Separate studies issued this week share the same conclusion that demand for rental apartments and other housing options will stay at elevated levels largely due to the continued robust household formation and limited affordable housing options, especially for detached single-family houses.
The first study was co-commissioned by the National Apartment Association (NAA), sponsor of NAA Education Conference & Exposition running this week through Friday at the Georgia World Congress Center in Atlanta. The report projects that based on current trends, an additional 4.6 million new apartment units will be needed by 2030 to keep up with demand as younger people delay marriage, the U.S. population ages and immigration continues.
The national vacancy rate for multifamily remained moored at 4.4% in the third quarter, unchanged since the fourth quarter of 2015 despite the large number of new deliveries.
This confirms what we have posited thus far about demand remaining robust even as supply growth increases. With that said, this equilibrium is tenuous and likely won’t last.
For markets that experienced either a large increase in rents over the last few years, or a steady influx of new buildings – or both – landlord pricing power is being tested.
Market conditions in the apartment market softened a bit in the third quarter, a period they generally see the highest activity and strongest rent growth.
On Pause, Those Fine Hopes for 2016
We started 2016 feeling fairly optimistic about the prospects of the office sector. With the national vacancy rate declining by 40 basis points last year, we were poised to finally see an acceleration in improvement in fundamentals for the office sector.
With national vacancies remaining stuck at 16.0% in the third quarter, it appears that optimistic hopes about the prospects of the office sector have been put on hold – at least till the fourth quarter.
While the numbers disappointed in the quarter, much of the decline was a lagged response to tepid employment and economic conditions in the first quarter.
Two Steps Forward, One Step Back
The national neighborhood and community center retail vacancy rate increased by 10 basis points during the third quarter to 10.0%; the retail mall vacancy rate decreased by 10 basis points to 7.8%.
Both minor changes represent a reversal in the second quarter when the neighborhood and community center vacancy rate decreased and retail mall vacancy increased, both by 10 basis points.
Neighborhood and community centers have lagged due to the slow growth in median household income that has kept a lid on discretionary spending over the last few years.
Both neighborhood and community centers and regional malls face competition from newer and fresher retail concepts as well as e-commerce.
A Downshift in Demand
The momentum in the industrial market slowed a bit as demand growth decelerated. Nevertheless, vacancy held steady in the warehouse and distribution sector as net absorption exceeded new construction by a small margin.
Although the industrial sector has outperformed other property types in terms of occupancy growth, the down-shift observed in the third quarter puts the asset class on par with office and retail which followed a similar pattern.
Echoing the sentiment we expressed last quarter, the slow but steady rate of growth should continue going forward as most metros continue to see demand growth for industrial space.
Vacancy declined in the Flex/R&D subsector largely due to a sharp drop in new construction.
Net absorption slowed somewhat but remained positive. Market rents increased but also at moderate rates, similar to the second quarter.
Once again, every metro posted positive rent growth for the quarter, although some outperformed others.
New Construction at the Cusp of Economic Change
The third quarter of 2016 was marked by a somewhat consistent trend – a pronounced pullback in new completions, relative to recent quarters.
This is readily apparent in the apartment and office sectors, but less so in neighborhood and community shopping centers where supply growth has been anemic for several years anyway.
What caused this pullback – especially in multifamily where we were expecting a deluge in new supply?
Any pickup in activity for new completions is likely to be driven by projects that are already in the pipeline, just waiting to come online in what may well be a deluge for the apartment sector in the fourth quarter.
Just when we think the apartment market can’t get any stronger, we hit the equivalent of 88 miles per hour and see cap rates reaching a new record-low level. We observe that the mean cap rate, illustrated by the dark blue line in the chart, declined by 10 basis points to 5.7% during the second quarter. The market continues to reach record-low levels and the average commercial real estate cap rate has now been below 6% for all of 2016.
It remains remarkable that this far into an economic expansion that investors are willing to pay such a premium for apartment properties. Certainly, the low-yield environment around the world plays a big role, especially given the relative strength that we have observed in apartment fundamentals. But ultimately what this shows is that investors, despite new supply growth, continue to be bullish on the apartment sector, even if only on a relative-value basis.
As the mean cap rate has continued to fall over time, it is unsurprisingly pulling down the 12-month-rolling cap rate, depicted as the red line in the graph. Due to the strong downward trend in the market, that metric has now fallen below 6% for the first time ever, reaching 5.9% during the second quarter. This demonstrates that these sub-6% cap rates are a longer-term, durable phenomenon and not a one-quarter anomaly.
The downward trend in cap rates for multifamily properties is also dragging down the historical long-term average cap rate, shown as the dashed line in the chart, which has now fallen to 6.5%.
The environment remains ideal for apartment cap rates to remain at or near historically low levels and possibly fall even further. Nothing fundamental has changed between this quarter and last quarter to alter that view. While hearing anecdotally from clients that they are starting to balk at such high apartment prices, that looks more like the exception these days based on the cap rates for properties in the market that are actually trading.
