Analysts Ponder Apartment Sector Peak

It appears that many real estate market analysts are at odds over whether the apartment sector has reached its peak. Vacancy declines have slowed and rent increases are …

It appears that many real estate market analysts are at odds over whether the apartment sector has reached its peak. Vacancy declines have slowed and rent increases are stagnating due to halting economic growth, but experts who have an optimistic view of apartment fundamentals say those indicators aren’t occurring in a bubble and that when viewed over the long term is shows that growth potential is still very strong. That said, it must also be noted that many apartment completions are coming online and absorption may not keep pace with supply, at least in the short term, which may further slow rent growth. For more on this continue reading the following article from National Real Estate Investor.

With vacancy declines slowing to a crawl and rent increases constrained by meager wage growth, market observers are wondering whether apartment fundamentals have peaked. This formulation is imprecise, incorrect and fails to capture the changing dynamics of the sector. 

Vacancy declined by 10 basis points during the third quarter to 4.2 percent. Although vacancy compression has clearly slowed over the last couple of years, the decline of 10 basis points does represent a slight acceleration versus last quarter when vacancy was unchanged.

Over the last four quarters national vacancies have declined by 50 basis points, on par with last quarter’s year-over-year decline in vacancy. More so than the magnitude of the vacancy compression, the simple fact that vacancy continues to compress despite such low vacancy rates and steadily increasing supply growth suggests that demand for apartments remains strong. The national vacancy rate now stands 380 basis points below the cyclical peak of 8.0 percent observed right after the recession concluded in late 2009. 

Supply ramps up; demand remains strong

Almost four years removed from the advent of the apartment market recovery, demand for apartment units remains robust. The sector absorbed 41,283 units in the third quarter, well outpacing absorption from the same period one year ago, and up 22.7 percent from the 33,634 units that were absorbed during the second quarter. Year to date, the sector has absorbed 20.1 percent more units in 2013 than were absorbed through this point in 2012.

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Part of what is driving healthy absorption figures is increased construction activity. A total of 36,269 units came online in the third quarter, an increase relative to last quarter’s 28,891 units and the 21,237 units that were delivered during the third quarter of 2012. This is the highest level of quarterly completions since the fourth quarter of 2009. As Reis has predicted for the last two years, we are on the precipice of the relatively large surge in new supply that most market participants have been anticipating, given strong fundamentals and the relative availability of financing for speculative multifamily building projects. We continue to expect roughly 125,000 units to be delivered in 2013 in Reis’s top 79 metropolitan markets.

But rising completions will not bolster absorption figures if new projects come online mostly empty; nor will absorption be as strong if new apartments poach tenants from older buildings. The fact is that most new buildings coming online lease up to 85 percent occupancy or higher within six to 12 months. Furthermore, absorption remains higher than completions, indicating that new projects aren’t leasing up at the expense of older buildings.

Asking and effective rents both rose by 1.0 percent during the third quarter. This is a slight increase relative to the second quarter when asking and effective rents both grew by 0.7 percent. Nonetheless, rent growth remains below the quarterly average from 2012. In previous business cycles, rent growth would be well above 4 percent once vacancies declined to the low 4s, but the slow economic recovery is hampering landlords’ ability to raise rents and further reduce concessions.

In the midst of rising supply growth, and against the larger backdrop of a single-family housing market that has been recovering for the last six to seven quarters, apartment demand remains strong. Rent growth is not as strong as analysts might expect, given the relative tightness of the market, and it is in the area of landlord pricing power where cracks are appearing in the sector’s seemingly impregnable façade.

Apartment outlook

Apartment fundamentals have by no means “peaked”—if by “peaked” one is to expect some form of sustained decline in occupancies or rents in the near future. Reis expects vacancies to begin rising slightly, starting next year, as supply growth ramps up even more. But our five-year forecast suggests that national vacancies will remain in the high 4s to low 5s, hardly presaging a market “decline.” Rents will continue to grow, albeit at a slower pace: 2012 appears to be our peak year for rent growth during this cycle, unless job formation accelerates, thereby stimulating faster rates of household and income growth. Without appreciably higher levels of economic and demographic performance, landlords will be unable to pass on rent increases to tenants earning higher wages. 

Still, some investors are considering the timing of exit strategies given their exposure to multifamily. The Carlyle Group has indicated their intent to sell part of their $2.3 billion apartment portfolio, in light of concerns about rising supply and constraints on rent growth. 

Demand for apartments remains robust, but deals that trumpet going-in cap rates below 4 percent may look less appealing given moderate rent growth and flat lined occupancies—particularly if cap rates are expected to increase in the next two to five years, in line with rising interest rates.

Brad Doremus is senior analyst and Victor Calanog is head of research and economics for the New York-based research firm Reis.


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