In this episode of The REconomy Podcast™ from First American, Deputy Chief Economist Odeta Kushi discusses multifamily supply-and-demand dynamics and the outlook for apartment rents with Senior Commercial Real Estate Economist Xander Snyder. 

Don’t miss a single REconomy episode, subscribe today.

Listen to the REconomy Podcast™ Episode 87:

“This implies that in the long run, beyond that two-to-three-year period, there's a reasonable expectation that demand will catch back up and that this oversupply will be sort of an intermediate-run dynamic. For now, though, at least on a national level, supply is outpacing demand.” – Xander Snyder, senior commercial real estate economist at First American

Transcript:

Odeta Kushi - Hello and welcome to episode 87 of The REconomy Podcast, where we discuss economic issues that impact real estate, housing and affordability. I am Odeta Kushi, deputy chief economist at First American and here with me is Xander Snyder, senior commercial real estate economist at First American.  Hey Xander, welcome. Well, spring is here, and that means it's the spring home-buying season, but let's not forget about the renters out there. After all, people don't just move into new homes in the spring, they also move into new apartments. So today we'll be looking at some of the trends shaping the apartment market and why renters looking to move, or find their first apartment, will likely have more options than they did last year.

Xander Snyder - Hi Odeta.  That's right, like housing, apartment leasing also follows seasonal patterns. Typically fewer people move in the winter and more people move in the spring. And this is true for both home buyers and renters. And, while it might be a little easier for folks in warmer climates to move year-round, it's clearly a lot harder to move when it's cold and there's snow on the ground. 

Odeta Kushi - Yeah, says the guy in LA to the girl in Washington D.C.

Xander Snyder - I went to school in a cold weather climate. Whenever I'd chat with my dad, who's back in LA during the winter, he'd always say, "Hey, hold on one second, I gotta go turn the AC up."

Odeta Kushi - Ooh, yeah, talking about rubbing it in.

Xander Snyder - Yeah, no kidding.

Odeta Kushi - Well, renters are typically younger than home buyers or are perhaps first-time households. So typically, you know, young adults moving out of their parents home and getting a place of their own, would be forming their own household. Of the roughly 146 million households in the U.S. only about 45 million, or 1/3 of them, are renters. This includes all apartment units, as well as single-family homes being rented.

Xander Snyder - Right. And, if you exclude single-family homes, the stock of apartments and buildings with five or more units is just over 23 million units nationwide. So, when we talk about the multifamily renter market, we're only really talking about half of the total renter market. The other half is comprised of single-family renters, about 14 and a half million of these, or renters in smaller buildings with between two and four units. So, Odeta, you mentioned earlier that renters who are planning to move in the spring will have more options this year than they did last year, as a lot of new apartments have come to market since then. In fact, the stock of apartments in the U.S. increased by approximately 600,000 over the last year and there's more coming soon. We've only recently come off of an all-time high of 1 million apartment units under construction nationwide. And this high was reached in the summer of last year, so many of those apartments are coming to market now. And elevated levels of deliveries will continue throughout this year and into the first half of 2025.

Odeta Kushi - Well, I mean from a renter’s perspective, it's always good to have choices. More apartments available to rent means more competition for landlords, who in order to compete and attract tenants may lower rent or at least not raise rents by as much. And, while approximately 70% of the apartments currently under construction are higher end, or what we call Class A apartments, some recent data suggests that large additions in the class A stock is not only having downward effects on Class A rents, but also on Class B rents, especially in high-supply cities. This is what we often call filtering. It's a concept that's known to both residential and commercial real estate. And, essentially, it means that when you build luxury apartments, it ultimately helps renters at all price points.

Xander Snyder - Yes, I found this dynamic particularly interesting. Yet, it's important to note that, even as this new record number of apartments is coming to market right now, new apartment construction starts are falling, and fewer construction starts today translate into fewer apartments that can be delivered to market tomorrow. And the implication here is, if construction starts continue to fall or remain low, then after this current batch of under construction apartments comes to market, there won't be a whole lot left to deliver in 2026.

Odeta Kushi - So, this is the wave of new apartment supply that renters will ride over the next two-to-three years, a period of oversupply, more substantial in some cities than others, followed by a balancing out of the market. This will keep rent growth in check for much of the country during the delivery phase, but will begin to push rent growth back up as the newly delivered stock gets fully leased up. But this all raises the question, why are multifamily construction starts falling?

Xander Snyder - Well, it's a combination of factors. First, higher interest rates have driven the cost of construction loans up, which means that builders need to either have a greater portion of their loan be paid in non-cash interest or they need to raise more equity in order to have the cash reserves on hand to pay the increased interest expense during the development phase, because there's no money coming in from rentals at that point. Now raising equity is costly as you're giving up your economic rights to an investment's future profits in exchange for money today. So that means that builders are faced with this situation where they have the prospects of slimmer margins, potentially larger downsides and more limited upsides, and that's not exactly incentive to break ground.

Odeta Kushi - Yeah, certainly not. And with construction loans, there's also a certain degree of limited credit available. Banks, for example, have pulled back meaningfully from the construction loan market. Taken together, this means decreased demand for construction loans and decreased supply of credit to fund development projects. 

