What’s Behind the Apartment Boom?

10 Sep What’s Behind the Apartment Boom?

Understanding the financial drivers which influence developer and investor behavior is important for communities hoping to attract private investment. Since 2007, financial market conditions have changed rapidly and continuously, limiting investment of any type. Recently, markets have stabilized enough to encourage some developers and investors to initiate new projects. Simultaneously, investors are returning to real estate, believing it to be a stable investment to protect against the future inflation that many feel will result from government spending and sustained low interest rates. Within the real estate sector, apartments are ideally suited as an investment against inflation, and also reflect a market with favorable demographic and economic trends, resulting in a significant number of new projects which include rental units. This article explores the drivers underlying this trend, allowing communities to collect and provide developers or investors with local information supporting these trends in order to encourage private investment while meeting local demand. Indicators from the Madison market are used to illustrate these global trends, because data is readily available for this market. Smaller communities without established local apartment developers may need to work with local property owners to collect similar information on a local level in order to support similar investment.

How can real estate protect against inflation? Unlike stocks, bonds and other investments, real estate values are not specifically tied to the value of the dollar. Similar to gold or other commodities, real estate has some inherent value and factors influencing demand and supply are not driven strictly by lending patterns. In reality, stricter lending or rising interest rates can actually improve the position of existing real estate by limiting new supply. The supply of new apartments is already low compared to historical trends, with permit activity from the Wisconsin Builders Association projecting approximately 1.7 percent growth in the supply of new rental housing over the next two years, a decline of 42 percent from 2008. This 1.7 percent is roughly equivalent to the anticipated population growth, according to Wisconsin Department of Administration projections. This is already good news for apartment owners, meaning that the current vacancy rate of 2.9 percent for the Madison area (statistics from Madison Gas and Electric) would be preserved in the future. As a result of solid fundamentals, apartment sales in the past 6 months nationally show apartments as the clear favorite real estate investment vehicle, with 25 percent more investment dollars spent on this property type than its next closest competitor. With increased competition in larger markets, investors (and developers) are beginning to explore opportunities for investment in ancillary markets, creating opportunities for smaller market communities to highlight local market opportunities.

What demographic and economic trends are the most powerful predictors of future apartment demand?

Demographic Trends: There are three primary trends which are most likely to influence the need for additional rental units in the next five years. These trends include the following:

  • Increasing population growth for segments of the population ages 18-24 and 65+. These two demographic sectors are some of the most likely to rent as opposed to purchase when selecting new housing units.  Using a local example, Appleton’s population of individuals aged 65 and over is expected to grow by 20 percent through 2017, in contrast to an overall population growth rate of 3 percent.
  • Prolonged impact of the recession, foreclosures and financial reform on the ability of individuals to qualify for mortgage loans. Some estimates suggest that 1/3 or more of those currently renting would be unable to qualify for a mortgage based on today’s credit score requirements. For those who experienced bankruptcy, foreclosure or prolonged job loss, the impact of financial difficulties on credit and purchasing power typically lasts 5-7 years, creating a sustained pool of renters.
  • Likelihood of a reduction in government programs to increase home buying. Most notably, the mortgage interest deduction, once a sacred institution, is on the table as part of the fiscal cliff discussions.  Eliminating this popular deduction would ultimately reduce the price of housing, but also minimizes the economic benefits of owning versus renting.

These trends have already begun to play out, with the recession driving many previous or would-be home owners into rental units. For instance, apartment vacancy in the Madison region has continually declined during the recession, from a high of 5.7 percent in late 2006, according to research by Madison Gas & Electric. In contrast to this growth in demand, the commercial building boom of the 1990s and early 2000s, combined with the cessation of all building during the recession has resulted in fewer modern apartment options. According to the census, only 11 percent of all rental housing in Wisconsin was built since 1990, in contrast to the more than 25 percent of units delivered during each of the preceding 20-year periods. As a result, the new construction pipeline will need to increase substantially over the next ten years to replace those units which are removed from the market while also keeping pace with emerging demand.

Economic Trends:
The largest economic benefit for apartment owners over other real estate sector investments is the nature of apartment leasing. The structure of apartment leases, typically 6- to 12-months in length, allow apartment owners to raise rental rates each time a unit is re-leased or renewed. This is in significant contrast to other types of real estate where lease terms of 3, 5 or 10 years are common. Landlords holding these property types are more reliant on market timing, tenant negotiations and property management to drive profit. This trend also holds up over the longer term, with an analysis of national apartment rental rate trends from 1999 to 2010 indicating a 19 percent higher per square foot rent for apartment units than they would be if rental rates had only grown at the rate of inflation during this same period.

In addition to the frequent turnover of units, the ability to pass on additional unknown cost elements is an added advantage. For instance, volatile costs such as utilities are typically separately metered to each unit, which relieves the owner of the need to forecast utility costs when signing leases. Additionally, the availability of government-based long-term fixed rate interest financing for apartment purchases mitigates the impact of inflation on mortgage costs. In this case, the same government programs which contributed to previously high rates of home ownership are still available to fund apartment building purchases, allowing for a fixed-cost loan apartment purchases versus other commercial property rate loans that more commonly feature adjustable rates.

In order for communities outside of major metropolitan areas to take advantage of the demand for apartment investments, they will need to provide local market information to support the need for additional inventory. By quantifying local market dynamics, including vacancy and rental rates, developers and investors will be able to assess the market without significant up-front investment. Understanding the fundamentals of the market can also help to identify appropriate development partners.

 

While investors are typically looking for a minimum of a 20 percent return, owner-operators may be willing to defer some initial profits in exchange for long-term operating proceeds. While the legwork to collect this data may be significant, maximizing current market opportunities can expand the property tax base and provide necessary residential infrastructure to maintain and grow the local population base.

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