Quarterly Update Shows Vacancy Rates Leveling Off from All-Time Highs
The good news is that, at the national level at least, rental vacancy rates seem to have leveled off. The bad news is that they remain near all-time highs. For the fourth quarter of 2004, the Census Bureau reported an overall rental vacancy rate (which includes both single-family homes and apartments) of 10%, compared to 10.2% a year earlier and the peak of 10.4% in the first quarter of 2004. For rental units in buildings with five or more units, the vacancy rate in the fourth quarter of 2004 was 11.5%, down from 11.9% in the fourth quarter of 2003. Vacancies in apartments with 5-plus units reached a record high of 12% in the second quarter of 2004.

If the equilibrium for the overall rental vacancy rate is somewhere near the 7.4% average for the last 30 years, the current rate of 10% represents an excess of nearly a million single-family and multifamily units. However, the equilibrium rate may be higher than 7.4%. For the last decade, the overall rental vacancy rate averaged 8.5%, and the rate for buildings with five or more units averaged 9.9%.  Using these as the standards, current total rental vacancies are too high by about 570,000—a number that includes about 265,000 apartment units.

Rental vacancy rates are likely to remain at uncomfortably high levels for some time, but there are several factors emerging that point to a continued gradual retreat from the current oversupply. First, there is the decline in multifamily rental production. In 2004, there were 225,000 multifamily units started for rent. That was 14.1% lower than the 262,000 started in 2003. Similarly, multifamily rental starts in 2003 were 4.7% lower than the 275,000 in 2002. These declines in rental starts were offset by increases in condo starts. Although multifamily rental starts declined in 2004, the number of multifamily rental units completed in 2004 (238,000) was virtually unchanged from the number completed in 2003 (236,000). The reduction in rental starts last year will translate into fewer completions in 2005.

Second, the belated recovery in employment and lower unemployment rates should translate into an increase in household formations beyond the increases implied by population growth. To the extent that weak labor markets held back household formations, the rebound should have more impact on rental demand than on homebuyer demand, because the people who doubled up rather than establishing independent households are more likely to initially become renters than home buyers.

Third, if mortgage rates rise as anticipated, the lure of homeownership will be reduced, drawing fewer households out of rental housing.

These factors are changing only modestly. The decline in multifamily rental starts is smaller than in past cycles. Employment growth is proceeding at rates well below the experience of the 1990s. And the long-term bond market is showing no inclination to lurch toward much higher rates.

Vacancy rates are not excessive everywhere (see map). The differences among states did not arise suddenly, and will not be eliminated in the next couple of years. 

Some markets with above-average rental vacancies, especially in the Midwest, already have had large reductions in multifamily permits and starts. Some new projects switched from rental to condo even before completion. Recognition of, and responses to, high vacancy rates have been less evident in many southern states.  Even where production levels have responded to demand, however, vacancy rates cannot be brought into line quickly. For one thing, as noted previously, production of new housing is small relative to the existing stock. Secondly, there are substantial lags between the time new construction is planned, permitted, and/or started and the time it comes to market. New production that is currently in the pipeline will add to the glut in overbuilt markets. Conversely, the pipeline of supply into tight markets takes a while to fill up. Finally, institutional factors such as regulatory delays, as well as lags in decision-making, postpone adjustments in planned production.

Cap Rates Expected to Increase

Although consumer demand for apartments has been soft, investor demand has been anything but. In fact, demand for investment opportunities has been strong enough to keep construction going. Investors have been willing to pay handsomely for equity interests in apartment properties, and lenders have been more than willing to provide mortgages with attractive terms, seeing rental housing as less risky than many alternatives and as an opportunity to diversify loan portfolios.

By driving down cap rates (the ratio of current net operating income to property value), the inflow of equity investments has produced capital gains for past investors that have overshadowed rental income. Returns over the past couple of years, measured as the sum of current yield and increase in values, have exceeded returns from most other investments. Investors in exchange-traded apartment REITs enjoyed average returns of nearly 17% per year from the end of 1999 to the end of 2004, compared to an average of a negative 2% for stocks in the Standard and Poors’ 500 index. 

