Lucky stars: saga of a bull market

Predictions of rising vacancy rates and slower rent growth failed to materialize this year, adding up to continued good times for the apartment business.


“The apartment industry hasn’t looked this good in some time,” said Jeff Adler, VP and general manager of Yardi Matrix during an interview with MHP in July. Yardi Matrix is a business development tool used by Yardi Systems, Inc. that delivers real-time market intelligence on multifamily properties in 100 markets around the nation. Moreover, Yardi Matrix sees no signs of a slowdown anytime soon, thanks to demand from millennials and other favorable demographic trends that pushed monthly rents in Q2 to a national record average high of $1,150, up 6.3 percent year over year. In fact, according to Matrix Monthly, a report developed out of Yardi’s acquisition of Pierce Eislen in 2013, rent growth, which has been above trend for several years, actually accelerated.

While at least some of the quarter’s rent growth can be attributed to the traditionally strong spring leasing season, increases of 1.3 percent month over month and 2.9 percent over the past three months, compared to 1.1 percent and 2.3 respectively in the same periods last year, represent the fastest rent growth in several years.

“It appears that we are in a demand/supply situation where, except for a few submarkets at the very high end, demand remains very strong. And, if you look at the bulk middle of the market, where there isn’t much additional supply coming online, jobs are still being created and additional households being formed by the sheer numbers of millenials, so there is a shortage in that $1,000 to $1,200 per month rent mark where renters earn 36k to 40k per year,” said Adler.

Rent growth is spread across all markets nationwide, but the Western and Sunbelt markets continue to dominate the charts while the Mid-Atlantic is the weakest. For the month of June, Portland topped Yardi’s 100-market radar with 15.1 percent rent growth. On a year-over-year basis year to date, Portland posted 11.7 percent rent growth, topped only by San Francisco with 12 percent rent growth, which fell slightly in June to 11.6 percent. San Francisco and Portland are two of five cities where rental growth outpaced growth in home values, according to Zillow. Others include Kansas City, Boston and Cincinnati.

Adler noted several Q2 market surprises. “We thought Portland, Denver and Seattle would do well, but they outpaced our forecast. And our prognosis for Sacramento was 9 percent, instead of 9.8. These markets are benefitting from San Francisco spillover, which is basically a Manhattan-type level market,” he said.

Even cyclical markets like Phoenix, Jacksonville and Orlando have done well, as have Austin and Houston, while facing new supply. Typical laggard markets in the Northeast and Midwest also produced surprising growth. “Historically, Southern and Western markets, which benefit from emerging intellectual capital nodes, better business climates and weather, have very strong demand and, in the past, anytime there was rent growth, a resulting flood of supply would crush it. We are not seeing that to the same extent because the demand response has overwhelmed the supply response,” said Adler.

But wages have not kept pace with rent increases, causing pain for the majority of renters, more than one in four of whom spend at least half their family income on housing and utilities, according to data from the Census Bureau, which also finds that the number of such households increased 26 percent to 11.25 million since 2007. This means that more of renters’ incomes must be dedicated toward housing instead of savings, forcing more people to forego buying a home while feeding into the demand for rental properties that pushed up rents in the first place.

How long can these levels of rent increases continue? Will we see concessions generated by an added level of supply, or will affordability issues arise as owners bump up against renters’ ability to pay rapidly rising rents?

Axiometrics, a Dallas-based apartment market research firm, believes that at this point in the cycle, affordability will become an issue in some markets and that high rent growth levels are unsustainable in others.

But Adler remains more bullish.

“Some reports we’ve generated suggest that if you are in a city with wage and population growth from one to two percent, you can support three to six percent rent increases. I don’t know how long 12 or 13 percent rent increases can continue in some of these extraordinarily hot markets, but the funny thing is, as we look at this at an aggregate level, the income-to-rent ratios point to the fact that there seems to be sufficient income growth, plus an income-to-rent ratio cushion in most secondary cities—not the sexy six, however—to absorb or fund higher rent growth. I think we might even continue to see those 13 percent increases for the next few years, until ratios move up, then, leveling to three to six percent on an ongoing basis,” he said.

Owners and operators will have to prepare for a shuffling of renters who reach their rent-to-income limits and must move down a grade to alternative housing in order to make things work.

“But I don’t think you’ll see a lot of discounting in any growing market, although there could be some concessionary activity in markets like Charlotte, Raleigh and Austin through lease-up as new supply comes online next year.

“As far as a percentage of stock, nationally we are delivering right around three percent. Charlotte, Austin and Raleigh are delivering around eight percent of stock and will be going through a bit of a rough spot, but population and jobs are growing at about four percent annually there, so overall that stock is still getting sucked up pretty quickly,” said Adler.

Reloading development

Effective nationwide occupancy of more than 95 percent, although varying from state to state, is also something that hasn’t been seen in anyone’s memory, said Adler.

While single-family starts are well below their annual average for the past 20 years, multifamily starts have surpassed their pre-Great Recession annual average. However this is still nowhere near the number needed to fill the demand from the growing number of renters created since the housing bubble burst. Freddie Mac estimates a shortage of  1.5 million multifamily units and Axiometrics believes it could take from nine to 13 years to make up for the units that were not built because of the Great Recession.

If you are a developer, you are reloading your development pipeline, says Adler, who thinks 2015 is a peak year for deliveries, with 277,000 units expected to come online, compared to 217,555 units in 2014.

