Earlier this month, the Federal Reserve Bank released its most recent edition of the Summary of Commentary on Current Economic Conditions, also known as the Beige Book. The publication, which is issued eight times a year, is based on reports from the Bank’s 12 districts and includes insights into the state of commercial real estate across the country. Although the information is anecdotal, it provides valuable information that can add color to existing knowledge of where we are in this stage of the commercial real estate cycle.
Since mid-2015, the Federal Reserve and other regulatory agencies have expressed concern about the boom in commercial construction activity. Much of this concern has been focused on multifamily development in particular—especially the rate of increase in activity since the trough of the 2009 housing-led recession and financial crisis. Many economists and industry experts have joined regulators in signaling caution over the past few years, although those fears have not materialized yet—at least not on a national scale.
To help clarify the state of multifamily construction today and what to expect in the year ahead, we compared the Beige Book’s anecdotes with our own market intelligence to identify the indicators to watch in 2016.
The fundamental demand driver for multifamily development is job creation. Rather than focusing on the rate of change year over year to identify overbuilding risk, however, the industry should pay closer attention to the jobs-to-permits ratio to identify which markets may be overheating. While some developments will never materialize—only 70% to 80% typically come to fruition—the ratio is a valuable snapshot of demand and potential supply.
Most experts agree that a ratio of 5-to-1 for jobs-to-new multifamily permits is the threshold at which the threat of overbuilding exists. But industry watchers should begin to take heed even before the ratio sinks that low.
Within a particular market, think of the ratio as a baseball warning track telling the outfielder he’s about to hit a wall. When you leave the grass and feel dirt underfoot, it’s time to get your bearings and figure out how much more space there is to run.
Using this metric to assess multifamily construction across markets, it appears there has been overall strong support from a jobs perspective, although some geographic areas are definitely overheating.
The latest Beige Book also highlights concerns about multifamily rents and the ability to sustain continued growth in the year ahead. This is especially true for markets, like New York and San Francisco, that have seen increases of 8% to 12% annually over the past 18 to 24 months.
This may be the year that rents begin to signal that supply is catching up to demand and economic headwinds are taking their toll. It’s likely that rental growth rates will moderate in certain markets, which should be reflected in underwriting standards. Banks will likely emphasize the use of proven rents instead of pro forma rents with 5% or more annual escalations. In other words, new-supply additions and slowing economic growth will reduce the ability to raise rents at levels seen over the past couple of years.
Needless to say, higher vacancy rates are typically correlated with additions to new supply that reintroduce rent concessions when lease-up expectations aren’t achieved. What follows is downward pressure on rents in the market as the “weakest link”—that is, new projects not leasing to pro forma—dictates the rent trend. The 2015 national average multifamily vacancy rates of 4% to 5% are likely to rise this year to a range of 6% to 8%—especially in those markets with large new-supply additions.
It’s worth remembering the truism, “All real estate is local.” That’s especially important to consider as commercial real estate approaches this post–financial crisis cycle peak. The areas with some of the most robust construction activity can be the areas that are especially susceptible to overcapacity. Houston, for example, was a strong market for multifamily activity in 2013 and 2014 but is now experiencing a pull-back due to troubles in the energy sector.
The success of multifamily developments will vary not only by city, but also by submarket or neighborhoods within a particular MSA. As supply increases, demand in one neighborhood can remain higher than demand in surrounding areas due to factors such as proximity to public transportation or employment centers. Even in markets that are technically overbuilt, there will be opportunities for multifamily development to succeed.
It’s important at this stage in the cycle not to generalize all of a market as overbuilt. The old adage about “location, location, location” is never truer than when a market cycle moves from expansion to overcapacity. The winners and losers in the next stage of the cycle (recession) are usually distinguished by quality of location and, then, “staying power” (which entails having capital backing to weather the downside of the real estate cycle).
What to Expect in 2016
Commercial real estate should have another productive year in 2016, although more disciplined monitoring of metrics will be important. New multifamily construction activity will be met with greater scrutiny in certain markets. Many lenders are already exhibiting more caution and discipline in response to the slowing U.S. economy, energy volatility, and anemic growth worldwide.
The Beige Book’s insights are valuable; however, the broader takeaway is that we’re late in a commercial real estate recovery and expansion cycle. As a result, there may be some friction between credit discipline and the need for growth. Those in the industry who do their homework can avoid repeating the mistakes we’ve learned from in the past by focusing on fundamentals and watching out for that warning track.
If you’re not currently monitoring a jobs-to-permits ratio market by market, you should be; it’s your early-warning indicator.