Is There A Possibility Of A Bubble Developing In The For-Rent Apartment Housing Market?

by KC Sanjay, Senior Real Estate Economist, and Ron Johnsey, President, Axiometrics, Inc.

Generally, I do not see a bubble in the for-rent apartment housing market at this time but it is on the horizon with its arrival dependent upon the relationships between supply and demand and interest and cap rates for each apartment market.  This is really nothing new; this is a cyclical business after all.  The strong apartment market fundamentals over the past two years when coupled with low interest and cap rates has resulted in values improving substantially from the trough.

This Is A Good Thing…

While this has aided operators, investors, and lenders in recouping most of their losses from the downturn, it has also stimulated interest in the asset class, resulting in apartment prices being bid up for existing properties and making development more financially attractive.  This is a good thing.  However, this success over time often results in excess supply financed with higher levels of low interest-rate debt so when supply eventually exceeds demand and interest and cap rates inevitably rise, the value of the projects fall to as much as the debt or lower, potentially creating significant losses for the stakeholders if they have to sell or refinance a property.  In order to diminish this outcome, the stakeholders are banking on strong revenue growth, particularly in the early years of the holding period, and similar going-in and going-out cap rates.  This outcome can be mitigated.

I think a good part of the interest and cap rate risk can be constrained by the borrowers and lenders if they do the following:  1. Limit mortgage loans to 75% to 80% loan-to-cost and/or loan-to-value ratios to create a cushion when the down turn occurs.  2. Require debt service coverage ratios of at least 1.20 times to increase the borrower’s likelihood of making the mortgage payments when revenues decline.  3. Minimize the number of projects financed with interest-only loans; require loans to amortize, further reducing leverage.  4. Make loans with longer maturities at these lower interest rates to ride out the trough.  5. Work with experienced and financially strong borrowers.  6. Calculate property values using going-out cap rates based upon reasonable estimates of the risk premium and forward 10-year bond yield.  7.  Diversify loans by borrower, geography (markets and submarkets), and product to limit risk.  8. Base revenue growth upon forecasts taking into account that supply will eventually exceed demand, resulting in slower revenue growth and lower occupancy rates.

What’s Coming…

We expect the U. S. apartment market to remain strong until 2014 when supply exceeds demand, slowing down rent growth to 4.0% in 2014 and 3.0% in 2015 from a peak of 5.5% in 2012.  This is still good rent growth, especially considering occupancy peaks at 95.3% in 2013 and declines to 93.8% in 2015.  These results will depend upon the relationship between supply and demand and the renter’s wage growth.  If supply peaks at about 276,000 units in 2014, about 23% below the peak deliveries of about 355,000 units in 2007, and absorption is 114,00 units, occupancy falls to a still robust 94.7%.  With moderate job growth in 2014 and 2015 of about 290,000 jobs per month or 2.5% a year and continued strong renter household formation in the prime renter age cohort of over 350,00 per year on average, I believe the apartment market has the potential to deal with the coming rise in interest and cap rates and potential over supply.

Additionally, as the economy picks up, wage growth should as well, enabling renters to better pay the higher rental rates.  At the last peak, median wage and salaries grew at 3.6% in 2007 and 3.9% in 2008 before falling to around 1.1% in 2010 and 1.2% in 2011, according to the Bureau of Labor Statistics (BLS). However, in markets with large increases in rental rates, average annual pay has grown rapidly as well.  For example in Santa Clara County, the home of San Jose, average annual pay was up by 11.3% in 2010, the latest data published by the BLS, while rents increased also by 11.3% on average.  In the District of Columbia, average annual pay increased by 3.5% in 2010 and rents by 7.8%.  While there is a greater disparity between wage and rent growth in this market than in Santa Clara County, keep in mind that the 7.8% increase in effective rents is equal to a $113 per month or $1,359 a year versus an increase in annual pay of $2,717 or $226 per month, almost twice the increase in rents.

The chart above ranks the top markets by the difference between the value lost during the last trough and the gain since the recovery (on the bottom axis), according to NCREIF, against the cumulative forecasted revenue growth from 2012 through 2114 (on the left axis).  It shows that the asset bubble risk varies by market and is largely dependent upon our future forecasts of revenue growth, which have to be accurate to keep the bubble from bursting.  Except for New York, which results are impacted by the drop in value of the massively large Stuyvesant Town –Peter Cooper Village, the results are not surprising: the markets that have mostly recovered their values have experienced strong revenue growth since the trough and are forecasted to have the highest revenue growth over the next three years (the upper right quadrant).

And One More Thing…

For the markets near or already at their peak value, such as San Francisco, the Washington DC metro area, Denver, and San Diego, investors in these markets are relying more on higher revenue growth over their holding period to achieve their return requirement, which may be more difficult to achieve.  The markets located in the upper left quadrant are the ones where the values have not recovered back to their peak yet and are forecasted to have high revenue growth over the next three years before getting back to their peak and , hence, may not be in an asset bubble situation over this period.  In the lower right quadrant are the markets where values have mostly recovered to their peak but the future revenue growth is not strong.  The markets in this quadrant, Miami, Chicago, and Boston, maybe candidates for the asset bubble to burst.