Vacancy Rates Are Already Rising

I’m sure you’ve heard it before: This time is different.

No, really, this time is different—at least in the apartment market. And by different, I mean there’s a seemingly infinite and insatiable pool of demand for rental units, because Generation Y is huge, with millions of them living at home just salivating at the prospect of moving out. And they have a preference for renting versus owning. Therefore, vacancy rates are going to keep falling, beyond a horizon that anyone can predict, and rent growth will remain stout.

Sound familiar? It should. This thesis is proffered up continually by experts and neophytes alike. But there’s just one problem with it: It’s wrong. And dangerous to believe.

The theory isn’t wrong in the sense that I believe it will be wrong; it’s wrong in that data are already demonstrating that it is wrong. There’s no need to wait and see how this plays out over the next few years.

Class Distinction

Between the second quarter of 2013 and the third quarter of 2015, the national vacancy rate was unchanged, at 4.3%, and was up 10 basis points from the cyclical low of 4.2%, attained most recently this past summer. These numbers demonstrate that, after falling dramatically, from 8% in early 2010 as demand greatly exceeded supply growth, new supply and demand for apartments have largely been in equilibrium over the past two years.

The national vacancy rate is now on the precipice of rising for the next few years. New completions have ramped up significantly in recent years, while demand, although strong, has abated slightly and simply can’t keep pace with supply growth.

If we focus on the segment of the market where there’s been supply growth over the past few years, we’ll see that vacancy is already rising and that demand already can’t keep up with new construction.

All the new construction in the market has been Class A. It’s not economically feasible for developers to develop Class B/C apartments at this juncture.

Initially during the recovery, demand outpaced supply growth for Class A units. That ratio didn’t last, however, and eventually new supply overtook net absorption. In 2010, for example, the construction- to-absorption ratio was a scant 0.6, and it was even lower in 2011, at 0.4. However, in 2012, things started to change. Construction began to increase, raising the ratio to 0.9. By 2013, it had risen to 1.1; in 2014, it increased to 1.2; and it has remained at that same ratio, year to date, in 2015.

Any ratio greater than 1 obviously indicates there are more new units being delivered than are being absorbed. Consequently, Class A vacancy has been rising since the first quarter of 2013, when it bottomed out at 4.6%. Since then, it’s risen 100 basis points (bps), to 5.6%. During the same interval, Class B/C vacancies have fallen by 110 bps, predominantly because no one’s building Class B/C units. This is the segment of the market that’s prevented overall vacancy from rising. However, Class B/C vacancy doesn’t have much farther to fall, so it’ll be unable to prop up the entire market as the market gets flooded with Class A properties.

Don’t Go “Camping”

Still believe that myth about insatiable demand? Don’t. It’s not true, no matter how many times you hear it.

Easy narratives are seductive, but the data don’t lie. There’s no pool of insatiable demand. Many developers keep building Class A units because they mistakenly believe vacancy will keep falling. I call this the “Incredulity Camp.”

Some others believe that while vacancy is likely to increase in the next few years, their properties will outperform all the others being built. I call this the “Hubris Camp.”

Competition today is fierce, and seldom, if ever, can properties really set themselves apart, especially in the face of rising vacancy rates, no matter how many lazy rivers they have, how large their infinity pools are, or what a great view their properties boast from the roof-deck fire pit.

Do yourself a huge favor and don’t fall into one of these two camps. Class A vacancy is already on the way up … and vacancy for the overall market is sure to follow.

Read the original article here.

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