Housing Options May Curb Rent Growth

Buttressed by high occupancy rates, apartment landlords in many U.S. markets are aggressively hiking rents at a rate that many commercial real estate experts believe is unsustainable as their competition grows.

Developers are beginning to add new units at a pace that's outstripping demand, and more first-time homebuyers are entering the market amid still-low interest rates and low-down-payment programs targeting the group.

So far, however, the shifting dynamics have failed to faze landlords. While some owners in Denver and other hot markets are providing moving allowances, big-screen TVs or other enticements, they keep ratcheting up the rent that they charge tenants.

"We've had a lot of new supply come on the market, and we thought rents would begin to decelerate," said Stephanie McCleskey, vice president of research for Dallas-based multifamily and student housing researcher Axiometrics. "But the apartment market has remained strong, which is exciting for us but probably not too exciting for residents.

High And Tight

The national average apartment rent of $1,211 per month in the second quarter represented a year-over-year increase of 5%, which was the highest annual rate of rent growth in four years, according to Axiometrics. Plus, renters in Denver, Portland, and the California markets of Oakland and San Jose endured annual increases exceeding 10% in the second quarter, the firm said. The average occupancy rate of 95.2% in the second quarter marked a year-over-year increase of 80 basis points and is largely considered full occupancy.

The healthy fundamentals are paying dividends for some of the country's largest apartment owners.

In the first quarter of 2015, Chicago-based Equity Residential (EQR) reported that funds from operations (FFO) of 79 cents per share marked an increase of 11.2% over the prior year. FFO is a measure of cash generated by real estate investment trusts and is considered a gauge of profitability.

Similarly, Arlington, Va.-based AvalonBay Communities (AVB) reported FFO of $1.88 per share, a year-over-year hike of 14.6% before "nonroutine" expenses that halved the growth.

Some 217,500 new units were added to the market last year and more than 277,200 are coming online this year, says McCleskey, who predicts that annual rent growth nationwide will eventually slow to an average of around 3% or more as new units open.

Hypersupply

The ongoing development, however, had already pushed more than 30 U.S. apartment markets in the first quarter into the "hypersupply" phase of the real estate cycle, including Denver, Austin, Dallas New York and St. Louis, according to a report by Glenn Mueller, real estate investment strategist for Denver-based Dividend Capital Group, a real estate investment management firm. Mueller, who studies 54 property markets, also expected most of the remaining apartment markets to enter the hypersupply phase over the second and third quarter of 2015.

The hypersupply phase of the cycle is the third of four phases and is marked by increasing construction, declining occupancy and slowing rent growth. It follows the "recovery" and "growth" phases, and it precedes the "recession" phase, a period of increasing vacancy and negative or below-inflation rent growth.

"We're actually at all-time peak occupancy levels nationally, so it's a very strong market," said Mueller, who also is a professor at the University of Denver's Franklin L. Burns School of Real Estate and Construction Management. "If developers can slow the rate of supply, I think the market can go into a hypersupply phase and then return to a growth phase.

Affordability At Issue

Renters would welcome a slow-down in escalating rents, however. Apartment dwellers in many markets spend an average of 30% of their monthly income on housing, compared with about 25% a generation ago, according to Seattle-based Zillow (NASDAQ:Z), a marketplace focused on for-sale and rental housing.

In major markets such as San Francisco, New York and Miami, it can be as much as 50%, adds Svenja Gudell, senior director of economic research at the company. Conversely, Zillow estimates that U.S. homebuyers can expect to pay about 15% of their income on a mortgage payment.

"We are finding that renting isn't affordable anymore because there's a tradeoff," Gudell said. "People may not go to the dentist or doctor, but that only works for so long. At some point they just say, 'I can't afford to pay this anymore.'

Becoming Buyers

Renters have few alternatives, but it appears that more want to make the leap to homeownership. The National Association of Realtors reported that the annual pace of home sales in May exceeded 5.3 million on a seasonally adjusted basis, a year-over-year increase of 9.2% and the highest level since May 2009. First-time homebuyers accounted for 32% of existing home sales in May, up from 30% in April and from 27% a year earlier.

That behavior is in line with what Zillow and data analysis firm Pulsenomics uncovered in an early 2015 survey of renters across 20 larger U.S. metros. Nearly 5.2 million respondents said they wanted to buy a house within a year, which was up from 4.2 million in 2014.

Still, homebuyers remain challenged due to a choppy jobs market, student debt burdens and tough underwriting, among other hurdles. The interest rate for a 30-year mortgage also climbed to 4% in late June from 3.65% earlier in the year, according to the Freddie Mac (FMCC) Mortgage Survey. The expectation of continued mortgage rate increases means that borrowers will qualify for less proceeds, Mueller adds.

Yet some roadblocks appear to be dropping. Fannie Mae (FNMA) mortgage borrowers in bottom 10th percentile of credit scores had an average score of 670 in September last year compared with 710 two years earlier, Zillow found. Additionally, first-time homebuyer programs from the Federal Housing Administration and other lenders are letting buyers put as little as 3% down.

"We won't have 5.2 million renters buying homes this year," Gudell conceded, "but the thought is definitely there."