Cap rates were generally in the 6% to 7% range in 2004. Five years ago, they were in the 8% to 9% range. The decline in cap rates was roughly in line with reductions in long-term bond rates. In some hot markets, recent cap rates were around 5%.

Cap rates are a very crude measure of expected return on investment. Current property prices may be a bargain if there is a realistic expectation of higher future occupancy and rents--and not many investors consider their own expectations to be unrealistic.

With interest rates rising, cap rates are not going to decline further. Therefore, future returns will depend more on the underlying fundamentals of (housing) supply and demand.

Demographic Forces Will Bring Future Improvements

Table 1 shows the proportion of households headed by people in different age brackets living in multifamily housing in 2000.

The share of the population who were household heads (the headship rate) also is shown, as well as the share of the total population in each age group that headed households in multifamily housing.
 
Among households headed by people under age 25, more than 60% lived in multifamily housing (column 4), a share that was progressively smaller in age brackets up to 55-to-64, with the shares among the oldest households somewhat higher than for those in the 55-to-64 year bracket.

The high multifamily share for the youngest households was offset by the fact that few people had established independent households by that age. This is shown by the headship rates (column 3). Column 7 shows the combined effect of headship and structure choice, with the share of all people in each age category who were household heads living in multifamily housing. The largest share of people heading multifamily households is the 25-to-29 year old age group.  After age 30, although more people are household heads, the greater tendency to live in single-family homes means the number of multifamily units occupied is smaller, relative to population.

The table also shows the shares of households and people owning and renting multifamily homes. Although the share of population renting multifamily units is lower past age 30, the share living as owner-occupants in multifamily units (mostly in condos) is higher among older age groups. The owner shares are shown in columns 5 and 8.

These proportions are not fixed. Headship rates and structure/tenure choices can and do change, but the general patterns (i.e., lower multifamily rental demand from middle-aged households, higher headship and condo demand from the older population) will persist. It is instructive therefore, to look at the implications of changes in the population in each age group on multifamily demand.

NAHB has produced population projections (Chart 1) based on assumptions of moderate immigration (about 700,000 per year) and high immigration (1.7 million per year).

Actual immigration since 2000 has fallen midway between those two alternatives, and for this simulation we used a simple average of the two alternatives.

Applying the 2000 ratios to the estimated and projected population change indicates that multifamily demand, especially multifamily rental demand, will increase more slowly in the next few years than in the early years of the decade, before accelerating around 2009 (Chart 2). Condo demand would move gradually higher, with nearly all of the net increase coming from people 55 to 74 years old.

The simulated increases in multifamily households of over 325,000 per year for 2001 to 2003 were not matched by actual demand. Although the simulated increase in multifamily households was approximately equal to multifamily production, the growth in multifamily supply—taking into account net removals—was less than that, but multifamily vacancies continued to increase. Fewer households were formed, and fewer of those chose multifamily housing, than the 2000 ratios implied.  This could mean some offsetting rebound as employment growth and interest rates increase, but many of the echo boomers who might have provided a boost to multifamily demand as they entered their 20s may simply skip rental and move directly to single-family housing. The more important lesson from this exercise is that the primary boost in multifamily rental demand from the baby boom echo, reflecting movement toward a peak in the number of births in 1990, won’t come for a few years.

Production Forecast Looks Steady for 2005-06 

Taking into account the condo boom, increased authority for new low-income housing tax credits and tax-exempt bond financing, and the continued opportunities for additional market-rate rental production in and around major metropolitan areas on both coasts, our forecast is for multifamily starts in buildings with five or more units to remain in the recent historical range of 290,000 to 320,000, with 2005 coming in at 302,000 (down 1.2%) and 2006 edging down by another 2.2% to 295,000 (Table 2).

With the increased condo share, as well as the work required to complete structures started in 2004, the inflation-adjusted value of new multifamily construction as reported in the GDP accounts is forecast to rise in 2005 to $33.5 billion (in 2000 dollars) from $33.0 billion in 2004. For 2006, the constant dollar value of fixed investment in new multifamily structures is forecast as $34.0 billion.

This article is based on material published in NAHB’s Housing Economics Online as part of the March 2005 Multifamily Forecast. To learn more or order a subscription, go to www.nahb.org/publications/housingeconomicsonline.
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