The apartment industry greatly outperformed the underachieving U.S. economy in 2011. In 2012, multifamily housing should continue to thrive as the country hopes to shed its muddling ways and move toward prosperity.
It was a year that started with high hopes and expectations, but that promise gave way to an increasingly disappointing reality. Now, it is simply a matter of limping through the end of the year, telling ourselves “just wait ‘til next year.”
While that pattern will be eerily familiar to any Chicago Cubs baseball fan, in this particular case it’s a concise description of the U.S. economy in 2011. This was to have been the year in which the fledgling recovery from the severe 2007-09 recession morphed into a robust, self-sustaining expansion resulting in solid job growth, a meaningful decline in the unemployment rate, healthy gains in personal income and corporate profits and the phasing out of what had been aggressive government intervention in the form of stimulative fiscal and monetary policy.
That at least was the view held by many private sector forecasters as we headed into 2011. While the year started out in good fashion, averaging over 200,000 new private sector jobs each month, the economy quickly turned south as we worked our way through the spring and into the summer months.
A spike in crude oil—and, in turn, gasoline—prices, the natural disasters in Japan, renewed worries about sovereign debt defaults in Europe, and a sharp decline in stock prices exacted a heavy toll on business and consumer confidence. The pace of job growth also slowed sharply.
While many believed these to be transitory factors from which the economy would quickly rebound, as the summer began to wind down we were confronted with revisions to the GDP data revealing that not only was the Great Recession even greater (i.e. more severe) than had previously been thought, but also that the United States had made less progress in recovering from the recession than initially estimated.
At the same time, the spectacle of partisan wrangling over raising the federal government debt ceiling contributed to the S&P downgrading the sovereign credit rating of the U.S. government. These events in turn contributed to even sharper declines in business and consumer confidence and the pace of job growth slowed even further, to the point that, during Q3, private sector job growth averaged just 117,000 new jobs per month, not sufficient to even move the needle on the unemployment rate, which remained entrenched at 9.1 percent.
Improvement At Risk
As 2011 draws to a close, the economy continues to muddle along in a pattern of slow and below-trend growth with significant risk of falling back into recession over coming quarters amidst renewed efforts at monetary stimulus (“Operation Twist”) and an ongoing debate about yet another round of fiscal stimulus.
Risks to the economy, including the potential fallout of Europe’s twin-headed banking system and sovereign debt monster and a likely recession in the Euro Zone, the prospect of a trade war with China, ongoing pressures on state and local government budgets and recessionary levels of business and consumer confidence, remain tilted to the downside.
What is surprising, however, is that many policy makers and private sector analysts still do not seem to have grasped the reality that the U.S. economy continues to face structural, as opposed to cyclical, headwinds, including the ongoing household sector’s deleveraging, long-term unemployment due to permanent job losses, continued malaise in the for-sale segment of the housing market, and an unsustainable fiscal path on the federal level.
These structural headwinds are behind our outlook for continued slow and below-trend economic growth, which we expect to remain the case through 2012. We expect labor market conditions to remain a challenge, with slow and uneven job growth resulting in little improvement in the unemployment rate during 2012.
Apartments Continue to Stand Out
In this environment, bright spots are relatively few and far between, but the apartment sector clearly stood out as such in 2011 and is poised to repeat that performance, despite increased downside risks, in 2012.
Perhaps most significantly, apartment absorption was far stronger in 2011 than would have been implied by a weak labor market, and this should again be the case in 2012. Positive net apartment absorption that seems out of proportion to job creation is a function of several factors.
First, we continue to see positive net household formation, albeit at a slower than normal pace. Second, while overall job growth is disappointingly slow, a disproportionate share of net new jobs is being landed by those in the 20 to 34-year-old age cohort—a prime renter demographic. Third, there is at present a much smaller than normal siphoning off of apartment residents into homeownership than would typically be the case, so an increasing share of new apartment renters represents additional, as opposed to replacement, demand.
Finally, there will be little let-up in the steady inflow of former homeowners displaced by foreclosure into the rental housing market, although a lack of clear-cut data makes it difficult to assess what share of these displaced homeowners end up renting apartments as opposed to a single family home.
The impact of strong demand for rental apartments will continue to be magnified by what in most markets across the U.S. remains an atypically restrained supply pipeline. After being suppressed in the years leading up to the Great Recession, apartment construction has yet to mount a meaningful comeback. Based on the growth seen to date in multifamily housing permits and starts and the time lags between the proposal, planning, and construction phases, it is unlikely that a significant pick-up in new apartment deliveries will be seen until at least mid-2013.
It is apparent that, as the performance of the U.S. economy deteriorated over the course of 2011, both lenders and developers turned more cautious and, as such, supply growth through 2012 and into 2013 will be slower than had been expected at the start of 2011. In terms of the bottom line, restraint on the supply side coupled with steady growth in demand will translate into another year of solid effective rent growth in 2012, which in turn will mean another year of healthy growth in net operating incomes.
It is worth noting, however, that in many markets further rent increases could lead to flows of renters out of Class A units into Class B/C units, thus reversing the flows seen in the years prior to the recession when apartment rents were falling across the board and making Class A units accessible to greater numbers of renters.
Single-Family Homes’ Impact Remains
As mentioned above, however, there are increased downside risks to the forecast for the apartment sector. Should the economy tumble back into recession with another period of net job losses and rising unemployment, the rate of household formation will slow even further, meaning less new demand for all types of housing. Oddly enough, however, the downside risks to the apartment market are not all tied to a deteriorating economy. Specifically, should overall economic growth and job creation surprise us to the upside (even if imagining this scenario does require you to channel your inner-Cubs fan), this could lead to an accelerated flow of renters into homeownership.
While faster economic growth would put upward pressure on mortgage interest rates, they will nonetheless remain low by historical standards. Moreover, given the extent to which house prices have fallen in many markets across the U.S. and the extent to which apartment rents have risen, in many markets the math favors buying a home rather than renting an apartment, at least a Class A apartment.
True, more stringent lending standards will make it harder for prospective buyers to qualify for financing, but in our view the flow of apartment renters to homeownership could be significant in markets such as Atlanta and the major metro areas in Florida, California and Texas, among others.
It is worth noting that even if significant numbers of apartment renters do not make the move to homeownership, single-family rental homes will still pose an increased threat to rental apartments in many markets. Recent months have seen investors become increasingly aggressive in purchasing existing homes, many of which had been in foreclosure inventories, and placing them on the rental market. While there is not widespread agreement as to the magnitude of the threat posed by single-family homes, we believe that in many markets it could be significant, particularly to the extent that apartment rents continue to rise over coming quarters.
While mindful of the downside risks, 2012 looks to be another healthy year for the apartment sector as a whole, but this does not mean that we won’t see significant regional variances. For instance, given recent announcements of plans for significant job cuts in financial services, those metro areas with heavy exposure to this industry—most notably but not limited to New York—will be vulnerable. Also, with government budgets remaining under pressure on the local, state and federal levels, we are likely to see further cuts in government payrolls in many metro areas across the United States, and Washington, D.C., may not perform as strongly as would have been expected a year ago.
Conversely, those metro areas with significant exposure to durable goods manufacturing, energy, technology and health care should be above-average performers, as should those markets that act as hubs for flows of goods involved in global trade. Thus, the major metro areas in Texas along with markets such as Miami and Tampa (both of which admittedly have much ground to recapture from the severe job losses seen during the recession), Nashville, Raleigh, Boulder and San Jose should be above-average performers during 2012.
Richard Moody is Senior Vice President, Applied Market Research Manager, for Regions Bank, Birmingham, Ala., and can be reached at 205/264-7545.