At the beginning of a panel discussion at the ULI Fall Meeting in New York City, a moderator asked the audience to raise their hands if they thought the apartment business was headed for a bust. At the end of the session, the moderator asked the question again—and the number had doubled.
“When we started, we had one person who expected a bust in the apartment business. Now we have two,” said John J. Healy Jr., principal, Hyde Street Holdings, and moderator of a session on multifamily rentals at ULI’s Fall Meeting in New York City.
Panelists were mostly positive for apartments, though the future is filled with both pitfalls and opportunities as apartment pros try to take advantage of strong demand for apartments, while avoiding overbuilt markets and paying too much.
Demographics Push Demand for Apartments
Demand for apartments is likely to be very strong as economic recovery progresses in the United States, partly because of huge pent-up demand for apartments from young people who put off moving into their own apartments while unemployment was high and are likely to do so as the economy improves. The percentage of 18- to 34-year-olds who live with their parents was 32 percent in 2012, up from 25 percent in 2005, according to an analysis by data firm RCLCO. In addition, marriage rates are significantly lower among young people, as they put off getting married until later in life—a trend that began long before the Great Recession.
Both trends bode well for the multifamily housing business. These young people are likely to eventually form households—and if they are still single when they do, they are likely to rent apartments rather than buy single-family homes. Factors like these will support demand for multifamily housing of more than 400,000 units a year from 2015 to 2017—compared with the average of just 296,000 apartments completed a year from 2012 to 2014.
“Unless construction increases well above [today’s levels], we are not facing a bubble,” said Charles A. Hewlett, managing director for RCLCO. “We’re not even meeting the structural demand.”
Trouble in D.C.
However, some markets are almost certainly threatened by overbuilding. In Washington, D.C., for example, developers are expected to finish 5,277 apartments in 2014—a 5.7 percent increase to the existing inventory. The new supply of multifamily housing comes after developers finished 2,757 new apartments in 2013—which seemed like a lot at the time and pushed the vacancy rate in D.C. up to 5.2 percent, from 4.4 percent the year before.
“Do you think Washington can absorb that much and maintain vacancy rates that low?” asked Victor Calanog, vice president of research and economics for data firm REIS Inc. Calanog said he does not, and his firm expects vacancies to rise again.
But even in D.C., rising vacancies have left the market relatively healthy. “The very worst thing [so far] that has happened is rents have plateaued,” said Toby Bozzuto Jr., president, the Bozzuto Group. “In Washington, people are renting and buying.” Overall, developers on the panel expect rents to briefly dip in the District, before the new units are absorbed. Once the current wave of new apartment crests over the next year, completions of new apartments in D.C. will taper off.
“In 2009, it was the only market that was growing—since then we have all moved out,” said Thomas W. Toomey, president and chief executive officer, UDR Inc. “The next markets to worry about are probably Dallas, maybe Austin.”
Paying Too Much?
Experts also worry that if the prices of apartment properties don’t stay high relative to the income from the properties, investors may have trouble when it comes time to exit or refinance their properties. Interest rates will eventually rise, pushing up yields. Canalog pointed out that if an investor buys an apartment property at a capitalization rate of 3 percent and has to sell five years later at 7 percent, the net operating income from the property would have to increase by 16.2 percent just to provide an internal rate of return to the investor of 3 percent.
“It’s a concern,” said Richard L. Boales, senior vice president, development, Equity Residential. In some cases, the danger of overpaying for properties is enough to keep real estate investment trusts (REITs) from buying. “We don’t mind waiting out cycles,” says Boales, though Equity has not yet stopped acquiring property.
The Bozzuto Group also is willing to step back from development and acquisition if the number don’t work. “We are structured so the fees cover our overhead, so that we don’t have to develop,” said Bozzuto. Though—once again—Bozzuto still has projects underway in the current environment.
Other developers take comfort in the prediction that the replacement cost of multifamily properties is likely to rise by 20 percent over the next five years—which will help support asset prices, according to UDR’s Toomey. Also, most multifamily REIT stocks have traded at values close to their net asset value, showing that the stock market, at least, has some faith in the value of their properties.