Keep an Eye on New Supply

by Gleb Nechayev, Senior Economist Torto Wheaton Research

Looking at various investment surveys, expectations for apartment performance remain quite strong. In fact, what is commonly referred to as the "risk premium" for institutional-grade apartments—spreads of appraisal-based average cap rates for these properties over long-term treasuries—averaged less than 50 basis points last year, well below the 200 basis points averaged over the prior 15 years!

To some degree, such expectations stem from a perception of improving supply and demand trends for professionally-managed apartments. The story goes that, after a decade of surging prices, housing affordability is at a historical low and, as homeownership boom tapers off, rental demand and rent growth will accelerate. Rental demand is further solidified by "echo-boomers"—a cohort of prime renter households that is expanding once again after a period of decline—and also by continuing high foreign immigration. At the same time, new apartment supply is edging downward as the composition of multi-housing development has progressively shifted towards condominiums in recent years and a substantial share of existing apartment stock has been converted to condominiums.

Yet the supply side of this story does have two elements of uncertainty with respect to new multi-housing supply. First, it assumes that the nation's condominium sales and prices will follow the single-family market pattern and would gradually cool down and stabilize, rather than collapse. Second, it assumes that in the process of this "gradual cooling," sales and prices of newly built condominiums will follow the pattern of existing condominiums. Both of these assumptions have a downward bias, in that they could result in higher-than-expected numbers of new rental units and could hurt occupancy and rent growth, both in the broader rental market and in its institutionally-owned segment.

On the surface, it does look as if apartment completions continue to edge down. Projects underway with a target completion in 2007 total less than 140 thousand units nationally—down from over 200 thousand units in 2001. Condominium completions, on the other hand, are expected to surge from an average of 100 thousand units over 2001-2005 to more than twice that figure, based on what's currently in the pipeline. As a result, the aggregate new multi-housing supply is shaping up to be substantially higher than in recent years.

Whether it will actually be higher very much depends on how existing condominiums sell.  According to the National Association of Realtors, slightly over 800 thousand existing condominiums sold in 2006, down 10% from 2005. At the same time, inventory of existing condominiums for sale stood at 520 thousand units in 2006, up 14% from 2005.

While the latest report shows some leveling off in sales and prices of existing condominiums nationally, this might indeed prove temporary if most of the new condominium units currently under construction are completed and put on the market over the coming months. In fact, if such a scenario were to occur, subsequent corrections in the national median price for existing condominiums would be more severe than the 5% reported at the end of 2006, pushing many condo units purchased as "investments" back into the rental market. Coincidentally, such a scenario would also have implications for rental demand, as it would make rising condo ownership competitive with high-end apartments.

New Supply: More Than Meets the Eye

Source: TWR/Dodge Pipeline

An alternative scenario (and a more likely one) is one in which only a portion of new units currently intended to be completed as condominiums are actually completed as condos. Instead, some could be completed as rentals, some deferred until later years (when developers are well-capitalized), and some abandoned altogether. This scenario might be favorable with respect to sales and pricing of existing condominiums, but not so for apartment investors who expect new rental supply to remain low.

Of course, the actual composition of this and next year's multi-housing completions nationally will be a function of local conditions. Places where sales and prices of existing condominiums are already declining are more likely to experience the latter scenario (unless the recent correction is viewed as a "bottom"). As to how many new units currently underway as condos will actually end up completed as rentals, as opposed to being deferred and abandoned is harder to say but, judging by recent trends, the split is about 50/50. This means that about 50 thousand more rental units have a good chance of being completed in 2007 than some are expecting, and as many deferred until later years or abandoned. In other words, even if you are already accounting (as we are) for higher rental completions in 2007, there is still room for error!

The $64 billion question is whether the current 50 basis point "risk premiums" provide apartment investors (and their lenders) with enough safety cushion to deal with potential market "surprises" such as these. It won't be long before we know the answer.

Return from Keep an Eye on New Supply to Real Estate Articles