A Year in Review: Trends in the U.S. Multifamily Market
by Ron Witten, Witten Advisors
For the nation’s multifamily housing markets, 2003 provided a wide array of results. While rental markets continued to struggle, investment markets set a record for apartment transactions at the most aggressive cap rates in recent memory, and buoyant condominium demand offered another very attractive exit opportunity for many rental properties.

As the economic recovery failed to generate net new job growth until the last few months of the year,
apartment owners again reduced rents in order to stimulate demand in a no-growth market as well as to compete with the ready access to home buying afforded by low mortgage rates and accommodating mortgage credit policies. This effort at attracting rental demand was moderately successful: 2003 absorption was positive, yet insufficient to match the relentless flow of new units delivered by an active development pipeline.

Employment: Jobs Begin to Bounce Back

The longest jobless recovery on record finally began to show signs of easing in late summer 2003. After losing 350,000 jobs from January through July 2003, the U.S. economy added 280,000 jobs from August through December. Supported by expansive fiscal policy and by the Fed’s accommodating monetary policy, current forecasts anticipate the U.S. economy extending its modest job gains in early 2004, then gaining momentum as 2004 progresses, setting the stage for relatively vibrant economic growth in 2005.

Rental Demand Hammered Down by Competition

 For much of 2001-2003, rental demand was hampered not only by job losses but also by intense competition from the for-sale housing market, with low mortgage rates and still-healthy
consumer confidence. Although home sales remained at all-time highs through 2003, rapid home price inflation – simultaneous with falling apartment rents – began to shift the rent-buy scale more favorably for renting. The outcome was improved rental demand in 2003, likely due not only to a) a fledgling job gain improvement and b) the widening rent-buy spread but also c) the initial entry of the large Echo Boom generation into the housing market.

Apartment rental demand for 2004 may be positioned to outperform that seen in a traditional economic recovery. Typically, the early stages of an economic comeback see an exodus of renters who had postponed buying a home during the recession due to job uncertainty. These move-outs often caused the apartment market recovery to lag the economic recovery. In the early 2000s downturn, though, home sales remained healthy, driven by generation-low mortgage rates and accommodating underwriting programs for buyers with marginal credit/financial conditions. With limited pent-up home-buying demand now remaining, 2004’s apartment absorption may rebound in concert with, rather than lagging, the return of significant job creation.

The Echo Boom generation could contribute to a near-term comeback in apartment demand from two perspectives: 1) accelerating number of young adults (who have the highest propensity to rent of all age groups), and 2) potential pent-up demand from these Echo Boomers whose entry into the work force often found poor employment prospects, encouraging a return to parents’ homes or at a minimum sharing housing costs by taking on more roommates than might otherwise have been preferred.

Apartment Supply Remained Strong

Despite the widespread softness evident in the nation’s apartment rental markets since early 2001, starts of new rental apartments during 2003 remained near the pace seen in the strong market of 1999-2000, again closing the year near 250,000 units. These production levels are far greater than recent supply/demand realities justify. Factors contributing to sustain overbuilding include:

a) accelerated production of apartments under the auspices of affordable housing programs, the most sizable being the low-income housing tax credit program where recent legislation raised theallocations available and thus likely expanded construction starts in 2003;

b) surprisingly high valuations on apartment properties (given oft-times disappointing net operating income) due to the lowest cap rates in modern apartment history, the result of several factors – the positive leverage available even at these reduced cap rates given the extraordinarily low interest rates; relatively unattractive investment alternatives due to a shaky stock market and low bond yields; and strong institutional investor appetite for acquiring apartment properties because of their historically superior risk-adjusted returns; plus favorable demographic forces in the foreseeable future; and

c) extended predevelopment periods in an entitlement environment unfriendly to apartment construction, meaning that projects entering the approval process in the favorable apartment market that existed until mid-2001 often obtaining building permits long after the market has softened, with builders opting to proceed rather than write off large pursuit costs.

Rental Outlook Improves in 2004

The steady flow of new starts should be met with improved demand in an expanding 2004 economy, stabilizing occupancy levels and creating some momentum for raising effective rental rates. For 2004, the nation’s rental apartment starts are forecast to edge lower, near 240,000 units. With affordable production holding steady near 120,000 units (55,000 tax-credit plus 35,000 bond-financed new units plus 30,000 new units receiving direct federal subsidy), this level of production would represent a 6% drop in market-rate starts.

Condominiums: Healthy and Growing

Condominium sales accelerated in 2003 and are expected to remain healthy in 2004, as a) lifestyle buyers drawn to this product are still able to access low-cost mortgages, and b) affordability buyers (in cities where home prices have skyrocketed) consider condominiums a lower-cost substitute for single-family homes. Condominiums typically offer access to ownership in locations where single-family homes are priced out of reach, a key attraction for lifestyle and affordability buyers alike. Stronger resale demand has begun to trigger additional construction of new condominiums, as well as the conversion of rental properties (some existing, some in the process of being built) into for-sale offerings.

The 10-15% increase in new condominium starts seen in 2003 may continue through 2004, as anecdotal reports indicate the successful sale of new condominium units in many of the larger and/or more expensive housing markets around the country. A number of rental developers have benefited from this trend, either by selling condominiums directly to individual buyers or by selling entire properties to condominium converters at prices higher than rental income streams support. The fundamentals which triggered the upsurge in condominium markets around the country appear likely to remain in place in 2004.

This analysis provided courtesy of Trammell Crow Residential, and J. Ronald Terwilliger, Managing Partner.