Xander Snyder - Right. And in addition to this financing aspect, construction material costs today are nearly 40% higher than they were pre-pandemic, so this adds additional pressure to builders profit margins. 

Odeta Kushi - Yeah, I mean a similar dynamic but in reverse led to the near record of apartments currently under construction. The pandemic drove people to move to new locales, seek out more space and greener pastures. The combination of the demand with the very-low interest rates that prevailed in 2020 and 2021 drove the surge of construction to respond to this new demand. 

Xander Snyder - Yes, here we are. Odeta, just after the four-year anniversary of the onset of COVID-19 lockdowns and still so many trends in the real estate market, both commercial and residential, are being driven by aftershocks from the pandemic. What a bummer.

Odeta Kushi - Yeah, I mean, for years, like that's hard to believe. But, you know, as we've said before, I think we're all ready for some precedented events at this point. So, when this particular supply aftershock is fully delivered, will there be a trough in new supply? Or will the trends that are driving construction starts down now be reversed?

Xander Snyder - Well, my thoughts are the pace of construction starts could pick back up in 2026, if two things happen. One, if interest rates come down meaningfully, and two, if there aren't any additional supply chain shocks that lead to the rapid acceleration in construction material costs that we've seen recently. If rates only come down marginally and if construction costs do not ease or increase, then there will likely be a trough in apartment supply sometime in 2026. You won't see it pick back up in construction starts.

Odeta Kushi - You know, the more we talk about it, the more the apartment market sounds like it's at a classic end of a business cycle point. A shock led to excessive demand and due to extremely cheap debt that resulted from the response to the shock, there was a boom in new apartment supply. As a result, the market will likely be oversupplied for some period of time, while demand catches back up.

Xander Snyder - Well, do we know that demand will catch back up?

Odeta Kushi - Well, probably, you know, you'll often hear economists talk about, in the short run, or in the intermediate run.

Xander Snyder - Or in the long run, we're all dead.

Odeta Kushi - Yeah, classic Keynes. Always the optimist. Now what's helpful about defining your time period is that different things can occur over different lengths of time. So, in the intermediate run, say over the next two years, it seems like some markets will be over-supplied with apartments. However, in the long run, the supply demand dynamics are different. Depending on the estimates you use, the U.S. has a structural housing shortage of between 2 and 5 million units. There are currently about 1.7 million housing units under construction, both apartments and single-family homes. That implies that, even if all houses and apartments currently under construction come to market tomorrow, we would still have a housing shortage.

Xander Snyder - So this implies that in the long run, beyond that two-to-three-year period, there's a reasonable expectation that demand will catch back up and that this oversupply will be sort of an intermediate-run dynamic. For now, though, at least on a national level, supply is outpacing demand. According to data from Real Page, about 436,000 apartments came online in the fourth quarter of 2023. And this is on an annualized basis, while the number of renter households rose by only about 234,000. Again, on an annualized basis. However, this rate of renter household formation, which is a measure of demand, is roughly back on pace with pre-pandemic levels, after having slowed at the end of 2022 and the beginning of 2023. 

Odeta Kushi - And it's worth keeping in mind that this oversupply varies meaningfully by geography. All real estate, after all, is local. Xander, you recently built a scatterplot that showed a clear negative relationship between excess new supply of apartments and rent growth. And for listeners, we'll make sure to drop a link to this chart in the show notes to this episode. And it shows that some regions are meaningfully more oversupplied than others.

Xander Snyder - Yeah, one thing that jumps out from the scatterplot is the regional variation in oversupply. For example, cities in the Sunbelt, like Dallas, Houston, Memphis and Nashville, have had above average new deliveries and below average rent growth. It was a fairly similar story for cities in the southeast, like Atlanta, Charlotte, and Orlando, as well as southwestern cities, like Las Vegas and Phoenix. Meanwhile, northeastern and midwestern cities, like Chicago, Boston, and Washington D.C. had below average excess new supply come to market last year and, as a result, moderately positive and above average rent growth. 

Odeta Kushi - So, all of this new supply across the country is not being delivered evenly by geography. But could this excess supply in some markets attract renters from markets with fewer options? Well, the U.S. Census Bureau found in a recent poll that out of 14.4 million renters planning to move in the next 12 months, 40% said they plan to move to a different neighborhood in the city. That means that 60% of renters are flexible enough to consider renting in a new city.

Xander Snyder - So, perhaps the advent of remote work will make the labor force somewhat more flexible and able to gravitate towards oversupplied cities where rents are steady or declining. After all, if you can get a big city salary in a cheaper geography, why not benefit from the disparity? Maybe that'll help fill some of this oversupply more quickly to the extent that remote work enables somewhat greater labor force flexibility than in pre-pandemic times.

Odeta Kushi - Well, it's an interesting hypothesis. We'll have to wait and see. Well, that's it for today. Thank you for joining us on this episode of The REconomy Podcast. And, as always, if you can't wait for the next episode, you can follow us on X. It's @OdetaKushi for me and @XanderSnyderX for Xander. Until next time.

Thank you for listening, and we hope you enjoyed this episode of The REconomy Podcast from First American. We're pleased to offer you even more economic content at firstam.com/economics. This episode is copyright 2024 by First American Financial Corporation. All rights reserved.

This transcript has been edited for clarity.