Yet another quarter has come and gone with supply exceeding demand, putting upward pressure on vacancy and moderating rent growth. And while most people in the market are coming around to the idea that demand isn't consistently exceeding supply any longer, that fact has not prevented apartment development from proceeding apace. And that's dangerous for newly completed properties.
Superficially, the data would seem to encourage development: Yes, supply is exceeding demand, but not egregiously so, and, therefore, vacancy is rising only slightly and rent growth is moderating, not declining. That all sounds benign enough. The problem is, this is what's occurring in the aggregate. Disaggregating these statistics, you find that the reality is far more daunting for the newest properties.
In order to see this reality, we must examine the vacancy rate for apartments by year of completion. For properties that were constructed between 1980 and 2012, vacancy rate by calendar year of completion falls within a very narrow range of just 130 basis points: 3.5% to 4.8%. Thereafter, vacancy increases in a nonlinear fashion, eventually reaching a roughly 57% vacancy rate for properties that have been completed through the first quarter of 2016 (see chart above).
Of course, to an extent, such a dynamic is normal. Newly completed properties require time to lease up and stabilize. However, over the past couple of years, the time it's taken for properties to stabilize has lengthened substantially and is now far greater than it once was.
It wasn't unusual in the past couple of years to see substantial pre-leasing of apartment properties and the stabilization of many properties upon completion or soon after. That's no longer the case. When supply exceeds demand, newly completed properties are forced to effectively pilfer tenants from existing properties. This process begins by offering concessions (which have been increasing) and then by lowering asking rents.
One of the key reasons rents don't decline in competitive environments like this (but rent growth slows) is that newly completed properties are expensive to build. Therefore, in order for the economics of these deals to work, they have to obtain asking rents that are far higher than the market average. This tends to have an inflationary impact on rents, even if newly completed properties are forced to settle for asking rents below their pro forma underwriting. This, of course, is partially offset by the increased competition forcing existing properties to lower their rents or, at least, moderate their rent growth expectations.
Newly completed buildings tend to have difficulty luring tenants away from other properties during times such as this because they tend to have the highest rents in the market; there's often little or no savings for tenants, especially considering the hassle and cost of moving.
Yes, the amenities in a newer building could theoretically be better, more varied, and so on, but in an environment such as today's, when rents are at record-high levels, that's still a tough sell. It's usually easier to entice potential tenants during recessions, when rents are falling and some people might want to trade up to a nicer building. The problem with this approach, though, is that it's often more than nullified by the tenants who are moving out during recessions, causing vacancy to rise.
Ultimately, it's better to develop properties during the early stages of a recovery period, when demand is on an upswing and supply growth lags the economic recovery. Development is more challenging later in the cycle. And we're currently very late in the cycle. By this juncture, more than seven years into an economic recovery, we'd usually be back in another recession, if not an altogether different recovery phase.
The properties arriving on the market today are doing so far closer to the next recession than to the previous one, and at a time when demand has seemingly hit a plateau and supply growth continues to accelerate.
As I’m fond of saying, the party in the apartment market isn't over, but these newly completed properties are arriving after all the punch is gone and all the popular people have already left.