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| Will the Decline in Ownership Benefit Apartments? |
| Written by Jonathan Smoke | |
| 08.15.2007 | |
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Discuss this article on the forums. (0 posts) In response to our series of articles about declining home ownership brought on by credit tightening—or some might say a return to sanity by the credit markets—we received another thoughtful suggestion for an article from a member of our HousingIntelligence community: “The combination of record foreclosure rates combined with the difficult lending environment for first time home buyers should significantly increase the percentage of household formations that become rent, driving the demand for apartments, reducing vacancy and increasing rents and values. Factor in lower interest rates and the impact of apartment values should be significant.”
 The logic proposed here seemed clear and straightforward. Assuming all other things remain equal, those households “on the cusp” of being able to afford a home but with limited credit history, poor credit, limited income, or limited means to make a sizable down payment should now be more likely to rent than to buy. So it would naturally follow that apartment vacancy rates should fall while rents increase.And since commercial properties such as apartments are valued primarily by cash flow from rents and cap rates, if the property is generating more cash and the cost of capital is stable or declining, the asset value should also increase. A hallmark of a good researcher is to know when he or she should ask someone who understands a topic better than him or herself. I will readily admit that I have limited experience with multifamily, so I turned to one of the most respected researchers in the commercial real estate business and asked for his opinion on our user’s comment. Here’s what Bret Wilkerson, CEO of Property & Portfolio Research, Inc. had to say: “First - on the demand side. Housing cycles and apartment demand have an interesting relationship - not always one for one. Today is no different. New households being created are almost all renter households, for a number of reasons: people don't want to buy in a falling market, new households often don't have the down payment required to buy a house (imagine, requiring equity!), and in many cases there are very attractive condo and housing units being rented at low rates. But there is a rub - if there is an economic downturn, household formation typically slows. Kids just out of college move back in with their parents, renters will double up, and so on - so there is less overall demand for housing.
Secondly - on the supply side we have had an immense amount of condos built or converted that are ‘shadow supply,’ and are actually being rented. These often don't get captured in statistics but they are real units. We actually have been tracking the number of housing units listed on Craigslist per household in various cities, and you've seen big jumps in Las Vegas, Boston, San Diego, etc. Rental growth had been spectacular, despite the run-up in the ownership market because so many multifamily units had been ‘taken out of the inventory’ to be converted to condos, but that is reversing and we're going to see rental growth slow. So you then have a scenario where income growth on multifamily properties is not quite as good as people generally think. When that shows up, there will actually be a decline in many places in apartment values. The one thing that helps -- and it helps significantly -- is that most investors see apartments as the port in the storm, and so they benefit from the ‘flight to safety’ that we see in many asset classes.” So, the key issue here is that all other things are not necessarily going to remain equal. That darn ceteris paribus! Challenging a rapid rise in demand for apartments is capacity hidden from the stats (and the underlying fact that for sale housing will always become “for rent” if that’s in the owner’s best interest). Indeed, any fans of Michael Porter’s Competitive Strategy should recognize that in the housing industry, apartments are substitutes for single family homes and vice versa. Furthermore, household formation may indeed slow if the economy hits a bump or if prices, including rents, outpace income growth. That doesn’t mean apartments won’t do well, it’s just that rent growth will be contained by some of these other factors. Bret, thanks for helping us see this more broadly. If any of our readers are in need of quality reports or advice in the commercial real estate arena, check out Bret’s company. Property & Portfolio Research, Inc. (PPR) is an independent real estate research and portfolio strategy firm that provides leading institutional real estate market participants with objective research on real estate cycles and their implications for investment strategy. PPR helps clients apply cutting-edge market research, analytics, and strategic thinking to stay ahead of market trends and maximize risk-adjusted returns. By the way, the implied assumption that interest rates could decrease is debatable given the contagion in the credit markets is making all forms of credit more expensive despite what the Fed may or may not due. But that is a topic for another day. 
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