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What’s Ahead for U.S. Apartments?

Apartment operating fundamentals reaccelerated modestly in 2018, as outstanding job growth helped absorb another year of elevated new construction. John Pawlowski answers key questions about the next five years for apartment investors, including: Where will private market operating fundamentals and asset values go from here? How will economic and demographic trends shift in the coming years? Why is Green Street's supply growth forecast more bearish than other forecasters? And, which apartment markets offer the most attractive risk-adjusted returns?

A Moderating Supply-Demand Backdrop

U.S. apartment demand has been strong over the past few years, and job growth -- one of the biggest drivers of apartment fundamentals -- was much more robust than expected as 2018 unfolded. Throughout the year, Green Street steadily raised its near-term job growth forecast. However, as the United States approaches full employment, Green Street expects the economy to create roughly 140,000 net new jobs per month over the next five years, which is about 35% fewer jobs than the number added over the last five years. Apartment demand is expected to moderate in response to the hiring slowdown. That said, higher wage growth (as fewer people enter the workforce) could boost apartment rents and help offset some of those effects.

Still Living at Home or with Roommates

Household formations, another key driver of apartment demand, can be best analyzed by considering ‘new owners’ and ‘new renters.’ For new owners, Green Street recently ratcheted back its homeownership rate forecast. The residential research team has become increasingly bearish on the prospects for a resurgence in homeownership absent a meaningful expansion in lending activity. The path to homeownership for renters remains tougher than previously expected.

In 2018, job growth topped 200,000 per month, the stock market rose much of the year, and most renters got a tax cut. Despite all that, home sales hit a wall, public home builder stocks fell 30% relative to the S&P 500, and move-out-to-buy rates for apartment REITs edged down, even in affordable markets. Many renters appear poorly positioned to transition from renting to owning. Young adults simply do not have enough savings for a down payment, and therefore they will be renting longer than they anticipated. Under the circumstances, Green Street expects the homeownership rate to creep up to the 65% range, but to remain well below levels seen prior to the downturn in 2008.

As for the outlook for new renters, Green Street expects rental formations through 2023 to slow to half of the vigorous clip of the last five years. Despite very strong economic growth, job growth, and higher labor participation rates in their age group, adults in their mid-20s to mid-30s continue to double up with roommates or live with their parents. The financial burdens of student loans, car loans, and overall weak balance sheets have left them with little room for incremental spending on housing. For years, these trends have been expected to reverse, but they have not – even in a year of economic strength.

Underappreciated Coming Millennial Demand Shift

A demographic trend that is not getting enough attention is the aging of today’s apartment renters and how that will dramatically alter the demand backdrop over the next decade. Many investment pitchbooks continue to feature the millennial boom as a reason people should invest in apartments, but this is a stale headline. As today’s renters move on from apartment living toward first-time home buyer or first-time single-family renter years, there will be fewer young adults to replace them. Beginning In 2020, there will be net declines in 25- to 29-year-olds, and by year 2025, there will be net declines of the broader group of 25- to 34-year-olds.

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The shifting demand backdrop matters because if developers don't adjust behavior, there will be greater supply and demand imbalances. For the most part, developers and operators are not currently adjusting their strategy to take into account the slowing demand profile compared to the recent past. Student housing offers a good case study of what happens when supply keeps growing in the later stages of a demographic wave. Student housing had its day in the sun from 2000 to 2008. But early this past decade, supply continued to expand amid slowing demand, causing a dramatic deceleration of growth in Net Operating Income (NOI) in the sector. The coming demographic shifts for millennials merit close attention heading into the next decade.

Third-Party Supply Forecasts Say What?

One of the most important takeaways for apartment investors is that supply will not slow meaningfully in the next three years. Third-party forecasters have predicted peak supply followed by a meaningful drop each year for the last five years. Every year they have been proven wrong. By this time in 2020, third-party data providers will be proven wrong again. Green Street’s new supply forecast remains meaningfully higher because attractive development margins and ample capital continue to support a base level of starts. Apartment development economics still screen too well versus other property types, and there is too much liquidity looking to find a home in apartments for the supply spigot to shut off. Builders will build until capital dries up, and capital isn't even close to shutting off within the apartment sector. In January, 2019 apartment permitting re-accelerated to the highest mark since mid-2015.

So, what do these supply and demand trends mean for apartment investors? Generally, investors need to be more selective in choosing markets over the next five years as pockets of oversupply become more prevalent. Job growth is slowing, demographics are shifting, and supply growth has not yet adjusted to a different demand backdrop.

Transaction Market Trends

The apartment transaction market is currently enjoying a high amount of liquidity, and cap rates in most markets appear to be on firm footing, particularly relative to other core property types. According to Green Street’s Commercial Property Price Index (CPPI), apartment asset values are up roughly 45% from prior peak levels, dramatically outpacing the appreciation in office, retail, lodging and other major sectors. Apartment cap rates have compressed by roughly 300 basis points from the trough in 2009 to current levels. The nominal cap rate for a national composite apartment portfolio now stands at 4.7%.

Sun Belt apartment markets remain active. The average cap rate spread between Sun Belt and coastal markets is at a cyclical low of 60 basis points, because market participants expect outsized near-term job growth in the Sun Belt to continue. Given the strong bid in those areas, the Sun Belt markets seem to be fully priced compared to the coastal markets.

U.S. Apartment Return Expectations

Green Street uses long-term expected returns as the foundation for investment recommendations on the sectors and markets poised for growth. Apartments screen favorably versus industrial, mall, office and strip centers based upon unlevered private market return expectations. Given its relatively favorable economics, apartments should continue to see re-allocations from property types such as office and retail -- sectors that still command significant capital in the commercial real estate world. The apartment sector’s enviable mid-6% unlevered Internal Rate of Return (IRR) is driven by its outsized long-term NOI growth and more favorable cap-ex profile.

Across major markets, Green Street expects better long-term NOI growth in gateway markets compared to non-gateway markets. Investors building a private market portfolio today, should look to the West Coast and several Northeastern and mid-Atlantic markets (such as Boston and Washington, D.C.) for better long-term returns. Investors should avoid Chicago in part due to the city’s fiscal challenges. (See Green Street Policy Matters).

Apartment REIT NAV discounts have narrowed dramatically over the last several months, but the majority of public apartment companies trade at modest NAV discounts. Green Street’s public and private valuation expertise helps identify opportunities across these relatively balkanized markets. Investors should consider buying apartment exposure through the big seven apartment REITs instead of via direct real estate, particularly when NAV discounts grow. Investors in REIT securities benefit from seven high-quality management teams and very well-positioned balance sheets at slightly cheaper valuations than for direct real estate, especially given the dramatic capital flows into the private side. Apartments have outperformed other REIT indices by about 700 basis points in the last six months, and there is still room to go.

While investors can still make money in apartments, they need to be more selective when deploying capital in both the public and private market. The very favorable demand-supply balance of the last five years is moderating, and pockets of oversupply will become more prevalent as developers move too slowly to recalibrate to decelerating demand.

Learn more in Green Street’s 2019 U.S. Apartment Outlook. The well-regarded report outlines key trends over the next five years for private market operating fundamentals and asset values as well as big picture themes impacting future investment performance. View an excerpt here.

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