Ryan Severino

Is the party over? The apartment market has been on an exceptional run for the past four years. A for-sale housing market in tatters, a weak recovery in the labor market that created mostly middling jobs for young workers, and benign supply growth all conspired to create a significant recovery in the apartment sector. However, the landscape is already changing. The for-sale housing market is finally showing some signs of life after a prolonged downturn, but the main risk to multifamily’s good fortune stems from an increase in apartment construction activity rather than single-family competition.

Construction activity has been slowly increasing over the past few years, but that went largely unnoticed due to the strong demand for apartment units. New completions in the top 82 markets in the country averaged just 10,623 units per quarter in 2011 and 19,585 units per quarter in 2012. Over the first three quarters of 2013, however, new completions averaged 27,411 units per quarter. This is the highest quarterly average since 2009, before the construction spigot was tightened in the wake of the recession. With net absorption continuing to exceed new completions, vacancies are continuing to fall while rents are increasing, creating a widely known narrative about the ongoing strength in the apartment market.

Yet, forecasts show that the tide is going to turn, sooner rather than later, and this will require a change in behavior on the part of investors for the next few years. In fact, construction is going to increase not only relative to recent history, but also relative to longer historical trends. New completions in the top 82 markets for 2013 are expected to total roughly 124,000 units. This is on par with the long-term historical average of roughly 120,000 units per year. However, for 2014, new completions are expected to total about 164,000 units, well above the historical long-term average.

Although demand for apartment units will remain rather robust, it is unlikely the market will be able to absorb this many units, causing vacancy to increase. This would represent a pronounced change from the past four years, when vacancy was compressing rapidly as demand far outpaced a subdued level of new completions.

Top Metros Will See Biggest Increase
On an absolute basis, the construction increase won’t be uniform across metro areas; instead, it will be rather concentrated. Construction activity in the top 10 metros (ranked by the number of new completions) should constitute roughly 44 percent of total construction in 2014. The biggest increases will occur in the major Texas markets—Dallas, Houston, and Austin. While it is well known that these three are among the fastest-growing markets in the country, it is improbable that they’ll be able to absorb all of the new projects slated to come on line next year. That’s why the vacancy rate in each of those markets is projected to increase in 2014.

Charleston, S.C.; Austin; Raleigh–Durham and Charlotte, N.C.; and Denver, too, are all expected to have inventory growth in excess of 4 percent in 2014. Not surprisingly, all are expected to have vacancy-rate increases next year. Beyond 2014, construction activity is expected to moderate, with average annual construction during the 2015–2017 interval falling below the long-term average.

National Vacancy Rate to Climb
Markets are going to have to contend with moderating demand, as well. This should cause the national vacancy rate to continue to drift higher, from about 4.1 percent at the end of 2013 to 4.9 percent at the end of 2017. However, that’s the silver lining, as this increase would still leave vacancy tight, at below 5 percent. Thus, the increase in construction activity, while notable, isn’t the death knell for the apartment market. Vacancy now is at a 12-year low, so even if it slowly increases, the market will remain very tight, creating an environment in which rents will continue to grow in excess of inflation.

Yet, while good deals aren’t going to disappear completely, investors are going to have to pay acute attention and refocus on due diligence going forward. Deals should be more heavily scrutinized at the submarket and neighborhood levels. In the recent past, with strong demand and little new supply, the rising tide of the apartment market raised virtually all ships. This has unequivocally papered over some mistakes that have been made along the way. But with construction activity increasing, the market isn’t going to be as forgiving over the next few years.

The party for the apartment market isn’t over, but it’s going to get a lot more crowded.

Ryan Severino is a senior economist and associate director of research at New York City–based Reis.