The Apartment Market: Looking Better for 2010?

Ryan Severino

Economist, REIS Inc.

MHN: What are your projections for the U.S. economy this year?

Severino: We expect the U.S. economy to continue to recover in 2010, but the recovery will be tepid. We expect real GDP to grow at a rate slightly greater than 2 percent this year. Nonetheless, we still expect some trouble in the labor market. Job losses are likely to persist in 2010, though not nearly at the rate that was observed in late 2008 and early 2009. Unemployment should continue to increase, peaking around 10.5 percent in the middle of the year. By the second half of the year, the recovery should be a bit more entrenched and the economy should begin to consistently create jobs. However, the pace of job creation will be muted.

Therefore, our outlook for the economy is cautiously optimistic—though we do expect real GDP to grow this year, we do not see the labor market starting to recover until relatively late in the year.

MHN: Is the apartment acquisitions market set to normalize this year? What are your projections for the sector?

Severino: While we expect to see improvement in the apartment acquisitions market in 2010, we do not expect the market to normalize fully during the year. Although credit conditions will continue to improve in 2010, the market will still be recovering from the fallout of the last few years. We expected transaction volume to bottom in 2009 and begin to increase in 2010. However, continued deterioration in fundamentals will continue to put downward pressure on prices and upward pressure on cap rates.

We would expect volume to be in the $10 to 20 billion range, prices to fall roughly 5 to 10 percent, and cap rates to increase roughly 50 basis points.

MHN: What is the outlook for the availability of financing for the apartment sector?

Severino: The availability of financing should improve in 2010, though it will still be a far cry from the environment of only a few years ago. Capital will be more readily available, relative to 2009, from virtually all sources of financing. The credit crisis will continue to ease in 2010, and the CMBS market should hopefully continue its resurgence.

Financing for construction and rehabilitation should also improve relative to 2009, but the continued deterioration in fundamentals through mid-year will dampen lender interest. If market fundamentals begin to improve in the second half of the year, as we anticipate, that could spur increased lender interest in this type of financing.

MHN: What are your predictions for interest rates and spreads?

Severino: We expect the Fed to keep interest rates at their current low levels until the second half of 2010. Only when the economic recovery is a bit more entrenched (after at least a few consecutive quarters of growth), and the labor market begins to improve by consistently creating jobs, will the Fed feel confident enough to begin raising interest rates. The Fed will try to avoid repeating the mistake made by the Bank of Japan in the ‘90s when it raised interest rates too quickly and halted an economic recovery. As long as inflation remains tame in 2010, which it should, the Fed will err on the side of caution and not increase rates until it has confidence in the recovery. Spreads should widen slightly as interest rates will remain at low levels while cap rates should drift higher. However, the increase in spreads will be narrow relative to the widening that occurred over the last couple of years.

Richard K. Green

Director

USC Lusk Center for Real Estate

MHN: What are your projections for the U.S. economy this year?

Green: I think we will see GDP growth. We have indicators that manufacturing is beginning to come back because of exports, and I think housing construction will improve, as inventories have been dropping pretty rapidly. Banks are starting to accept short sales, which will help reduce the number of foreclosed properties on the market.

MHN: Is the unemployment rate set to improve earlier than expected in 2010?

Green: Employment is a lagging indicator, so it will likely remain high for a while. But the November 2009 numbers were better than expected.

MHN: How concerned are you about the commercial real estate sector? Is another financial crisis waiting to happen as a result of troubles in the CRE sector, much as the foreclosure crisis had contributed to the present downcycle?

Green: I think it’s a train wreck—especially in retail. People paid far too much for commercial real estate in 2005-06, and so when loans come due, it is difficult to make a refinance work. But it is much less important to the broader economy than residential. I am hopeful that lenders will accept haircuts, and so avoid having large inventories dumped on the market.

MHN:  What is your outlook for the apartment market this year and beyond in terms of demand-supply?

Green: The demographics are good for apartments now—the population of people entering their 20s is large, and will be for the next few years. Those people need to get jobs, though.

MHN: When do you think construction and acquisitions capital will return to the multifamily market?

Green: Beyond Fannie/Freddie? I think that so long as they are lending, it will be difficult for the private sector to compete.

Bernard M. Markstein III

Vice President, Forecasting and Analysis

National Association of Home Builders

MHN: What are your projections for the U.S. economy this year?

Markstein: NAHB is cautiously optimistic about 2010. We believe that the recession ended in the latter part of 2009. The economy has had some difficulty in gaining its footing but has been struggling forward. As we move through 2010, we expect to see some overall strengthening and improvement. However, compared to most post-World War II recoveries, which show strong growth in the early stages, this recovery is shaping up to be relatively moderate, with slow but steady growth. Overall, we forecast that real (inflation-adjusted) GDP will grow 2.9 percent for the year, or 3.4 percent from fourth quarter 2009 to fourth quarter 2010.

