First, a story torn from the history books:
“In 1593 tulips were brought from Turkey and introduced to the Dutch. The novelty of the new flower made it widely sought after and therefore fairly pricey. After a time, the tulips contracted a non-fatal virus known as mosaic, which didn’t kill the tulip population but altered them causing “flames” of color to appear upon the petals. The color patterns came in a wide variety, increasing the rarity of an already unique flower. Thus, tulips, which were already selling at a premium, began to rise in price according to how their virus alterations were valued, or desired. Everyone began to deal in bulbs, essentially speculating on the tulip market, which was believed to have no limits.” See Investopedia
Are seeing a bubble forming in the multifamily market? Are apartments prices behaving like tulip bubble? My assertion is we are not likely to see a bubble in the multifamily market in 2014. With the caveat that predictions beyond a year tend to be susceptible to error, the next several years appear to continue the gilded age of multifamily.
To answer our question of the day lets look at the definition of a speculative bubble provided by Robert Shiller in his must read book Irrational Exuberance:
“A situation in which temporarily high prices are sustained by investors’ enthusiasm rather than consistent estimation of real value.”
So we will now turn to the three prongs of the definition to reach our conclusions:
1. Are Prices Temporarily High?
The best way to compare apples to apples across the US multifamily market is to evaluate cap rates. The cap rate is simply the net operating income divided by its value. Consider the following chart:
Cap rates and pre-recession price per unit seem to look like 2006, so we can say it appears the market looks frothy by the look of the chart- but is that enough to state we are in a bubble? Lets turn to investor expectations to delve into why that is not the case.
(Side observation: I would argue that commercial lending standards keep a higher level of sanity in commercial real estate. Loan to value maximums in the 75% to 80% range and debt service coverage ratio of 1.2 times. I decline, however, to declare any market with human participants strictly driven by rational behavior.)
2. Are Investors Overly Optimistic?
Trying to judge the rationality of investors is an interesting endeavor. We know from the Urban Land Institute’s (ULI) annual economic survey that we see optimism for multifamily across the board the 2013. But is the optimism OVERLY optimistic? Only time will tell but lets look at some of the signals we are trying to read from the demand side and competitor supply side to gauge the appropriate level of exuberance.
Household formation stats show pent up rental demand through 2016
“Shocking new data reveals that of the 5.5 million new households that will be formed between now and 2016, an estimated 3.8 million, or nearly 70% , will be renters , not homeowners according to Jeffrey Friedman, CEO of apartment REIT Associated Estates Realty (Nasdaq: AEC ).” See Renter Nation
On the supply side we see construction permits still below historical levels:
“My view is that we are nowhere close to a bubble in the multifamily industry. Last year, we only had 233,000 five-plus multifamily unit starts, and that’s well below the average we did in the past 10 years, when production was very stable. It was really close to 300,000 units. We haven’t even gotten back to that level. I think if you look at the demand levels, we can justify at least 300,000 and perhaps as many as 350,000 to 400,000 multifamily units going forward, to cover pent-up demand, ongoing demand, and the loss of stock that comes in the wake of a hurricane or older buildings deteriorating. Nationally, we’re a long way from meeting the level we need. Permits are higher, so that may be an indication that we may be picking up the level of new construction. And demand is certainly higher now than it was before.
— Mark Obrinsky , vice president of research and chief economist, NMHC”
3. Is There Basis for Current Estimations of Value?
Indeed when we look to the ULI consensus forecast we find evidence of market equilibrium. The long-term average rental vacancy rate is 5.3 percent. The consensus forecast for 2013 is 4.9% with a stable 5.2% for both 2014 and 2015 projected. The e long-term average rent growth is 2.7 percent. The 2013 through 2015 forecast appear inline with that rate.
So overall, absent a black swan event (unforeseen major shock) the multifamily market is quite healthy. So what do you see? Anything cause you to disagree with my findings that apartments are not tulip-like for now?
Post Script: For a great read on the the history of market meltdowns see This Time is Different by Reinhart and Rogoff.
Photo: La Citta Vita