Where We Are in the Multifamily Development Cycle
By Scot Eisendrath, Managing Director
Most apartment developers are keeping very busy. There are cranes in the sky and it’s hard to find a general contractor, architect or other service provider without a backlog of business. There is chatter about too much supply, overbuilding and potentially reaching the peak of the current cycle. The fact that the second quarter of 2016 marked the fifth consecutive quarter where new multifamily supply exceeded net absorption of new units (per research firm Reis, Inc.) supports that fact.
There is also the alternate view that favorable demographic trends and fairly stable market fundamentals for the multifamily sector are laying the groundwork for an extended run for the apartment development cycle. Let’s look at some key trends that support that hypothesis.
Average apartment completions in the U.S. over the past 20 years have been roughly 250,000 units per year (see graph #1). Average apartment completions in the U.S. since 2010 have averaged approximately 200,000 units per year. While there is significant construction today, most of that is “catch up” for a period when the U.S. was undersupplied by 350,000 units based on historical averages. That does not take into account population growth over that period of time, as well as demographic changes that have led to a nation that favors renting over owning a home.
Consider Phoenix, a market that in past cycles has been plagued by over-supply, where we see very similar dynamics. In Phoenix over the past 20 years, apartment completions have averaged approximately 5,700 units per year, but since 2010 the average has been about 3,200 units per year. So, based on historical averages, Phoenix has been undersupplied by about 15,000 units (see graph #2). Again, these numbers don’t fully account for the phenomenal population growth (#4 in the nation in 2015, adding 370,000 new residents since 2010) and superior employment growth (#2 in the U.S. for 2016 at 3.2%) that Phoenix has experienced.
And while there is significant supply in the pipeline, apartment deliveries are projected to peak in 2016 or 2017, which is evidenced by a slowdown in permitting activity over the past couple of quarters. This slowdown in permitting is likely related to tightening credit, which is discussed further below.
As noted above, over the last few quarters the supply of new units has outpaced demand. However, the vacancy rate has only risen slightly, and is still at a very healthy 4.5% nationally as of the end of the second quarter (having risen from a low of 4.2% in the second quarter of 2015, according to Reis, Inc.) In addition, while rent growth appears to be slowing, we are still seeing solid rent increases, including 4.1% in the first quarter of 2016 compared with the prior year, according to Axiometrics, Inc. The fact that rents are still increasing and we are not seeing declining or flattening rents yet is of course a positive sign and illustrates the strength of multifamily demand.
There are factors at work driving apartment demand. A primary driver of apartment demand is job growth, and our economy has been producing in excess of 200,000 jobs per month. Second, because of the recovery in the general economy, household formation has been strong, averaging over a million new households per year. Third, and we don’t want to beat a dead horse, but millennials are a huge population cohort and many are renters by choice. That’s because of student debt loads, a desire for mobility and other factors; many will likely continue renting later into their adult life than earlier generations. That’s borne out by the data –we’ve become a renter nation with a homeownership rate that has fallen from above 69% in 2004 to a recent 62.9%. With roughly 125 million households, that’s more than 7 million renters that have been added to the U.S. rental pool in just over a decade.
Financing and Regulatory Pressures
There have been recent regulatory factors affecting construction financing that has made it much more difficult for developers to get loans to fund development projects. While 12 months ago construction loans with 65-70% leverage and limited recourse were commonplace, developers today are faced with a tightening credit environment demonstrated by more loans with leverage ratios of 50-60%. Because of more stringent post-recession banking regulations, in particular High Volatility Commercial Real Estate (HVCRE) rules, which affect regulatory capital requirements for lenders for higher risk construction and development loans, lenders’ appetite for construction loans has been diminished, leading to higher interest rate spreads, and lower loan levels relative to total construction costs, making financing apartment developments costlier. This may lead to good projects that are in the planning or proposed stages never getting built, which will also regulate supply in the short term.
Surplus of Luxury Apartments
If you take a close look at the new supply being delivered, it is highly concentrated in the Class-A, high-end luxury segment, and located mostly in downtown urban locations. The fact that land prices and construction costs have increased significantly over the past couple of years, coupled with increased, more complex and costlier government regulations, the only apartments that can really be delivered economically are Class-A. This has created oversupply in one segment of the market and undersupplied the balance of the market. In fact, according to Costar, the June 2016 vacancy rate in Class-B apartments is 3.3%, while the vacancy rate in Class-A apartments is 6.7%. While it is difficult to build affordable apartments in today’s environment, there is definitely pent-up demand outside of the downtown urban cores and a need for more choices for renters at different price points.
In conclusion, while we have had a few good years in the multifamily development arena, it appears we have solid market fundamentals and positive demographic trends to support extending the current multifamily cycle for a couple more years, especially as to Class-B and suburban apartments.
Scot Eisendrath is Managing Director of Pathfinder Partners, LLC. He is actively involved with the firm’s financial analysis and underwriting and has spent 20 years in the commercial real estate industry with leading firms. He can be reached at email@example.com.