nearly 60% of new construction requires income of at least $75,000 to qualify as “affordable”^[2], and nearly 30% of the units will require annual income of at least $100,000 to qualify as affordable.
• A slowdown in US job growth could further exacerbate the rent growth deceleration.   The Houston and Denver markets are a good example of how this ill-timed new supply might impact rents if job growth dissipates.

Sources: Axiometrics Inc., BLS (from Axiometrics Apartment Market Outlook for 2016)

Will rent growth ultimately recede below the historic trend of ~2%^[3]?  Unlikely, due to a confluence of sustaining factors outlined below:

• Limited supply of new housing units following the financial crisis. Since 2010, housing units per households formed has averaged just 0.54 per year^[4]. This compares to the long-term annual average of 1.08. The chart below illustrates the trough in multifamily construction that occurred following the financial crisis.

Multifamily Construction as a % of GDP

Source: Credit Suisse CMBS Market Watch 2016 Year Ahead Outlook

• Demographic trends remain favorable for apartments. The millennial cohort is now the largest generation in the US. It encompasses more than 75 million people^[5] ranging from the age 18 to 34, a prime age to rent. Millennials are delaying key life events such as marriage and family formation versus previous generations.
• Tightening of credit and swelling student loans has made home ownership more challenging. Lending institutions distanced themselves from subprime borrowers and have increased standards to qualify for a home mortgage. In addition, it’s estimated by TransUnion that over 7 million consumers were negatively impacted by the housing bubble burst and by the end of 2014, only 1.2 million have recovered enough to meet Fannie Mae guidelines.
• Recent pull back in construction lending which will limit future projects beyond the current pipeline. Lenders are becoming more selective as the real estate cycle enters the late innings. Plus regulatory changes require larger capital reserves against construction loans.
• Segments of the market with limited new supply will continue to experience strong rent growth, notably Class B/C properties. In 2015 the Class B/C properties saw occupancy rates near 97% while rents rose around 6% year-over-year on a same store basis^[6]. During the same period, existing Class A properties rose only around 3%. It’s worth noting that the Class B/C segment encompassed approximately 60% of the total supply in 2015^[7].

To sum it up, fundamentals are stable but certain segments of the apartment sector are vulnerable. The abundance of new supply could cause rent growth to rapidly deteriorate if the US economy stalls.  A more likely scenario is slightly weaker apartment fundamentals over the next few years as the new supply is absorbed and the US economy continues its tepid expansion.  Rent growth should continue to decelerate but will likely remain modestly above trend because segments of the market where supply has been limited (e.g. suburban and Class B/C properties) will bolster the otherwise anemic rent growth that will be experienced in Class A urban markets.

^[1] Source: Axiometrics
^[2] 30% of annual income
^[3] Per CoStar historic rent growth has been 2.2%
^[4] Source: US Census Bureau
^[5] Source: PEW Research Center
^[6] Source: CoStar
^[7] Per REIS the total market in 2015 was approximately 10.4 million units