How Long Is the Tunnel?

While the collapse of the for-sale housing market has been a boost for many apartment markets, apartment developers need to know whether they should risk capital now on new construction.

It is now one year since I was on a speaking panel titled, “The Light at the End of the Tunnel?” It’s an interesting question for economists and a critical question for anyone involved in multifamily housing.

While the collapse of the for-sale housing market has actually been a boost for many apartment markets, apartment developers need to know whether they should risk capital now on new construction. Likewise, apartment investors need to know how to underwrite income, occupancy and other parameters during the initial years of a new acquisition.

Given the continued bumps in the economy, the tunnel metaphor is worth revisiting. There are at least two questions related to the tunnel metaphor we should consider in order to make good apartment development and/or investment decisions. They are: How long is the tunnel? (When can you expect recovery?) and what is the light at the end of the tunnel? (What kinds of properties should you target?)

With all the conflicting economic indicators we see each day, let’s take a look at the first question, “How Long is the Tunnel?” To (somewhat) accurately answer that question, we need to settle on a definition for what constitutes a recovery. Going back to that old adage that “a recession is when your neighbor is unemployed, but a depression is when you are,” we can all probably agree that a recovery will be apparent when we each get back to our prior level of business.

So, let’s define recovery as that point at which excess inventory is absorbed sufficiently to a) support meaningful increases in rent and b) make new construction feasible on a fairly wide scale.

Anyone who has heard me speak knows that it all gets back to jobs for multifamily. The only thing that is guaranteed to cause the absorption we need is a lot of new jobs. When we are asked by a client to forecast future rent growth, leasing absorption or occupancies, our proprietary forecasting model heavily weighs the potential for local changes in employment.

Think about it: if you don’t have a job or are underemployed, you’re not going to rent or buy; you’re going to find a friend or relative who has some extra space for you. In fact, depending on the specific market, it’s pretty predictable that, for every three to six new jobs, demand is created for one new unit.

But what about the “tunnel?”

We’ve lost a lot of jobs since this recession started. When we look at the most recent employment statistics from the Federal Bureau of Labor Statistics, real unemployment is still almost 16 percent on a national level. Admittedly, it can be more than a little discouraging if we just look at the macro national prospects for job recovery. Fortunately, apartment development and investment is a local business!

Looking at the prospects for recovery in metros we track for clients, we do see the end of the tunnel sometime between 2013 and 2014, based on local potential for net job growth. Having said that, however, the overall national recovery may take longer, and some markets may even lag the national job recovery.

There’s a lot of time between now and then for global and national economic drivers, both positive and negative, to push or pull that forecast. But until and unless we see those, we need to plan for 2013/2014 in many markets. If you’re a developer, depending on your typical project delivery schedule, you may want to start preparing new projects now for delivery into your local recovery. Or if you’re an investor, you need to make sure you budget for the possibility of no or slow income growth in the near term, until your local recovery is expected to take hold.

Now that we’ve identified the end of the “tunnel,” let’s take a look at the “light” we’re likely to find there. What kinds of properties should a smart apartment developer or investor be working on right now?

When we perform renter surveys or focus groups for clients, we again find that each market is unique. But, in general, we are seeing two interesting trends that are likely to shape many markets for the next ten to fifteen years:

Smaller units. Younger renters are willing to give up space for better amenities and finishes.  Although encountering a bleak recession during their formative years has ingrained a certain budget-mindedness, those in the 20- and 30-year-old segment still want to have luxury both in their units and in the gathering areas of the community. So, many of them will choose to rent a smaller unit in order to enjoy luxury appointments on a more affordable budget.

Larger units. There are huge numbers of middle-aged renters with families, many of whom, unfortunately, lost their homes to foreclosure, who need space and crave stability. So, while there remains an enormous “shadow market” of single-family home rentals in many markets, there is an opportunity for professionally managed apartment properties with larger two- and three-bedroom units that appeal to this large demographic segment.

One innovative project for which we recently provided guidance will incorporate product to address both of these trends. The site is large enough that it will contain three separate “villages.”  We recommended that, in addition to a traditional one- and two-bedroom garden-style community, a higher-density building, including a mix of studios and smaller one-bedroom units be planned, as well as an area of lower-density townhome buildings with several three-bedroom units and direct-access garages. Based on our client’s development and construction schedule, this project should also hit the local recovery just about right.

Your local recovery will have its own distinct shape, and your local market trends may be unique as well. Make sure you critically analyze the economic and demographic forces in your market to build or buy the right product at the right time.

Patrick S. Simons is the founding principal of Strategic Property Economics, an Irvine, Calif.-based market research firm. He has been involved in the development of or investment in more than 20,000 residential units in several major markets.