New Construction: Friend or Foe in 2015?

2014 was certainly an interesting year in the apartment market. The national vacancy rate rose for the first time in roughly five years, to 4.2 percent, although rents continued to grow more quickly than in the other major property classes, which actually experienced vacancy declines. Construction was the culprit behind the rising vacancy rate and has become the primary concern in the market as we train our sights on 2015.

On the whole, the apartment market should be relatively healthy this year, but the situation continues to evolve due to the seemingly inexorable increase in new-construction projects.

Last year was the inflection point in the apartment market—not just because vacancies rose, but because 2014 was the year construction increased to levels significantly above the historical average level of completions of roughly 120,000 units for primary U.S. markets. For 2015, that trend is set to continue, with new construction likely to rise 76 percent above the historical average, to roughly 211,000 units. This would represent the highest level of new completions in a calendar year since the 1990s, a substantial increase from just a few years ago. In 2012, for example, new completions totaled just 79,000 units, fewer than half of 2015’s projected numbers.

One could argue that this ramp-up is simply a reallocation across time: Construction figures, depressed by the recession, were too low relative to demand over the past few years, which helped push vacancy rates to such low levels. Now, with vacancy tight and rents growing, development is increasing as the market catches up.

There is a kernel of truth to this explanation. Construction bottomed out in 2011 at less than 43,000 units, well below levels that pure demographics would have dictated. However, because the depressed economy reduced both household formation and construction capital, and development dried up—at least for a while—conditions overwhelmed any underlying demographic demand.

Despite the boom in construction, Reis projects that the national vacancy rate will only rise slightly, to 4.9 percent this year, a roughly 60 basis-point increase from where we project the final 2014 vacancy numbers will be. This is because demand is projected to remain strong in 2015, which will keep a lid on vacancy increases.

Millennials Fuel Demand
There will be roughly 45 million people in the country between the ages of 20 and 29 in 2015 (see chart below). That will create strong demand for apartments, just not enough to keep pace with the surging levels of construction. Nonetheless, a national vacancy rate below 5 percent still offers an incredibly tight market that will give landlords leverage to push asking-rent increases. In fact, Reis projects that asking rents will rise by roughly 3.7 percent this year, well in excess of inflation, which is currently tracking at around 2 percent.

Because vacancies will remain so low, landlords will be able to raise rents even as vacancy increases. Moreover, the new units coming on line will be built to Class A specs, commanding rents well above market averages. This will also put upward pressure on rents, which should more than offset any decrease in rents from existing buildings that feel the pressure from new competition in the market.

Tech Markets Drive Metros
As 2015 begins, the drivers of performance at the metro level aren’t likely to change. Technology- and energy-oriented markets should continue to outperform the broader market. In fact, the top six markets ranked by projected asking-rent growth—including San Jose, Calif.; San Francisco; and Seattle—are all centered around tech.

Although the economic recovery should spread to a greater number of industries this year, technology should continue to have the strongest impact on the apartment market.

All of this good news doesn’t let discipline off the hook, however. Vacancy should remain tight and rents should grow further in 2015, true, but market participants will nonetheless need to sharpen their pencils.

The combination of strong demand and weak supply growth over the past few years has papered over a lot of investor and lender mistakes. That market isn’t going to be nearly as forgiving going forward as it has been in recent years … and that changeover begins now.

Read the original article here.

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