As the housing market has fitfully struggled through a decade-long recovery, homeownership rates fell to a 40-year low, and have not yet recovered to their historical level of 64 percent. Unsurprisingly, the number of renters has soared to an all-time high during this period of time.
The inventory of single family rental homes has increased from a little over 11 million units in 2009 to nearly 16 million last year. And the reported number of housing permits and starts has been inflated by an almost unprecedented amount of multifamily construction.
Even with this rapid increase in apartments, supply has lagged behind demand across the country, driving monthly rental rates higher and higher. And this enormous demand — and lucrative rental income — has led to a boom in multifamily property prices. Some industry analysts have suggested, in fact, that multifamily pricing may be approaching bubble territory; others have theorized that we may begin to see some of these units converted from rentals to condominiums either due to pending oversupply or to allow their owners to profit from the high prices that have resulted from the current under-supply of available homes for sale.
So are we looking at a multifamily market bubble?
Peter Muoio, executive vice president and Chief Economist at online marketplace Ten-X doesn’t think so.
“We definitely do not think there is a bubble in the multifamily market,” said Muoio. “Certain markets have particularly heavy supply pipelines that are proving difficult to digest in the immediate term but vacancies generally remain healthy and rents rising in most markets that have less acute development pipelines. While things may be overvalued to some degree, it does not constitute a bubble.”
Jamie Woodwell, vice president, commercial real estate research for the Mortgage Bankers Association agrees, and notes that multifamily property values are a function of the income they generate and capitalization (cap) rates, and that both of those factors have contributed to rising prices over the past few years.
“Property incomes have been growing strongly since the recession – 11 percent in 2015, 7 percent in 2016 and 4 percent in 2017. Cap rates – which move inversely to prices – recently rose from their record lows (5.9 percent during Q4 of 2017) to 6.1 percent in the first quarter. The spread between multifamily cap rates and the ten-year treasury (3.3 percentage points) is only slightly tighter than the median quarterly spread seen between 2001 and today (3.7 percent), meaning investors are a bit more aggressive on multifamily pricing than they traditionally have been. Given how strong the multifamily market has been, and how low interest rates remain, that’s probably what one should expect.”
Neither Muoio nor Woodwell expects to see prices reverse course, much less go into the kind of free-fall the market experienced during the Great Recession. Said Woodwell, “A significant market blow — like a shock in GSE lending or a dramatic rise in yields — could affect values, but investors appear to be on the lookout for overbuilding, waning demand or any other signs of distress.”
Even though household formation among owners has reversed a multi-year trend and surpassed renter household formation for several consecutive quarters, Mark Fleming, chief economist at First American, agrees that multifamily pricing should be fairly safe.
“The fact that owner household formation is on the rise again I don’t think necessarily means that multifamily is going to be in trouble. Even the simple demographic argument that there are lots and lots of younger Millennials still demanding rental housing should give multifamily more time. Maybe the large price gains in multifamily are more reflective of the challenge of meeting all that Millennial demand than speculative and economically non-fundamental behavior.”
But will builders or building owners try to leverage their investments by converting apartments into condos? The lack of home supply, coupled with pent-up demand continues to drive purchase prices to record levels in many parts of the country. And some metro areas have recently begun to experience slightly higher apartment vacancy rates than the record low numbers that have been common since the housing boom and bust in the mid-2000s.
Again, the experts don’t see this as the most likely scenario, partly because capital continues to be readily available – and relatively affordable – for multifamily construction.
“Conversions of apartment buildings to condominiums tend to come when individual households are more bullish and/or have greater access to financing than do institutional multifamily investors,” Woodwell explains. “It’s hard to identify when conditions may shift on those fronts, but the strong rental market and ready multifamily capital have likely been holding conversions relatively low these past few years.”
Muoio also doesn’t expect to see a rush toward converting apartments to condos. “With interest rates rising we do not think conversion is a major play. To the extent it does happen, it wouldn’t change the (homes for sale) inventory situation much.”
It may be that condos aren’t exactly what homebuyers are looking for anyway, but that doesn’t mean that we won’t see some rental units come back onto the market as owner-occupied inventory.
“There is some evidence that in order to meet the shortage for owner occupied homes, a lot of single family rental stock is actually converting back into inventory,” Fleming contends. Interestingly, he sees this conversion happening primarily among properties owned by individual — rather than institutional — investors, who are taking advantage of current market conditions, and “cashing in on all the equity gains.”
So the general consensus appears to be that, while a handful of markets may be slightly overbuilt, and pricing has outpaced traditional fundamentals, there’s still more than enough demand — at least nationally — and enough attractively priced capital available to support the price levels in the multifamily sector. It’s probably worth noting that household formation has lagged behind expectations for a number of years since the financial market meltdown in 2008, and there are still between 25 and 30 percent of young adults living at home with their parents — an age cohort that typically rents first and buys later — so we may not even have seen demand for rental units peak.
Might we see a price correction, especially on a localized basis? That’s entirely possible. Will we see the multifamily bubble burst, and a wholesale conversion of rental properties into owner-occupied condo units? From this vantage point — at least for now — neither of those things seem very likely to happen.
