In this episode of The REconomy Podcast™ from First American, Chief Economist Mark Fleming and Deputy Chief Economist Odeta Kushi discuss the outlook for apartment rents, examining how and why rents are changing and where rents may decline, with Senior Commercial Real Estate Economist Xander Snyder.
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“In a way, a lot of these cities with large supply pipelines are actually victims of their own success. Sunbelt, southeastern and southwestern cities attracted a lot of in migration during the pandemic, as people sought out warmer locales and more space. And, actually, that trend was even there before the pandemic. And, as a result, rents increased. Higher rents incentivize new construction and, in some cities, that new supply now outweighs existing demand. The virtuous cycle has turned vicious.” – Mark Fleming, chief economist at First American
Odeta Kushi - Hello and welcome to episode 83 of The REconomy Podcast, where we discuss economic issues that impact real estate, housing and affordability. I'm Odeta Kushi, deputy chief economist at First American and here with me is Mark Fleming, chief economist at First American and welcome back Xander Snyder, senior commercial economist at First American. Now today we're going to chat about something that's front of mind for a lot of people right now -- apartment rents, how they're changing, why they're changing and where they might decline.
Mark Fleming - Hey Odeta. Hi Xander. Welcome back and, if Xander is here, that means we must be delving into the land of commercial real estate.
Odeta Kushi - That's right.
Mark Fleming - Certainly, we're certainly past the heaviest days of the pandemic era, when we saw double-digit apartment rent growth. Now that rent growth is slowing and, in many parts of the country, declining outright. That, of course, raises the question, why is rent growth still positive in some places, but declining in others? We always like to understand why. Xander, surprise, surprise. You've done some research on this recently. Is there a common trend?
Xander Snyder - Yeah, just coincidentally, I've done this research. Well, typically, cities that have had substantially more apartment deliveries than there is demand for apartments have seen rent fall. And this makes some intuitive sense. If there are more apartments than there are households that want them, then households have more choices and landlords have to compete for those households with lower prices, or in this case, lower rents.
Mark Fleming - Ah see, it always comes back to supply and demand. In this case, more supply relative to demand and quote prices for apartments, aka rents, fall. It's the law of supply and demand, I'm air quoting here, because do we really have laws like physics in economics?
Odeta Kushi - We're a social science after all. But yeah, it sure does seem like the quantity of new apartment supply is going to play an important role in the multifamily story of 2024. After all, there is a near record number of apartments under construction nationwide. And a lot of those are scheduled to be delivered this year.
Xander Snyder - Right. And the thing is, this new supply is more concentrated in some markets than others. All else equal, the larger the quantity of new supply in the city relative to the existing stock of apartments, the more that that new supply will impact rents. So cities with a large number of units under construction as a percent of inventory are likely to see rents fall further than those with limited new supply. As the year goes on, there'll be this dance between supply and demand in different apartment markets, depending on where more of these new deliveries are completed.
Mark Fleming - Uh, listeners. The video on that moment was perfect. He did the shoulder wiggle for the dance. It's Xander's dance between supply and demand. I don't think they taught that one at cotillion class and I have to wonder. And because I like the 80s, what '80s dance are we channeling right now? Isn't it the case that new supply only puts downward pressure on rents, I mean, you're adding more to the stock, if the demand isn't there to lease those new units. For example, there could be a 2,000 new unit delivery to a market, but only 1,000 households looking to rent. That would be excess supply, relative to demand and rent would decrease. In other words, deliveries is a measure of new or additional supply. Right?
Xander Snyder - Right. It's just a measure of new supply. Apartment deliveries is a measure of new supply. So, if we want to account for the difference in demand for apartments across different cities, then we also need a measure of demand. And one way to do that is just count up all the units that were leased in a given period and then subtract that by all the units that were vacated. This gives you the change in apartment demand, which is typically referred to as net absorption.
Odeta Kushi - So, as an example, when we say that net absorption in a city was 2,000 units, that means 2,000 more units were leased than were vacated. This indicates strong demand. Conversely, if 2,000 more units were vacated than released, that would indicate weak demand.
Mark Fleming - It's kind of like the commercial equivalent of months' supply on the resi side, right?
Odeta Kushi - Yeah, it does seem that way.
Mark Fleming - So now we have a metric for both supply and demand. New deliveries measures new supply and net absorption measures the demand. How do we combine these two into that single magical measure? And what does it tell us?
Xander Snyder - Well, to get a sense of the relative imbalance between supply and demand in some city, we can simply subtract one from the other. So, if you take new deliveries from new supply, and subtract net absorption demand, you get a measure of the leftover stock of new apartments that haven't been leased. When that new excess stock is positive, then supply is outpacing demand. When that new excess stock is negative, demand is outpacing supply. So, by combining the supply and demand measures, we get this single measure of the market-level imbalance, and whether that imbalance is a shortage or an excess.
Mark Fleming - And, of course, since cities vary in size, it's best to interpret this number relative to the size of the existing stock of apartments in that city. So, as an example, if new excess stock in some city is 2%, that means that the stock of apartment supply in that metro grew by 2%, after all new deliveries were made, and the leasings were completed.
Xander Snyder - Exactly.
Odeta Kushi - Now, what we can't show you on the podcast is a very neat chart that Xander put together that shows the relationship between new excess stock, which is this combined measure of the imbalance in supply and demand in the market, and rent growth across major cities. But there's an interactive version of the chart, so you can find your city to see where it falls on the rent growth spectrum compared to average. We'll have a link to that in the show notes to this podcast.
