A Balancing Act | The Ongoing Challenges Facing Multifamily Supply
Multifamily development continues to make headlines, with over 900,000 units underway across the U.S. as of Q3 2023. Apartment demand weakened in late 2022 and continued into 2023, and although the trend is reversing, is it reversing fast enough? Many markets are reporting a supply pipeline that outpaces demand. In addition, most deliveries are projected to be Class A properties when the need for affordable housing is ever-growing. Add a slowing economy, insurance concerns, and declining construction lending to the mounting challenges the sector faces — How do these deliveries affect the overall market, and what challenges are slated for 2024?
Record Deliveries Meet Waning Demand
The imbalance between multifamily supply and development has existed for decades. It took a sharp turn in 2022 as the post-pandemic boom wore off, and demand declined while construction remained bullish. In Q3 2023, the sector hit a positive note, reporting the highest absorption rate in two years. However, the increase in absorption was met by 140,000 delivered units, making Q3 the eighth straight quarter of supply excess.
This imbalance hurt rent growth throughout 2023, but Q2 and Q3 were relatively steady compared to previous decreases. From Q3 to Q4, monthly rent rates fell $8, while year-over-year rent growth grew from 0.8% to 0.9%. Although the ongoing supply and demand challenges are hindering rent growth, there are several other factors in play. This year brought historically high interest rates and inflation, rising energy prices, and weakened consumer spending. Rent growth is by far the most affected by the robust pipeline of supply applying pressure to rent rates.
Occupancy among primary and secondary markets is balanced due to solid job growth. RealPage stated occupancy rate stabilized at 94.5% in September, marking the third consecutive month that rates have held constant. Although occupancy rates are steady, an influx in supply over the next few quarters could encourage rates to fall. The Federal Reserve expects job growth to slow in the first half of 2024, which could also strain occupancy rates.
94.5% occupancy is just 20 basis points below the 2010 average, which suggests further market normalization.
Not only is there an imbalance of supply and demand, but there is an imbalance within the supply pipeline. There are more Class A apartments under construction than any other multifamily property type, contradictory to the affordable housing crisis in major U.S. markets. The average vacancy rate of Class C apartments is 6.6%, while Class B and Class A apartments average 9.7%, according to CoStar Group.
There is a shortage of 7.3 million affordable and available rental homes for renters with extremely low incomes in the U.S., up 8% from 6.8 million in 2019. Source: Urban Institute
The Markets Outperforming
Although the U.S. multifamily market is experiencing challenges across the board, including rent growth, supply, operational costs, etc., specific markets are outperforming the averages.
Multifamily performance is strongest in the Midwest and Northeast, with New York and New Jersey leading the pack. According to Yardi Matrix, New York City and New Jersey averaged 5.6% and 5.2% annual rent growth, respectively. These regions are the most stable in terms of supply and demand issues. Midwest and Northeast metros lack oversupply and feature resilient economies, helping the markets stay balanced.
In the current marketplace, the reason why some metros are underperforming is often one of two issues: The hangover effect of post-pandemic growth or regulatory restrictions.
Secondary markets experienced extraordinary growth post-COVID-19 as migration from densely populated cities heightened. But, as the pace of migration slowed and renters returned to urban environments, renter demand decreased, and the units desperately needed in 2021 were now coming to market after the urgent need had passed. Industry outlets have referred to this outcome as the “hangover effect” from the explosive post-pandemic growth.
Essentially, the growth after COVID-19 was so strong and critical that the markets were likely to see fundamentals decline as the figures were unstainable. Some primary markets experiencing hangover imbalance are Phoenix, Tampa, and Nashville. The West is another region facing obstacles, but unlike most of the country, the supply and demand imbalance isn’t the primary issue. For landlords in the western U.S., it’s less about supply and demand and more about process delays and the regulatory environment. Although the region is in dire need of housing, specifically affordable housing units and the absorption rates are positive, development in the West slowed starting in 2022. This is because investors have to work harder to earn a profit on their properties. Rent control, environmental restrictions, and various renter-friendly government regulations discourage multifamily development. The regulatory environment, coupled with rising operating costs, greatly hinders development activity, in turn hurting the supply pipeline
The Hangover Effect: The excess of growth in one period of time causes a slump of the same proportion thereafter.
How Developers And Owners Are Pivoting
During difficult markets, investors and developers need to get creative with how to turn a profit. Renters in today’s markets are much more demanding than previous generations, knowing what they want for housing and expecting top-of-the-line amenities for the current rent rates. Mixed-use development grew widely popular and is in high demand as they combine modern living with accessible retail and office space. In addition, developers facing a lack of available land are repurposing established buildings and converting them to multifamily. Office-to-apartment conversions are a leading trend in primary markets. Investors must also research and ensure they understand their target audience, aligning their property to the community’s demographics and needs.
Another challenge causing owners and operators to pivot is rising insurance costs. Insurance costs are not a new issue in the multifamily sector, but over the last year, conditions have worsened, and multifamily owners are feeling the heat. Due to industry consolidation, companies exiting certain markets, increasing claims, and the ongoing climate crisis, insurance companies are rising their costs drastically. In order to combat the increased costs, developers look to construct buildings that sustain extreme weather and are up to code. At the same time, owners are more proactive with property upkeep, hoping to decrease the cost of their policies.
Insurance premiums have risen more than 100% in some instances in FL and TX. – Source: Multifamily Dive
What to Expect in 2024
Interest rates are expected to start decreasing in mid-2024 as the Fed’s inflation target of 2.0% is expected to be met over the next few months. Until the interest rates fall, commercial real estate will stay in a down market, multifamily included. However, the market as a whole is healthy, and much of the outside factors that are causing the decline will eventually turn back positive. In early 2024, markets will see their supply pipeline decrease, helping the sector regain balance. The current lending environment makes it more difficult to close deals, but several primary and tertiary markets offer opportunities. The multifamily sector is historically resilient, and this downturn is no different.
