The Great Recession collapsed single-family home dynamics, and the effects of all that wealth destruction force-changed the residential market, strengthening rentals and weakening ownership. As a result, homeownership rates dropped from almost 70 percent before the economic crisis to 64 percent today, meaning about 4 million to 5 million housing units switched from ownership to rental.
At the same time, demographics were shifting, as millennials entering the workforce and baby boomers in retirement began moving back into the inner cities to take advantage of cultural opportunities and other urban amenities.
Since the economy began to recover, multifamily has been the stallion in the commercial real estate paddock, but the question now is how much longer will this horse run? Will multifamily be Triple Crown Winner Seattle Slew, or will it be a California Chrome, panting to finish fourth at the Belmont in 2014.
If you were going to handicap this race, these are things you want to know. Supply has been very strong. In 2008, 143,000 rental units were constructed, then came the recession and development slipped to 37,000 to 78,000 units between 2010 and 2012. By 2013, the apartment development market was back, with the construction of 170,000 units in 2013. According to CoStar Group, the market will deliver almost 260,000 rental units this year and another 400,000 units over the 2015 to 2016 period.
The demand has been there for the new housing, and the optimists think the market will handle all that is in the pipeline. “New units totaling 250,000 to 300,000 annually sounds like a lot because we were coming from under 100,000 units four years ago, but if you look at it terms of undersupplying during the recession years, it’s not,” says Peter Donovan, senior managing director at CBRE Capital Markets – Multifamily in Boston.
The country is still not building a lot of single-family homes, he adds for good measure. “If you look at new construction, we’re doing 500,000 homes annually, when we should be doing 1.2 million homes. That shows the lack of demand. If people aren’t buying homes with interest rates as low as they are now, what’s going to happen when interest rates start to move up?”
So far, the rental market has been able to handle the increase in new supply as the national vacancy rate, according to CBRE, has fallen to a very tight 4.4 percent in the second quarter. The vacancy rate fell in 38 of the 63 U.S. markets CBRE tracks.
For a while, rent gains followed vacancy declines, but some divergence has occurred, and this has given multifamily market handicappers some pause. Coming out of the recession, average rental gains jumped above 4 percent. That could drop to under 3 percent this year, and CoStar forecasts rental gains will be in the 2 percent range in the next year or two.
In fact, CoStar’s economists have gone bearish on multifamily.
“Multifamily continues to be popular, but we are beginning to see cracks in the veneer,” says Michael Cohen, director of advisory services for CoStar Portfolio Strategy in Boston. “We are tracking over 200,000 units of new supply over the past year, which is starting to take its toll on overall fundamentals. The question is, when will that new supply start having an impact on stabilized inventory? In most markets we haven’t seen that yet, but certainly with more supply coming down the pipeline, we anticipate that having an impact on stabilized assets soon thereafter.”
CoStar notes three trend lines: big spikes in rent growth in cities such as New York and San Francisco are a thing of the past; vacancies are rising in select markets; and concessions are beginning to rise, also in select markets.
Cohen notes, “the demand side of the equation should look good as long as the economy continues to hold up, but we do expect concessions to pick up, rent growth to moderate and net operating income growth to also moderate.”
None of this, however, has slowed investor demand. Sales of “significant” apartment properties totaled $7.8 billion in July, presenting a 14 percent year-over-year increase, reports Real Capital Analytics. Initial demand has been for class A properties in core markets, but as RCA observes, tertiary markets have become hot, with sales activity up 31 percent year-over-year in July.
Strong demand has compressed national apartment cap rates to below 6.5 percent, and an even lower 4 percent in San Francisco and 4.1 percent in New York City, according to RCA.
This seems to be the crux of the matter for multifamily. Donovan says cap rates have flattened out, plus if investors need better returns, they can turn to B and C markets, or value-add strategies.
If you hedge your bets, consider Cohen’s observation: “Multifamily continues to be very popular. The problem is, investors are so in love with the sector it makes it hard to achieve the return hurdles.”
Steve Bergsman is a freelance writer based in Mesa, Ariz.