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Apt. Market Facing Slower Lease-Up of New Construction in 2016

While Construction Remains at Peak Levels, Rent Growth Expected to Moderate as Cycle Enters Stretch Innings
February 23, 2016
Apartment projects such as Rockrose Development's 974-unit development at 43-25 Hunter St. show the torrid pace of residential construction in booming submarkets like Long Island City and Hunter's Point in New York City.
Apartment projects such as Rockrose Development's 974-unit development at 43-25 Hunter St. show the torrid pace of residential construction in booming submarkets like Long Island City and Hunter's Point in New York City.
The U.S. apartment market continued its biggest boom in history in 2015, hitting historical highs in rental rate growth, investment sales and new construction while matching the previous year's strong absorption and occupancy growth.

However, much of those gains were achieved in the first six months of the year. The market slowed considerably in the second half, as lease-up of newly delivered apartment projects cooled and rent growth plateaued, particularly in the fourth quarter.

CoStar's recent market analysis suggests that consecutive waves of construction sweeping across many U.S. metros is finally over-taking demand in the long-booming U.S. apartment market, according to analysis presented at CoStar's 2015 State of the U.S. Multifamily Market Review and Outlook.

Construction of new apartments continued to pour into many metros in 2015, with 214,000 new units added across the 54 largest U.S. markets -- an 8% increase over the previous year, which was also a record -- with 30 of the top US markets seeing more apartment units added in 2015 than in 2014.

Absorption held steady for the year at around 210,000 units rented, and the average vacancy rate ended the year at a cyclical low of 3.9%, virtually unchanged from the end of 2014.

Developers are expected add another 7.5% to the overall apartment supply this year totaling about 230,000 units, said Michael Cohen, CoStar director of advisory services, who presented the analysis along with research strategist John Affleck and senior economist Ethan Vaisman.

The undisputed U.S. apartment market standout of 2015 was Nashville, where almost all things commercial real estate are booming. Nashville is adding a projected 10,500 units, or 11.3% of inventory, over the next 24-month period.

New York City is projected for 32,000 or 2.8% of inventory while Dallas will see 31,000 units deliver in 2016, or 5.1% of inventory during the two-year period, with both metros adding more than half of that new supply this year.

With the pipeline full of new projects under construction or starting this year, Atlanta, Los Angeles, Seattle, greater Washington, D.C., Denver, Boston, Austin, San Antonio, Chicago and Charlotte are all expected to see a large number of new apartment units come online.

"Starts and permits data suggests the heightened level of apartment construction will persist, with an additional supply wave in the making," Cohen said, pointing to the permits for 500,000 units in the U.S. pulled in 2015, a 25% increase over 2015 and more than 53% above 2013’s 370,000 permits. "The level of supply may be beginning to create some headwinds."

Urban submarkets within New York City, Denver, Chicago, Nashville, L.A., Atlanta and Dallas saw the highest number of construction starts in 2015.

By far the highest was Long Island City and Hunters Point, a former industrial and manufacturing district which is now one of the fastest growing residential submarkets in the New York City metro, with 8,871 units started in 2015 and a total of 12,000 units now under way. The supply wave, 90% of which is luxury dwellings, has pushed Long Island City/Hunters Point vacancies up 60 basis points year over year to a still-tight 3.5%, but that number is certain to move upward over the next 12 months, Cohen said.

New Project Leasing, Rent Growth Slows

CoStar data indicates that the 50,000 units or more delivered each quarter, combined with rising rents, are finally having an effect on the previously unchecked demand for apartments. Lease up of newly delivered apartment projects was slower in 2015, with units lingering on the market compared with projects delivered during 2013 and 2014.

In total, 25 of the major U.S. markets posted lower apartment vacancy while 29 saw their vacancy increase in 2015. Underscoring the timing of the market changes, only four of the 54 major U.S. markets in CoStar’s national index saw occupancy gains in the apartment market during the fourth quarter of the year.

Average U.S. rents grew at a torrid 6% in 2015, outpacing the 3%-4% of recent years. Some markets saw even bigger rent spikes, such as San Francisco, where asking rents are now 35%-40% above their pre-recession peak.

However, rent growth slowed considerable in the second half of the year, cooling to just 2.4% on an annualized basis -- down sharply from the 9% growth recorded in the first half of 2015.

While it can’t yet be called a trend, rental household formation also slowed in the last two quarters of 2015, as the U.S. homeownership rate edged up slightly again in the fourth quarter, the first consecutive quarters of increase since 2009.

"Landlords, property managers and developers need to be mindful of the fact that we are beginning to see renters think about that math of rent-versus-buy, particularly as the 10-year interest rate has dropped below 2% and mortgage rates are quite favorable," Cohen said.

Part of the fourth-quarter slowdown may be seasonal, as rent growth tends to flat line later in the year, Affleck said, noting that growth rebounded somewhat in January, though at a lower rate than a year ago.

"We feel it’s pretty likely that rent growth has peaked," Affleck said. "That’s not to say rents will start to decline or plummet like they did in 2009, but we expect growth this year will return to the standard 3%-4% range, rather than 6%."

Large apartment developers such AvalonBay Communities, which has the largest development pipeline of the public apartment REITs, consisting of 26 properties under construction valued at $2.9 billion, noted the late-2015 slowdown and acknowledged the effects of new supply.

Higher levels of deliveries in some submarkets, particularly in urban cores, may impact local markets as owners use concessions to stimulate absorption during lease-up, said Timothy Naughton, chairman and CEO of AvalonBay, during the company's earnings call earlier this month.

While the fourth quarter is typically is a slower period, the leasing slowdown for AvalonBay's higher-end projects in the San Francisco Bay Area "was a little beyond seasonal adjustment," and slower growth is expected with deliveries accelerating in the market, added Sean J. Breslin, AVB chief operating officer.

"We did expect some softening, and the question going forward here is, what's the basis of job growth since we know what supply is going to be," Breslin said. "Our expectation is that the market will moderate through 2016."

Investor interest in apartment remained torrid even as fundamentals began to soften in the second half of the year, Vaisman noted. Buoyed by a number of large portfolio deals, fourth-quarter sales volume topped $40 billion and prices continued to trend upward, with the three-quarter moving average price per unit now standing at $130,000. Total apartment sales volume grew by 18% to over $153 billion in 2015, edging out office for the second straight year as the product type with the highest volume among major property types.

That said, annual sales volume growth has decreased steadily since 2010, save for a small uptick in 2014. Six years deep into the apartment market recovery and expansion, Vaisman said it wouldn’t be surprising to see sales growth fall into the single digits in 2016.

"When all is said and done, 2015 may be the peak year for apartment sales this cycle," Vaisman said.
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