“We’ve run some numbers on this and I think we will continue to deliver right around this level for several years, although the margins are thinner and the risk is higher because everyone knows we are in a mature market—the 6th or 7th inning in a game that’s going extra innings—not at the early stages. Anyone who has been in the multifamily business for any length of time is scared out of their minds knowing this can’t go on,” he said.

Most development is targeted towards the lifestyle renter. “We thought there would be a rotation and that demand would slack off at the higher end and, as new supply delivers into those markets, we would see a rotation to the renter-by-necessity in the $800 to $1,200 monthly rent who doesn’t have the disposable income to choose to own. But job formation at the upper end has been robust, concentrating in centers of demand stronger than we anticipated,” said Adler.

“Like the man who was asked why he robbed banks said, ‘because that’s where the money is,’ developers have little choice when it comes to where they build,” said Adler.

Because of the high cost of land, the cost to develop and some of the cities’ zoning changes, developers can’t make a new development pencil without charging at least $1700/$1800 a month in rent or $2000/$3000 or more a month in the more expensive markets. Add in greater banking regulations and capital requirements and the result is that today’s level of leverage in the developers’ capital stack is more restrained. While the somewhat low level of lending is increasing and credit terms are loosening, overall market conditions make it nearly impossible to get a loan on pro forma. Developers are at 65 to 70 percent total cost, which is hampering the level of supply response, said Adler.

“If you are a workforce housing developer, it’s not going to happen unless the land is free or donated because affordable housing tax credits are not sufficient to keep up with demand,” said Adler.

Lifestyle renters make up only about 20 to 30 percent of the renter population. Adler points to a study by Stephen Klineberg, Rice sociology professor and co-director of the Kinder Institute for Urban Research, that shows that from 1949 to 1979, income grew at the same rate across all income classes. Since 1979 however, income growth has been going to people at the upper end, primarily those who have access to a quality education and are involved in the technical or related fields.

“Technology, software, robotics… these industries are paying well and renters in these sectors are forming households and supply is getting absorbed. If you do not have access to a high quality education and are locked out of a field that has the capability to earn a good salary, you are hurting. To a certain extent, if you are in a city that is doing well, you can be in the service sector and glean increases in compensation, but you will pay for it in rent because rent is increasing faster than wages, particularly on the low end in major cities,” said Adler.

The bulk of renters are in the middle and another 20 percent are at the lower end. Workforce housing makes up the majority of the rental housing stock and that stock is being acquired and renovated by private entrepreneurs—value-added players who are upgrading the older assets to compete effectively with the newer properties.

American dream deferred

While rental supply continues to grow, eventually it will move to the suburbs or close-in urban submarkets where opportunities still exist, because the urban CBDs have already been built out, says Adler. And, despite reports to the contrary, Adler says the American Dream of having children and owning a home is still very much alive among Millennials, merely deferred longer compared to previous generations.

“Today they are choosing a lifestyle that puts them in the center of everything at the expense of owning a car, giving up mobility for a lifestyle predicated on a safe urban environment.

“One thing people forget is that reduction of crime since 1991 in urban centers of the U.S. has been dramatic and has created the environment to revitalize urban downtowns, but in the last six months there have been indicators of an increase in violent crime in urban centers such as Baltimore and New York, said Adler.

To advise its investment clients, Yardi looks at specific fundamentals that foster growth, such as concentrations of commercial capital, taxes and infrastructure investment. At least one third of the factor weighing in towards a positive investment in any multifamily market is weather. Civic leadership also is important, as are incentives to support the creation of intellectual capital, like start-up credits, infrastructure and the existence of an urban transport system. Are there cultural institutions and other amenities that support retention of talent? Also extremely important is the cities’ will to maintain effective policing.

“Some cities in the Midwest and Northeast aren’t making the right choices in investments and have done little to create or foster commercial capital nodes and they will struggle. When I talk with investors, I explain that they need to have a reasonable assumption of where values will go in the future.  The big question today is what will happen in ten years when Millennials have their second child,” Adler said.

He expects in the next decade Millennials will no longer be core-dependent. They will move to the close-in suburbs that have become urbanized by developers who focus their activities on reclaiming environments that are not downtown, making school districts more important. Boomers will fill in the urban gap in the CBD.

Developers already have started the march towards the suburbs, creating urban environments just outside major cities with mixed-use, transit-oriented projects that offer renters all the amenities of the CBD within walking distance of their apartment home.

One such project currently leasing in the East Bay submarket of Walnut Creek, just miles from downtown San Francisco, is the 126-unit Ascent Walnut Creek, one of several properties totaling 1,000 units that Mill Creek Residential is building in select Bay Area locations. For those renters who work in downtown San Francisco, transportation via BART is within blocks of Ascent Walnut Creek, while professional jobs with companies like Wells Fargo Advisors, Global Capital Markets and Fidelity Investments, as well as a number of retail shops and restaurants, also are within walking distance. The property offers a host of lifestyle amenities like valet laundry services, a fitness studio and numerous community hang-out spots that are important to Millennials.

Adler thinks another recession is guaranteed, but when it will happen is anyone’s guess. “For now, we are still at the sweet spot. Any of us who have been around the apartment industry for some time are waiting for something to go wrong. Meanwhile, we’ve never seen anything go this right for this long and we’re waiting for the roof to cave in and we can’t believe our good luck,” he said.