Commercial Property Sales Slowdown as Investors Pull Back
First Quarter Leasing Levels, Net Absorption Remained Strong Despite Fewer Sales, Price Decline
Commercial real estate prices and investment volume declined for the second consecutive month in February, despite robust leasing that bolstered net absorption and CRE fundamentals in the first quarter of 2016, according to the new release of CoStar Commercial Repeat-Sale Indices (CCRSI) data.
Both the value-added and equal-weighted U.S. Composite Indices, the broadest measures of aggregate pricing for commercial properties within the CCRSI, declined in February. The value-weighted index, influenced chiefly by larger transactions, declined by 0.6%. The equal-weighted index, comprised of a higher number of smaller deals, declined 0.8%.
Investment sales volume across the commercial property sector also declined from last year’s torrid pace. The number of observed repeat-sale trades dropped 12.1% over the last 12 months ending in Feb. 2016, compared with the same period in 2015.
The drop in sales activity was apparent in both the high and low-end sectors as the composite pair count fell 10% in the investment-grade segment of the market and 12.6% in the general commercial segment in the first two months of 2016 compared with the first two months of 2015.
Leasing activity remained strong, with total net absorption of 155.1 million square feet across the office, retail, and industrial markets, contributing to a total of 655.1 million square feet of net absorption for the 12 months ending in March 2016, a 10.7% increase from the same period last year.
Indicating a ‘flight to quality’ among tenants, investment-grade properties posted the strongest year-over-year absorption growth, increasing 14.8% in the past 12 months compared to last year’s period, while the general commercial segment expanded by 1.9%.
The two-month slowdown in CRE price growth suggest that pricing may reach a plateau for the cycle in 2016, according to CoStar’s repeat-sale analysis, with trends indicating the two composite indices could level off this year after several years of steady appreciation at a 1% average monthly clip.
Investors have enjoyed a remarkably strong performance in the commercial property markets over the past several years, with limited new construction and the ongoing economic expansion helping to hold vacancies near cyclical lows and spurring rent growth.
The performance is apparent in the CCRSI value-weighted index, which has exceeded its prerecession peak level by nearly 20%, while the equal-weighted index has moved to within 5% of its previous peak.
However, general global economic uncertainty and higher interest rates have begun to put upward pressure on capitalization rates, weighing on price growth this year.
During the fourth quarter the mean office cap rate increased very slightly, but when rounding to tenths of a percent remained unchanged at 6.9%. This is actually up 10 basis points from the level during the fourth quarter of 2014. Meanwhile, the 12-month rolling cap rate was also essentially unchanged versus last quarter at 6.8%. These signals are largely the same ones that we received last quarter. Over the last year cap rate compression for office has slowed. We all know that the in-quarter mean cap rate can be a bit volatile, but the 12-month rolling cap rate is clearly showing some signs of stalling. While this merely looks like a pause, it is important to note that office fundamentals continue to offer attractive upside. In many markets across the country the outlook is brighter over the next five years than was has transpired over the previous five years. But is this true for all markets? Is it impacting transactions and pricing at a more micro level? For now it is important to note that in the historical context, cap rates remain near historically-low levels.
When we compare the current 12-month rolling cap rate to the mean 12-month rolling cap rate, we find that it is under by about 40 basis points. This is roughly in line with the difference from last quarter and 10 basis points narrower than what we observed in the apartment market. We mentioned last quarter that the shifting pool of properties traded from quarter to quarter could cause cap rates to rise in short term. While that is what we observed (albeit slightly), the market nonetheless remains incredibly pricey.
Stronger Retail Demand Rent Growth Seen Shifting to Second-Tier Markets
As Rents in High-End Districts Start to Moderate, Investors Widen Their Horizons to Include Strong Trade Areas in Secondary, Tertiary Markets.
The national vacancy rate for retail real estate in the U.S. edged down to 5.9% in the fourth quarter of 2015 after logging a healthy 20 million square feet of net absorption and setting the stage for rent growth in a growing number of shopping districts in the coming year.
Meanwhile only 12 million square feet of new retail space came online in the final quarter of 2015, culminating a moderated pace of shopping center construction last year that continues into 2016, according to data presented during the CoStar’s 2015 State of the U.S. Retail Market Review and Forecast.While retail construction remains at relatively low levels compared with previous cycles, the 70 million square feet of new shopping center space currently under construction across the U.S. is the highest level since the most recent recession, according to Suzanne Mulvee, director of retail research, who presented the outlook and forecast with Ryan McCullough, senior real estate economist.
Although the list of new retail projects includes 21 malls and five outlet centers, only 10 power centers are under construction, considerably less than in previous cycles.
However, the 86 grocery-anchored neighborhood centers under construction is a significant increase from the last couple of years, reflecting the growing strength of smaller independent in-line tenants. The increased confidence in grocery-anchored centers also reflects growing economic strength at the local level as the effects of the economic recovery continue to spread.
