Few asset classes can boast a convergence of favorable circumstances to rival that of the apartment sector. Whether by choice or necessity, record numbers of American families have swelled the rental ranks since the onset of the housing market collapse, fueling the robust property fundamentals that undergird the sector’s post-crisis investment thesis.
Absent stronger economic foundations for space demand, no other property sector has evinced a similar pattern; and so, nearly four years after the economy’s return to expansion, apartments continue to define the recovery in commercial real estate. But the sector’s outperformance cannot persist indefinitely. In 2013, firming housing market conditions will coincide with the cycle’s first measurable increases in apartment supply, moderating property income trends and reinforcing the need for risk management in new lending.
Priced Near Perfection
Investors, developers, and lenders have all responded to the momentum in apartment fundamentals trends, lifting multifamily valuations and raising debt encumbrance to within range of their previous peaks. Dallas-based research firm Axiometrics reports the apartment vacancy rate was comfortably below 6 percent heading into 2013, supporting rent growth well in excess of renters’ current income trajectory. Cap rates on property sales and refinancing appraisals have also tested new lows over the last year, falling well below 5 percent for the most aggressively contested assets.
In divining the relationship between fundamentals and liquidity, the availability of historically low-cost financing has been a critical input in the multifamily equation. When dislocations in credit markets were most severe, Fannie Mae, Freddie Mac, and the Federal Housing Administration ensured the flow of capital, even in submarkets where the sector’s occupancy rates and income trends were deteriorating. Following the sector’s inflection, banks, life companies, and conduit lenders have all re-engaged with borrowers, fomenting a degree of competition that raises questions about the soundness of apartment underwriting trends.
The Wake of the Housing Crisis
For many advocates of the new apartment paradigm, flush credit conditions reflect a secular shift in multifamily demand that will persist even after the nascent housing recovery takes hold. The observational logic is sound. In some cases, household preferences have changed, favoring the mobility afforded by renting over ownership. For others, access to mortgage financing is constrained by tighter credit standards and larger required downpayments, even if affordability weighs in favor of a home purchase. Over an even longer term, demographic and lifestyle changes are delaying the exodus of young families to the suburbs, postponing the tenure shift away from renting that accompanies migration ex urbis.
It is entirely plausible that the housing crisis has left an indelible mark on our convictions about the American Dream and the importance of homeownership. While the debate is hardly near its conclusion, it is also reasonable to expect that housing finance reform will see more limited subsidies to homeownership. But in the extreme, the sector’s promoters dismiss the notion that cyclical forces are also at work. That myopia has afforded lapses in credit risk measurement that threaten the long-term performance of newly originated multifamily debt across capital sources.
Beware Assumptions
The next year will test overly sanguine assessments of the apartment sector’s resilience. While the investment thesis will remain intact, new forces are coming to bear that will temper its momentum. An enlarged development pipeline that will see completions roughly double in 2013 is not least among them. The profound rethinking about homeownership’s role in the life of our nation will permanently enlarge the tally of renters, but rising home values and modest easing in single-family credit will also encourage greater balance in tenure choice.
Not every market will see apartment demand adjust to a housing recovery in the same way. But we will repeat costly investment and lending errors if we assume that crisis levels of demand are the new normal.
Market forces will combine over the next year with shifts in the policy environment, as well. As the merits of experimental monetary policy diminish, the distortions it has introduced to asset markets will become more identifiable. There is little doubt the multifamily sector has benefited enormously from the active engagement of the agencies and their public stewards. In particular, a status quo where Fannie Mae and Freddie Mac have been able to arbitrage the creditworthiness of the Treasury has resulted in substantially lower costs of capital to borrowers.
The context of apartment investment will change dramatically as the long end of the yield curve rises and as legitimate questions are raised about sustainable market structures. While the Federal Housing Finance Administration has managed down public exposure, conservatorship has never been a mandate to decide existential questions.
Absent a self-sustaining turnaround in housing, policymakers have been loath to address housing finance reform in a serious way. But a world without the agencies, at least as we have known them up to now, will receive its hearing as housing rises further from its nadir.
Sam Chandan, Ph.D., is president and chief economist of Chandan Economics, a New York–based research firm, and adjunct professor of real estate at the Wharton School of the University of Pennsylvania.