Xander Snyder - Everyone likes a scatterplot right?
Odeta Kushi - Yeah, especially when they're super colorful.
Mark Fleming - You know, if Ben Stein had more colorful charts in his econ classes, Ferris Bueller wouldn't have ditched as often. Anyone? Anyone? Anyone? Bueller? Bueller? But we digress. Back to the chart, you'll definitely want to play around with this one. What the chart shows is a clear negative relationship between new excess stock and annual rent growth. In other words, as new supply outpaces demand, rents tend to decline and vice versa.
Odeta Kushi - I've actually got the interactive version of the chart open right now because I am curious about some markets, specifically my hometown of Rochester, New York, which seems to be in the upper left quadrant of the chart, which indicates higher than average rent growth and not a lot of excess stock entering the market.
Mark Fleming - Lucky, lucky Rochester. I too have the interactive chart open to see how my own hometown of Philadelphia is comparing. Unfortunately, unlike Rochester, it's in the upper right quadrant of the chart indicating higher than average rent growth as well as new excess stock. That said, Philadelphia doesn't seem to fall as far from the trendline as Rochester.
Odeta Kushi - That's true. It looks like Rochester rent growth was much higher than other cities with similar levels of new excess stock. Elsewhere, rents fell the furthest in cities in the Sunbelt, Southeast and Southwest. So, cities like Phoenix, Houston, Dallas, Atlanta and Orlando had a large amount of new supply come to market without sufficient demand to absorb it all. As a result, rents have fallen in these regions over the last year.
Mark Fleming - In a way, a lot of these cities with large supply pipelines are actually victims of their own success. Sunbelt, southeastern and southwestern cities attracted a lot of in migration during the pandemic, as people sought out warmer locales and more space. And, actually, that trend was even there before the pandemic. And, as a result, rents increased. Higher rents incentivize new construction and, in some cities, that new supply now outweighs existing demand. The virtuous cycle has turned vicious.
Odeta Kushi - I like that alliteration there. What about on the other end of the spectrum? Cities that didn't have a lot of new excess stock come to market over the last year? Are there any regional patterns on the supply scarcity side?
Xander Snyder - Yes, typically cities in the Midwest and the Northeast added substantially less new supply than those in the Sunbelt and the Southeast. So, these are cities like Chicago, Boston, and Washington D.C., which had positive annual rent growth in the low single digits. Now, while low single digits is not the breakneck speeds of two years ago, where we saw, you know, rent growth grow at double-digit rates, low single digit rent growth is certainly enough for some conservative deal budgets to still pencil out.
Mark Fleming - It also seems to me that there's a pattern in terms of how easy it is to build in certain markets versus others making an important distinction there about what we see in the pattern geographically. Are there any cities or regions that don't fit this general trend? Sometimes outliers can be as interesting as the trend itself?
Xander Snyder - Yeah, well, typically cities in the West. So, in this case, cities like Los Angeles, San Francisco and East Bay and Sacramento, had low rent growth, despite also having added little new stock, little new excess stock. And one possible explanation is that Western cities are often costlier with higher rent-to-income ratios, which just means that people use more of their income on rent. So it may be that it's just harder to achieve those rent hikes because people can't afford to pay much more in some of these western cities. Now, that said, New York is also notably an expensive city, and it had positive rent growth in 2023 at similar levels of new excess stock as some of these western cities. So the West's off-trend outlier performance probably can't all be attributed to affordability issues.
Odeta Kushi - So excess supply is associated with lower rent growth and we have a lot of new apartments coming to market this year. That would imply that cities with a lot of new excess stock due to a lot of construction that began when rent growth was much higher will be facing the largest rent slowdowns or declines.
Xander Snyder - That's how I interpret it. And it's worth keeping in mind how excess supply will interact with the broader context of multifamily distress this year as well. And, while multifamily distress is currently quite low, there have been meaningful increases in insurance premiums and other multifamily operating expenses, like repairs and maintenance. And we've covered this in other episodes as well, but these have, for some, already put downward pressure on net operating income or profits. So you add slower rent growth on top of that, and that could push some struggling buildings into a situation where maybe they're no longer able to service their debt.
Mark Fleming - Okay, okay, one more alliteration. One banks pain might be some renters gain.
Odeta Kushi - Mark always coming in with the positive perspective here, right, because I mean, it's true more supply and lower rent growth may pressure profit margins for owners, but it would also mean more choices for renters and, possibly, the option to spend a little less on rent as well.
Mark Fleming - Another bright spot that I'll point out is that not all cities fall into this category. Several have supply and demand more in balance and healthy, moderate rent growth, to go along with it.
Odeta Kushi - Always good to end on a high note, and it's always Mark, bringing in the positive so we'll take it.
Mark Fleming - Glass is half full.
Odeta Kushi - Yeah, exactly. Thanks so much, Xander for joining us to chat about this interesting relationship between supply and rent.
Xander Snyder - My pleasure.
Odeta Kushi - Okay, well, that's it for today. Thank you for joining us on this episode of The REconomy podcast. Thank you for joining us on this episode of The REconomy Podcast. If you have an economics-related question you'd like us to feature in the future, you can email us at economics@firstam.com. We love to hear from our listeners. And, as always, if you can't wait for the next episode, you can follow us on X. It's @OdetaKushi for me and @MFlemingEcon for Mark. 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.