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Breaking Supply Wave, Potential Volatility Expected to Test Apartment Market Resilience in Coming Year

Pricey Core Urban Properties Still Attract Well-Heeled Crowd While More Renters Take Fresh Look at Lesser-Quality Existing Apts., Potentially Slowing Lease-Ups for New Projects
December 29, 2015
If current projections hold, a total of about 455,000 new apartment units will be added to the inventory in the top 54 markets making up CoStar's national index from the beginning of 2015 through the end of the coming year. Despite the elevated new supply rolling into almost every U.S. metro, continued strong demand from renters is enabling landlords to push up rents in many markets.

As a result of the intense development focus on urban markets, apartment vacancies are beginning to edge higher in certain CBD and secondary business districts, setting the stage for suburban and non-CBD urban locations, such as Oakland, CA, to see more occupancy and rent appreciation. Vacancy rates in these non-CBD locations are expected to remain at least 50 basis points below those in business districts, according to CoStar projections.

"While 4- and 5-Star vacancies have remained resilient over the past year, the sheer amount of supply should push vacancies up for premier product, particularly since most of the new product is delivering at higher prices than its previously delivered competition," noted Sam Tenenbaum, real estate economist with CoStar Portfolio Strategy.

Conversely, the "average asset" market of 3-Star multifamily properties should continue to be supported by strong demographics, including an improving employment picture for 20 to 34 year olds, along with the ongoing difficulty of qualifying for mortgage loans needed to make the leap into home ownership. Demand will keep this average-quality apartment market relatively tight as the vacancy spread between the highest quality and lesser quality units widens over the next year.

Meanwhile, landlords may find it challenging to actually achieve their forecasted market rents in the coming year, according to Janet D. Neman, senior managing director with the Los Angeles office of Charles Dunn Co. Although apartment supply has been catching up with explosive demand over the last two years, market fundamentals have balanced out and the current wave of multifamily and mixed-use development could create some volatility toward the end of 2016, Neman said.

"We see the state of renter-landlord relations being shaken up due to unrealistic speculation about rents," Neman said. "Market rents are being projected at hundreds of dollars more than what might be considered average for an area, and although there is fierce demand for rental housing, the price per square foot for minimum to moderate rate apartments has skyrocketed."

With low capitalization rates and a three-decade history of volatility, investors are expected to become more cautious about what they purchase, she added.

"It’s a seller’s market right now, but the tide could swiftly change to a buyer’s market, especially if interest rates rise (further)," Neman said, predicting that investors will turn to 1031 exchanges from multifamily properties into triple-net retail properties in 2016 in an effort to minimize risk and hedge the anticipated impact from rising interest rates.

Meanwhile, the lease up process will likely be rougher sledding for developers of the hundreds of new apartment communities wrapping up construction across the U.S. in the coming year. In the fiercely competitive market, project stabilization will take longer, with evidence already mounting that leasing in some recently built communities is already lagging.

As of third quarter 2015, properties built in 2015 had an average vacancy rate of 35%, which is 7% higher than the vacancy rate of properties delivered in 2014 marketed during the same time last year, according to CoStar data.

In CBDs and secondary business submarkets where the vast majority of construction is taking place, new deliveries are twice as likely this year as compared to 2012 to have a rent premium of 5% or higher compared with the next-most expensive building within the same submarket, according to CoStar Portfolio Strategy. While the rental rates reflect the highest quality of construction, demand may suffer as the rents on new units move far beyond the reach of all but the highest-income rental households.

New supply is already beginning to slow down in many metros, according to Christine Espenshade, managing director in JLL’s Baltimore office, who specializes in representing owners in multifamily investment sales in the Mid-Atlantic region. Meanwhile rents and income on existing properties continue to rise, even though absorption has been at all-time high levels, Espenshade said, adding that rental rates and development will flourish in suburban markets over the next year.

Kimberly Roberts Stepp, principal with Long Beach, CA-based Stepp Commercial, is not quite so bullish on the investment sales front.

"We expect that multifamily real estate will have another strong year in 2016, but in the latter part of 2015, we began to feel a marked slowdown in the aggressiveness of buyers," Stepp said. "The high-priced deals that were trading in weeks, if not days, earlier in 2015 are now languishing on the market."

"It is our opinion that as the wave is cresting in terms of pricing, many sellers will come out of the woodwork this year so as not to miss the boat on this historic peak," Stepp continued. "Demand will be there, but we believe buyers are beginning to be more discerning about their purchasing and properties may stay on the market for longer periods."

For example, multiple apartment property owners in Santa Monica and L.A.'s Westside are reporting that tenants are not responding to their high asking rents, adds colleague Aynsley Armbrust, vice president with Stepp Commercial. That sentiment is echoed by the National Association of Realtors, which projects that landlords will continue to see a moderate increase in rent in 2016, though at a decreasing rate from previous years.

Several apartment investors noted that rising rents and the continued focus of developers on luxury developments have nudged many renters into seeking older Class B communities that offer similar services and amenities as Class A properties but at a more affordable price.

"Nationally, effective rents at Class B communities are estimated to be nearly 30% below those of Class A, making them especially appealing to millennials and other cost-conscious renters," said David Schwartz, co-founder and CEO of Waterton, a real estate investor and property management company with a focus on multifamily and hospitality properties. "Underscoring the demand for older units is the Class B vacancy rate, which began trending below that of A communities in the first half of 2014."

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