MHN: Generally, how do you think apartments will fare this year?

Markstein: The rental market should hold its own in 2010. Rents will struggle to keep pace with inflation. The recent rise in vacancy rates is troubling and is a threat to the outlook. The difficulty in obtaining financing for new multifamily projects means that the flow of new multifamily construction completions will slow in 2010 and 2011. Thus, the inflow of new apartments into the market will slow. Most owners who have wanted to sell their condos but who have been unable to get a price they consider reasonable and therefore are waiting for the market to improve have already put their condos on the rental market. Thus, the net flow of additional condos available for rent should slow considerably next year.

MHN: Discuss the supply overhang in the condo market.

Markstein: The improving economy and the home buyer tax credit will encourage some renters to purchase a house or condo and leave the rental market. To the extent that they purchase a condo, they will, in some cases, reduce the number of condos in the rental market. To the extent that they buy a house or condo where the former owner does not move into a rental, or the unit was not on the rental market, they will reduce the number of renting households.

However, the same improving economy will allow some people who were sharing a rental or living with friends or relatives to move into their own rental units. Meanwhile, continuing foreclosures will force other households into the rental market. The net result (along with normal growth in households) should produce some marginal growth in renters, helping to push the rental vacancy rate down.

The overhang of condos for sale will continue at a high level, though it will come down slowly. Both the improving economy and the home buyer tax credit will help reduce the overhang.

MHN: What is the forecast for the apartment rental occupancy rate in 2010?

Markstein: We expect the rental vacancy rate to peak in the fourth quarter of 2009 or the first quarter of 2010. From there, the vacancy rate will inch downwards. Rents will continue to increase—but at a slow rate—falling below the rate of inflation in the first part of the year and roughly matching or slightly exceeding inflation in the second half.

MHN: Is the supply of apartments going to continue to be severely limited in 2010, as it has been in the past year?

Markstein: Yes, the number of new apartments added to the market will continue to fall in 2010. We do not expect significant conversions from condos to apartments in 2010. We are forecasting only 73,000 apartment starts in 2010.

MHN: Will there be a shortage of apartment properties?

Markstein: As I previously noted, we expect rental demand to increase marginally throughout 2010. Apartment supply should be more than sufficient to meet demand, although the rental vacancy rate will inch downward. It is unlikely that there will be a shortage of apartment properties in the next year or two. It will be at least 2013 or 2014 before a possible shortage could emerge. More than likely, a fair number of new multifamily projects will be underway by then.

Mark Obrinsky

Vice President and Chief Economist

National Multi Housing Council

MHN: What are your projections for the U.S. economy this year?

Obrinsky: Although GDP growth turned positive in the second half of 2009, the recovery has not yet become self-sustaining and durable. Households will continue to deleverage (and increase savings) in 2010, as well they should. But this will keep personal consumption from rebounding more rapidly. And unless export demand improves more than most forecasters expect, business investment too will be subdued. As a result, economic growth is likely to be below par for much of 2010.

The most important economic indicator for the apartment industry is employment. And it’s hard to be optimistic on that front.

The recent pattern has been that the job market keeps getting worse long after the recession is officially over—and then rebounds only gradually. Employment should turn positive in 2010, but I don’t think we’ll get very far toward regaining the jobs lost in the downturn—the worst employment downturn since the Great Depression.

MHN: What is the forecast for apartment rental occupancies in 2010?

Obrinsky: Demand for apartment residences will be sluggish, at best, to begin the year. But the expected turnaround in employment, coupled with the historically small pipeline of new apartments, should cause occupancy rates to bottom out in the first half of 2010, then rise gradually in the second half. On average, rents will probably decline further, although a few areas, such as the Washington D.C. metro market, may see some rent increases.

MHN: Is the supply of apartments going to continue to be severely limited in 2010? What is the trend for apartment demand?

Obrinsky: Last year, new apartment construction set a record low for the post-World War II era, largely due to a lack of financing. While the worst of the crisis is past, banking and financial market activity is still a long way from normal. For that reason, construction finance is likely to remain constrained, and new development will be quite low again in 2010. At the same time, [apartment] demand will be constrained by the slow recovery (or worse) in the job market.

MHN: Will there be a shortage of apartment properties? If so, when?

Obrinsky: There are several demographic trends that should provide a strong impetus to the apartment market in the coming years: overall population growth; the entry of echo boomer and millenial generations into the housing market; continued high levels of immigration once the economic recovery kicks in; and continued shift in household type toward more single-person households, single-parents and roommates, and away from married couples with children.

Once the recovery gathers strength and becomes fully self-sustaining, it is quite possible that demand will outstrip the low-level new construction. If that happens, excess inventories will be worked off quickly and market conditions could tighten considerably, leading to occupancy rates above the long-term average and rent growth higher than the overall inflation rate. That is not likely to happen before 2011 at the earliest.

