Without question, the apartment market outperformed all expectations in 2010. Occupancy levels recovered fully, returning to normal as the year closed.Effective rental rates rose on a year-over-year basis for the first time since 2007. Cap rates plummeted as investors jockeyed to take advantage of the good news, in turn lifting apartment values sharply.
Yet all this hoopla occurred against the seeming headwinds of sluggish employment growth and stunningly affordable home purchase options—including still-lower home prices and remarkably low mortgage rates subsidized by the Fed's efforts to keep long-term interest rates down. Which begs the question: Is this seemingly unsustainable boom in fact not sustainable? Can the apartment market continue to “defy gravity” again in 2011?
Understanding 2010
Although last year's rental demand was fueled almost entirely by record levels of leasing in the first half of the year, absorption sputtered during the second half.Despite this, 2010 was the secondbest year for leasing in the past 16 years. While occupancy levels firmed up mostly at the top of the market, the improvements were widespread, reaching all classes of apartments across most markets.
The power behind this recovery came from two sources. First, more than 60 percent of the jobs added in 2010 were filled by young adults, as 20- to 34-yearolds' employment count rose by 875,000—a stark contrast to the loss of 2 million young-adult jobs in 2009. A strengthening U.S. economy should provide more job opportunities for young adults in 2011. This segment is vital to the apartment business, since most young adults rent, and a preponderance of those renters choose apartments.
Second, despite low house prices and low interest rates, the U.S. homeownership rate fell to 66.6 percent by year's end. While some owners became renters through foreclosure, other potential buyers simply sat on the sidelines, waiting for a less volatile housing market and more certain job market. The “premium to buy,” or rent/buy spread, is now close to zero, as the monthly cost of homeownership fell and rents began to rise. As the economic recovery gains momentum, however, mortgage rates (and therefore house payments) are likely to escalate through 2011, a trend that should make homeownership less affordable, thus benefiting rental demand.
Building Boom
All this good news in leasing and property values has not been lost on developers and their capital providers. Multifamily construction has clearly bounced off the bottom, as low cap rates in many markets created a profitable margin for new development.
Consider that construction lenders have begun to ease their underwriting standards—though they are still far from 2007 norms. In light of these positive indicators, the 2011 forecast for rental apartment starts should hit 150,000- plus units, with further increases likely in 2012 and beyond. Sharply higher than 2009 and 2010, this year's starts should slightly exceed replacement levels, as the market loses around 120,000 existing units in an average year.
For now, further confirmation of a firming market is found in two quarterly indices recently released by the Washington, D.C.–based National Association of Home Builders (NAHB).
Multifamily Production Index (MPI). Tracking developer sentiment about new construction on a scale of 1 to 100, the MPI is currently at 40.8, up more than five full points since the previous quarter and the highest reading since the fourth quarter of 2006. The MPI component tracking developers' perceptions of market-rate rental properties reached 51.7, the first time this figure has surpassed 50 and gone into “improving” territory since the second quarter of 2007. (In this index, any number above 50 indicates that more respondents rated conditions as improving rather than declining.)
Multifamily Vacancy Index (MVI). This index shows similar reason for optimism, declining recently to 33.3, the lowest number since the third quarter of 2006 and at half the rating of a year and a half ago. (In this index, readings below 50 indicate declining vacancies.)
Historically, the MPI and MVI have performed well as leading indicators of U.S. Census figures for multifamily starts and vacancy rates, providing information on likely movement in the markets one to three quarters in advance. Translation: The apartment market seems to have turned the corner after struggling heroically in 2008 and 2009.
Going forward, the key drivers are lining up for a great 2011 performance. More jobs plus ongoing fear of homeownership bode well for leasing. Still, one of the biggest questions facing the industry is if (or when) new construction might derail the recovery.
Back in the dark days of October 2008, the Witten Advisors forecast anticipated we'd be in “heaven in 2011.” While that was perhaps hyperbole, the apartment industry is certainly positioned in 2011 for its best year since the mid-2000s—and a far cry from the deep doldrums of 2008.
Ron Witten is founder of Witten Advisors, a Dallas-based multifamily market advisory firm that helps investors, owners, and developers anticipate future performance in 42 U.S. markets.
