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Dec. 27, 2011

Multifamily's Future in 2012

By Poonkulali Thangavelu, Contributing Editor

Thanks to a favorable combination of limited supply and demand edging up, market conditions for the multifamily sector are likely to be favorable in 2012. As well, the tepid market for home buying is likely to continue into 2012, further boosting rentals.

Although multifamily market observers expect that the economy will merely plod along in 2012, not improving much from 2011 levels, they still expect somewhat higher vacancies and effective rents.

This sanguine outlook is based on the expectation that the U.S. economy does not dip back into a recession and that there is no significant spillover from the European debt crisis.

Mark Obrinsky, chief economist at the National Multi Housing Council, notes, “The one wildcard probably is what exactly ends up happening in the Euro zone, whether we will see a breakup or some countries leaving the Euro, and what the consequences of that are. I don’t think anyone is quite sure what the impact will be on the U.S. economy and U.S. financial markets.”

If the European debt issues don’t have any further negative impact in the U.S., Obrinsky anticipates that, in the most likely scenario, the U.S. economy will continue to grow in the range of 2 percent to 2.5 percent in 2011.

Demographics support demand

In this sort of modest growth scenario, there is not likely to be any major uptick in employment that will lead to high demand for multifamily rentals. However, the sector will still benefit from demographic factors.

According to Ron Witten, president of Witten Advisors, young adults in the age group of 20 to 34, the prime cohort for renting, have been holding their own in the job market. “The data suggests that somewhere over 60 percent of the jobs created in 2010 and 2011 have been 20- to 34-year-olds going to work. That’s very good news for the apartment sector,” Witten says. He expects to see absorption of about 150,000 multifamily rental units nationwide in 2012.

Another factor that will boost rentals is that homebuyers are still not back in full force. Witten expects that as home prices remain soft, prospective buyers—and lenders—will continue to remain cautious. This means “it’s another year of renting sounds better than buying for the average consumer,” he says.

On the supply side, construction has been muted for the last few years. According to Obrinsky, apartment construction reached the lowest figures on record in 2009 and 2010 as developers found it difficult to get construction financing in the aftermath of the financial crisis.

While the construction situation has improved and there has been a pickup in new construction in 2011, additional supply is not likely to enter the market until late in 2012 or 2013. This means that demand is still ahead of supply for the moment.

Scope for rent growth

With demand outpacing supply, market observers expect that vacancies will continue to edge down, supporting slightly higher effective rents.

Witten Advisors is looking to a 5 percent vacancy rate nationwide, as well as a reduction in concessions that will make for effective rent growth of a little more than 4 percent. However, in the laggard markets, such as Las Vegas, Witten is anticipating vacancies in the range of 7 percent to 8 percent, which means landlords will have fewer prospects to raise effective rents.

In the tightest markets in Northern California and the San Francisco Bay Area, Witten anticipates a 2 percent to 3 percent vacancy rate and rent growth in the 8 percent to 9 percent range.

Obrinsky notes that vacancy rates are no longer at the high levels they were a year or two ago, and there’s reason to believe they will decline further in 2012. While this will generally be favorable for rents, some metro areas that have seen big rent increases so far may see that slowing down. However, Obrinsky expects that areas in which rent increases have been nominal may see higher growth in rents.

And while there is still a shadow inventory of single-family housing that is adding to the rental stock, and potentially impacting multifamily rents, this is a segment that is not directly competing with multifamily units.

Richard Green, director of the University of Southern California Lusk Center for Real Estate, notes, “I think there is an opportunity if someone can come up with a good management model for single-family houses. It could be more competitive to supply. Until that happens, I see it as being pretty segmented.”

Will price appreciation continue?

Given the favorable fundamentals for the sector, investors are likely to continue to be interested in multifamily properties next year. However, Green has seen multifamily properties trading at “very expensive prices” in 2011 and doesn’t know if that will be sustainable in 2012. Obrinsky, too, believes that favorable multifamily fundamentals are already reflected in prices to some extent.

“Investors will have to decide whether they think an individual property at the asking price, or something like that, is a good investment or not. That’s where the rubber meets the road,” Obrinsky says. And as multifamily companies try to figure out the best portfolio strategies by shifting their holdings geographically or by asset type, he sees continued room for deal making.

Also, ready availability of financing is likely to continue to fuel multifamily investments in 2012. For one, Fannie Mae, Freddie Mac and the FHA are likely to continue providing debt financing at favorable rates.

Green notes that there is limited multifamily mortgage financing available outside of Fannie Mae and Freddie Mac.

This means “if Congress decided to really start winding them down, that could put a hole in the investment climate for multifamily,” explains Obrinsky. However, he doesn’t see this happening in 2012, although it could happen in the next couple of years.

On the equity side, too, multifamily properties are likely to continue to hold investor interest. However, Green expects that multifamily property cap rates will creep up in 2012.

Cap rates in the sector are currently in a low 4 percent to 5 percent range, due to expectations for rising rents. This fuels investors’ appetite for multifamily properties, which is likely to be influenced, to some extent, by how the economic recovery shapes up. As Witten notes, “To the extent economic recovery is rapid, that could cause investors to look more toward other forms of commercial real estate. Our outlook is not for very rapid acceleration in the economy, so we don’t expect to see a strong comeback in office, industrial and retail properties. The equity will continue to focus on apartments.”

More of the same likely

If the U.S. economy continues to see slow growth in 2012, Green doesn’t anticipate that the Fed will start tightening on the short-term interest rate front in the next year. This means that interest rates are likely to continue at historic low levels in 2012.

Long-term interest rates also point to low expectations of inflation, according to Green. That’s one reason why he doesn’t expect rents to grow too much, considering that economic inflation also influences prospects for higher rents.

And while low interest rates have traditionally lured homebuyers, things are different in this cycle. Even if the anticipated slow growth in employment continues in 2012, prospective homebuyers still face the hurdle of saving up for a sizable down payment.

For the multifamily sector outlook, this all adds up to a situation similar to the one in 2011. Obrinsky anticipates that “it’s enough growth [in employment] to keep demand moving upward. It’s not enough of an economic punch to jumpstart the for-sale housing market. That part of the market will remain in the doldrums. It’s not a bad scenario from the standpoint of the apartment industry.”

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