By J. Ronald Terwilliger. The biggest challenge multifamily rental housing faces today is a shortage of renters. In prior recessions, with job loss came the expected fall-off in rental demand. This time around, however, interest rates remain so low that people continue to buy homes at record paces. Consequently, multifamily is not only losing renters to a lack of jobs, we're losing renters to homeownership.
Given tepid demand and unprecedented home buying, what frustrates me the most is market-rate multifamily housing's supply level. It hasn't dramatically fallen back as market circumstances suggest that it should — as it did in the early 90s. The business of real estate developers should be fairly simple. People overcomplicate it, but it's nothing more than building new supply to meet demand — preferably pent-up demand. It really is that simple. Yet if you look at multifamily starts for the first six months of 2002, they're virtually at the same level as last year. Nevermind that market-rate markets are already over-served and overbuilt.
All the Rage
What people don't seem to realize is that even in a recovering economy, excessive market-rate building will prolong multifamily housing's recovery until 2004, at the earliest. My guess is 2005 or 2006, depending on when supply begins to slow. The problem is that people love multifamily in times of recession.
Historically, its volatility has been lower than other income-generating product types. At the same time, commercial and single-family builders see multifamily as a way to combat the industry's cyclicality. Lenders and investors, on the other hand, are searching for alternatives to the stock market. By default, they look to real estate. When they do, they think back and remember that multifamily is one place they didn't lose money in the last recession. They're betting multifamily is the place to put their money once more.
Here's where the human phenomena become relevant: Builders will build when they can get capital on acceptable terms. As long as there's enough equity (which is usually at least 25 percent of cost), banks will make construction loans for development of new market-rate rental apartments. Investors see multifamily rental as one of the better places to invest in new development. Until investors cease making equity available for new market-rate multifamily rental development, markets will remain soft and we will experience a prolonged recovery.
Photo: Courtesy NAHB
What both banks and investors ignore are the differences that this cycle brings. The most glaring distinction is that multifamily supply was shut down almost completely during the 1991 recession, but has hardly even slowed during this one. Roughly 100,000 multifamily housing rental units were built nationally between 1990 and 1993 (in the mid-80s, we were building five times that many). In addition, the majority of those units were subsidized. So we had about 30,000 market rate apartments being built each year from 1991 to 1993. Today, we've got four to five times as many market-rate apartments being built, and yet, market conditions are every bit as bad as they were then. The worst oversupplies are in places where it's easiest to get permits — generally the southeast and southwest. Nationally, there are almost no strong rental housing markets compared with two years ago.
While there are niche opportunities to build market-rate rental, the broad-based opportunities that existed for most of the 90s no longer exist. The best markets right now are in Southern California, Southeast Florida, parts of the Northeast, and Houston. With the exception of Houston, the entitlement process produces true supply constraints. Developers are beginning to find these markets, and it's only a matter of time before they, too, start to soften. In general, the industry is going to have to downsize its production capacity for the next two to three years to get supply and demand back in balance — even in a recovery economy (which should produce higher mortgage rates).
If you're a smart developer, there is some commonality to all real estate development, and this permits some overlap. Single-family builders dabbled in multifamily in the past as an anticyclical measure, but now pursue it with more focus. I wouldn't necessarily say there are too many single-family builders in multifamily today. They're entitled to go there, just like my company is entitled to move into single-family. The danger we all run by moving into a new product line is paying the dumb tax — making rookie mistakes.
More of a concern is the growing number of commercial builders moving into the multifamily product line. Herein lies the real danger with too much capital being available. Recession breeds the inclination for commercial builders — particularly office builders — to cross over; the availability of capital does the rest. Multifamily's biggest appeal is that, unlike the financial community, it doesn't require pre-leasing to obtain development financing. This is a crucial distinction for those commercial builders unable to finance the product line they know best.
Recovery isn't expected anytime soon. All we can do is wait it out. In the meantime, there are many things we can do. On the Multifamily Leadership Board, one of our priorities is debunking the negative stereotypes associated with apartments. We also are encouraging builders to provide the product the market demands. No one should assume that what they did last year will work next year. Markets need to be continually reassessed.
Some builders already have begun to make adjustments. Low interest rates are prompting many of us to shift production to condos and build fewer market-rate rentals. Nevertheless, the only real brake on this behavior will come with rising interest rates, which will slow the outflow of renters into the for-sale market. Households would be less encouraged to leave rental apartments in search of homeownership. While I'm in favor of homeownership, I think lenders have gone a little overboard by making mortgage financing too easily available. At the margins, households with minimal down payments and unstable jobs have been attracted to ownership. Let's hope there is no housing bubble and that mortgage delinquencies stay under control.
Published in BIG BUILDER Magazine, December 2002