A new generation of multifamily apartment projects is under construction across America. Within the next year or two thousands of brand new properties will be competing toe to toe with single family landlords for tenants. Will investors be up for the challenge?
Soaring vacancy rates and rising rents have driven multifamily construction to the highest level in years. The nation’s apartment-vacancy rate in the fourth quarter fell to its lowest level since late 2001 In the fourth quarter, the vacancy rate fell to 5.2 percent from 6.6 percent a year earlier and 5.6 percent at the end of the third quarter, according to Reis. Increases will likely top the 10 percent mark annually for the next couple of years, according to John Burns of John Burns Real Estate Consulting quoted in CNNMoney last year. (See Rental Outlook 2012: The Good Times Roll on.)
Multifamily Construction Boom
The Multifamily Production Index, a leading indicator for the multifamily market released by the National Association of Home Builders (NAHB) last week, showed steady improvement in the apartment and condominium housing market for a sixth consecutive quarter. The index provides a composite measure of three key elements of the multifamily housing market: construction of low-rent units, market-rate rental units and “for-sale” units, or condominiums. In the fourth quarter of 2011, the MPI component tracking builder and developer perceptions of market-rate rental properties recorded an all-time high of 64.3, while low-rent units increased as well to 55.5.
“The apartment and condo sector continues to be a bright spot in the housing market, with the overall index at its highest level in six years,” said NAHB Chief Economist David Crowe. “The rental components have been the driving force behind the increased index level.”
In fact, developers have been slow to the respond to the rise in the rental market because of difficulties getting financing. The rental boom caught the multifamily sector and multifamily investors, who have been burned before by overbuilding in response to shifting demand, have been slow to respond.
“Capital is limited in this current market, and developers are having a difficult time obtaining the credit needed to finance the development of new apartments,” said W. Dean Henry, president of Legacy Partners Residential in Foster City, Calif., and chairman of NAHB’s Multifamily Leadership Board. If more financing becomes available the current pace of construction will not only continue but increase.
Should Investors Worry?
Are investors who are buying thousands of single family homes with plans to rent them out for as long as it takes for home values to appreciate prepared to do battle with the big boys?
A good case can be made that investors need not worry because single family rentals are a distinct category appealing to a different tenant market (see SFR: Birth of a Category). After all, single family homes offer indoor and outdoor space, privacy, yards, a sense of neighborhood, parking, security and feeling of living at parity with homeowners. Those plusses translate into a rental premium worth 8.7 percent more than apartments, according to Jon Pastor, CEO of Rent Jungle, the most comprehensive rental listing site on the web, who calculated that on his site 2 bed homes nationwide average $1,345 per month compared to 2 bed apartments nationwide at $1,237.
There’s no doubt that a certain category of tenant prefers the single family home lifestyle. But when new projects open with discounts and first month free offers, they will put pressure on local rents and that single family premium will increase. Will tenants pay 9, 10, 15 percent more to live in a former foreclosure rather than a spanking new apartment, or will single family landlords be forced to lower rents to compete if they want to keep their properties leased?
The multifamily boom is a work in progress and it’s too early to know what its impact on rental markets will be. Should financing become more available, it may become the biggest period apartment construction in decades. Moreover, rentals are very sensitive to employment trends and the overall national economic picture is so cloudy today it is hard to foresee where demand will be a year or two from now. Some maintain there’s no need to worry; there will be plenty of tenants to go around. Certainly demand is strong and supply is lacking. Reis reports that apartment cap rates have been falling since the third quarter of 2009, declining by 124 basis points to 6.4 percent last year, and have plenty of room . The near term rental outlook is promising. Rent.com reports that 45 percent of property managers are experiencing lower vacancy rates compared to 2010 and that they expect the median rent rate to increase 3 percent by the third quarter of 2012. Moreover, the number of concessions afforded to renters is declining. “I think the rental markets are still extraordinarily promising because what we’ve gone through will ultimately create more renters than owners as we go forward,” says David Crowe, chief economist at NAHB. But no one is making forecasts for three years or more from now, which also happens to be the period when the impact of the multifamily construction boom will be felt.
A History of Overbuilding
For investors, history provides reasons for concern. Time after time, apartment s have been built not just to meet, but to exceed demand. “The long time lags and large sums the developers spend to plan a project may create a bias to go forward with a project even if there is evidence that market conditions are weakening. Moreover, real estate lenders may sometimes be guilty of assessing the creditworthiness of a proposed development on the basis of current or recent past performance of the commercial real estate sector rather than a realistic projection of future prospects. Large fluctuations in commercial construction are, therefore, not surprising from a historical perspective,” wrote C. Alan Garner, a former assistant vice president and economist at the Federal Reserve Bank of Kansas City, several years ago.
Will history repeat itself? Will developers once again overbuild, drive rents down again and ignite fierce competition with single family landlords? Or will there be plenty of tenants for all? Every uptick in rents encourages more multifamily construction and hastens the day we’ll find out.