US Apartment Fundamentals on Road to Recovery

The last two weeks have been “earnings season” for US Apartment REITs reporting 2Q results. Uniformly all the companies have been reporting better than previously expected operating income (NOI- Net Operating Income), primarily driven by a lower drop in rental revenues, year over year, and increasing revenues on a sequential basis. Renewal rental rates are up about 1-3 per cent, retention rates are up about 5 per cent (leading to a decline in turn related expenses), while rents on new leases are recovering to the point where they are above in-place rents. Occupancies are up 70-200 basis points as well.

Bottom line - the downturn in Apartment fundamentals is over and recovery is most definitely underway. The driving factor behind this turn of events in the face of a slowly growing economy (more later) is the shift from homeownership to renting, as a result of tightening lending standards and the general lack of allure of homeownership. Demographics, while favorable to the 22-35 yrs old core renting group is helpful, is not the main force at this time.

As stated previously in these columns, new rental supply is muted (no more than 100,000 units per year or ~0.3 per cent of stock, down from the 300,000 unit run rate previously), so a shift in the renting “market share” is occurring. Geographically, the Eastern Seaboard (Boston to Washington DC) is benefiting the most, while the West Coast (Seattle to San Diego) is coming back more slowly.

Meanwhile, the core of the economy is anemic. This morning, the US government released the non-farm payroll report, which showed only limited increases in private sector employment, +71,000 in July, off a revised downward +31,000 in June. The totals included distortions associated with US government temporary Census Bureau hirings/firings, so the private sector totals as the ones to watch.

While all recoveries first generate increased profitability of companies before new hiring, this one seems to be particularly weak. Other economic graphs demonstrate that the recovery in GDP and employment is much weaker this go ‘round than in previous ones. For this alas, one can only look at US government policies as the driving force. By focusing on government spending rather than tax reduction, adding significant new tax increases, government mandates, and increased hostility to small business, current policy is continuing a significant shift in power away from the private sector, or to those sectors where large private enterprises can be “steered” by government policy and regulators.

At the same time, the Apartment industry continues to benefit from a declining cost of funds, as 10 yr financing costs follow the Ten Year Treasuries, currently at a 2.9 per cent, which results in mortgage rates of about 4.9 per cent or less. Among the real estate sectors, there’s no doubt that apartments are the healthiest, given both the shift in renting vs. homeownership and the subsidized access to debt capital. One raises NOI, the other raises asset values.

How long this can last is now the question at hand. Most Apartment REIT management teams remain thankful for the bounty, but very wary about its sustainability in the absence of meaningful job growth. Meanwhile, the acquisition market for apartments is continuing to heat up, and institutional buyers continue to bid up the price of in-fill major city assets, down now below 6 per cent cap rates.

The current course seems to be one of anemic growth, consumer de-leveraging (slow retail sales), and an increased role for government leading to a less vibrant economy. The projected increase in the US debt burden as percentage of GDP is truly frightening. It is very doubtful to me that the American electorate will accept this as the “new normal”, where living standards decline as public sector unions enjoy fully paid health care and generous pensions unavailable to the private sector.

The declining approval rating of the President and the Democrat Party, seems to me that a massive change is in the offing in the November election at the federal and state level. I certainly hope so, for only a pro-growth agenda driven by the private sector can restore a vibrant US economy. In the meantime, US multifamily is a pretty darn good place to be.

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