In somewhat of a change in pattern from the previous retail supply boom from 2006 to 2008 and earlier, developers do not appear to be focusing on building new shopping centers in far-out suburban locations in the path of anticipated housing and population growth. Rather than ‘chasing rooftops’ into the outer suburban fringes, builders are targeting more urban mixed-use infill projects, especially in such supply-constrained markets as New York City, Miami and Honolulu.
Between 1% and 1.5% of new retail inventory is currently under construction in these three markets, including major projects such as Miami’s Brickell City Centre, shopping centers near the World Trade Center and Hudson Yards in New York, and Honolulu’s International Market Place, opening this summer in Waikiki.
Meanwhile, other former high-growth retail markets that are not as supply constrained, such as Raleigh, Nashville, Houston and Charlotte, are seeing considerably less construction than the 2006-2008 cycle.
Year-over-year demand growth in 2015 was strongest in such markets as Dallas, Raleigh, Fort Lauderdale and Orlando, FL; and Austin, markets that have now shed their overhang of vacant store space from the last cycle.
Western U.S. markets enjoyed the strongest rent growth in the cycle so far, led by Honolulu at about 13% last year and a cumulative 50% over the course of the current cycle. San Francisco, which has seen little demand growth due to supply constraints, still enjoyed 10% rent growth in 2015 and 30% since the beginning of the recovery.
Later recovering Southern markets like Atlanta, which are now experiencing solid population and demand growth, are positioned to reap rent growth that has remained elusive so far due to the glut of vacant space from the last cycle.
“We’re going to see these markets start moving up on the rent growth spectrum this year,” McCullough said, adding that markets like with Nashville, Austin and even Houston are already seeing growth in the high single digits.
Houston, in fact, is seeing a much needed bright spot in its commercial markets, where office sector demand is being hit by the decline in energy prices and its effect on the local economy. Houston’s retail sector is holding up better because population growth has outpaced retail supply for so long that the market has actually seen less retail space built per capita than any time during the last 30 years.
“That’s really strengthened the retail market and helped insulate Houston from further economic shocks,” McCullough said.
Conversely, markets such as Washington, D.C. and New York City, which experienced strong retail growth earlier in the recovery, are now slowing. Rent growth in D.C., for example, fell from 7% in 2014 to under 2% last year. Midwest markets are similarly playing catch-up in both demand growth and rents.
Following a hot start early in the recovery, rent growth in the most well-heeled U.S. trade areas with at least $2 billion in spending power within a three-mile radius has slowed considerably in recent quarters.
“In some of the premier retail districts around the country, while we would anticipate good rent growth, I don’t think it’s going to be as explosive as what we’ve seen in the past,” McCullough said.
The national vacancy rate rose by 10 basis points in the fourth quarter – to 4.4 percent. This is the second consecutive quarter that national vacancies have risen, but these patterns do not necessarily suggest a massive weakening in apartment fundamentals. If anything, this was right in line with our forecasts at the beginning of 2015 that vacancies would finally begin to rise, after being stuck in the low 4s for a couple of years. Demographics and demand remain strong, but developers brought close to 200,000 units online in Reis’s 79 largest markets, pushing vacancies up in even places like Denver or Seattle, where the question of whether robust job creation and a vibrant economic environment could outweigh the thousands of apartments coming online. No, it couldn’t, and it didn’t. The vacancy rate in Denver rose from 4.3 to 5.1 percent in 2015, and in Seattle it rose from 4.7 to 5.3 percent. Denver and Seattle added what was in effect anywhere from three and a half to four percent of new inventory in 2015, and that exerted upward pressure on vacancies.
With that said, the apartment sector also had a banner year in terms of asking and effective rent growth – the other major driver of top line revenues, aside from occupancy rates. Asking rents grew by 4.6 percent at the national level, and effective rents grew by 4.7 percent. Those figures are stronger than the peak years in 2006 and 2007, and one would have to look back to the period from 1999 to 2000 to find rent growth figures that were comparably strong – and back then vacancies were in the low three’s.
So where is multifamily heading?
Supply and Demand Trends
Our expectations for multifamily have not changed. We expect vacancies to rise through the end of our five year forecast period, but if this comes to pass and national vacancies end 2020 in the low 5’s, that just doesn’t spell doom and gloom for multifamily properties. Supply growth for 2016 will likely be stronger than the past year’s, adding to the upward pressure on vacancies, but this is not news either. If anything, there is anecdotal evidence of finance sources throttling back on apartment developments, waiting and seeing whether new properties that opened their doors lease up at an acceptable rate before they green light new investments.
What we are projecting for the multifamily sector is very much a soft landing, with ample runway for rent increases despite worries of median household income and wages not catching up. Now, that doesn’t mean rent growth won’t be cramped by rising vacancies – already, concessions are making their way back to places hardest hit by new supply. It just means that overall, while market players may need to backpedal on the most optimistic of double digit growth rate projections, demand and supply conditions for multifamily remain healthy. The riskiest play, as always, will be those submarkets and neighborhoods enduring large amounts of new supply – they face the larger risks of income loss and occupancy deterioration if we are struck by a recession over the next five years.