Katie Schnidman Pelczar

Real Estate Economist

Property & Portfolio Research

MHN: What are your projections for the U.S. economy in 2010?

Pelczar: We expect GDP growth of 2 percent to 2.5 percent in 2010. The economy remains challenged by powerful headwinds. Despite recent stock market gains, household wealth is still $13 trillion below its peak, and efforts to rebuild these savings will weigh on consumer spending. Even if consumers wanted to spend more, depressed home values and tight credit—not to mention high levels of unemployment—would preclude many from doing so. Perkier emerging economies and a weak dollar have lifted prospects for exports; around 50 percent of the federal government’s fiscal stimulus funds are still in the pipeline, and business inventory restocking has several more quarters to run. Still, given the disproportionate contribution of consumer spending to GDP (nearly 70 percent), its strength will largely determine that of the broader economy.

We expect the unemployment rate to peak at 10.6 percent in the middle of 2010. Recall that after the 2001 recession, it was nearly two years before job growth resumed in earnest, and nearly one million jobs vanished in the interim. Given the severity of recent employment losses, we do not expect the lag to be as long this time. Indeed, companies may not be hiring, but they have started to engage temporary workers and to increase the hours of existing staff, two traditional leading indicators for broader employment. But while the job market will certainly improve, we do not expect the labor market to return to “full employment”—an unemployment rate of 5 percent to 6 percent—until 2013.

MHN: What is your prediction for apartment supply this year?

Pelczar: Almost 120,000 units (0.9 percent of inventory) were delivered in 2009, more than the annual average over the last five years. And while a small percentage of this new supply is actually condo buildings turning into rentals, most of it stems from the last vestiges of the prior cycle’s lax lending environment and cap rate compression. However, through 2010–11 new deliveries will be minimal, averaging additions of just 0.2 percent per year. This lull in construction will give the apartment market some breathing room, but development will return in full force by 2013–14, especially in Southern metros.

Despite the recession, developers will continue to demonstrate their propensity to build in Texas. Over the next five years, Dallas will see 51,000 new units and Houston will gain 31,000 new units. Add in Austin and San Antonio, and the big four Texas metros will account for a full 22 percent of supply additions in the 54 largest U.S. markets over the next five years, despite the fact that existing Texas stock is less than 11 percent of the current apartment inventory. However, as a percentage of current inventories, the up-and-coming Southeast metros will actually take the cake for supply additions, with Raleigh adding 14 percent in inventory, followed by Charlotte, at 11 percent, over the five-year forecast.

MHN: What is your forecast for the apartment acquisitions market?

Pelczar: Distress is hitting home in the multifamily sector, and as more assets become troubled, the bid/ask spread should tighten in 2010, causing sales volume to rise quickly. In the last cycle, apartment sales volume peaked in 2005 (due to the condo conversion craze), while office, retail, and warehouse sales volume peaked in 2007. This timing, combined with the sector’s shorter lease terms and tumbling NOIs, is resulting in expedited distress.

Delinquencies in the apartment market have risen by about 600 basis points in the last 12 months as of the third quarter, compared with less than 400 basis points for all other major commercial property types. The typically higher loan-to-value ratios and lower debt service coverage ratios in this sector are certainly not helping matters either, and just as delinquencies are mounting, the vultures are circling.

Since apartment investment has been sliding since 2005, there is plenty of pent-up interest in the sector. And if PPR’s client activity is any indication, that interest is growing daily. The apartment sector’s strong drivers—including healthy demographics, an increasing renter pool, and stabilization in the labor markets—going forward are driving investor interest.

And, of course, the greater availability of debt in the multifamily sector will propel investment volume through 2010. As Fannie and Freddie continue to finance multifamily loans, apartment investors have a leg up on their other commercial counterparts. But should the GSEs cut down on their apartment lending activity in the second half of 2010, sales volume could certainly take a nose dive.

MHN: Are apartment prices still set to
decline for the year ahead, according to your projections?

Pelczar: At present, the market is still working through the excesses of the past several years and unwinding the effects of overexuberant cap rate compression. This correction, of course, is exacerbated by a sharp downturn in fundamentals.

Apartment values are expected to fall by more than 45 percent cumulatively in this cycle, as pricing slides though next year and into early 2011. The good news is that the bulk of these value declines are in the rearview mirror, as value losses in 2010 should amount to less than 15 percent.

And, when national fundamentals begin to stabilize in the second half of next year, apartment investors are likely to re-enter the market as cap rates prove to be increasingly attractive. Cap rates will reach the 8 percent range in 2010 and remain elevated in 2011. It will take some time for cap rates to recover, despite strong capital value growth averaging more than 7 percent from 2012–14. But it is certainly possible that heightened investor sentiment will cause apartment values to rise even more than expected in the outer years of the forecast, causing income returns to fall more quickly.

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