From a small northwestern observatory…

The latest issue of Marcus & Millichap’s apartment research just hit my desk, and while they may some important observations, I think they may miss the bigger picture about why the apartment market is so hot today.

First, the good news — apartments are the brightest star in a recovering commercial real estate market.  As M&M note, leading economic indicators are trending up — not nearly as high as the pre-crash peak, but higher than we saw at any time between 1990 and 2005 or so.  Job growth is rugged, but at least it’s in positive territory, albeit not at levels we need to get America’s fiscal house in order.  Apartment absorption is in strong, positive territory, with some of the best, sustained numbers we’ve seen in over a decade.  These are all positive trends for the apartment investment market.

Despite the well-wishing about owner occupied housing, that market continues to be sour — home sales are moribund, with a report out today that new home sales have trended back down to 350,000/year.  While some statistics show prices beginning to stabilize or rise, others continue to show cycling around 2003 levels.  Our own models here at Greenfield suggest that home prices and new home sales volumes will not return to healthy levels until the home ownership rates stabilize.  In addition, a recent report out of the homebuilding community points to lack of buildable lots as a very real impediment to growth in this area.  We would add that structural issues in the lending arena will keep lot development at all-time lows for several years to come.

In short, many investment funds have viewed apartments as the next instant money machine, and indeed occupancy rates are frequently well above optimum levels.  There is plenty of research to suggest that a “healthy”, profit-maximizing apartment market has an occupancy rate around 93%.  A 100% occupancy rate suggests that rents are too low, and indeed this has happened in many markets as developers have chased occupancy rather than profitability.  As  stabilized apartments raise rents, NOI increases, and with them cap rates.  As a result, cap rates are actually on the rise again, up from 2006 levels, and with the decline in 10-year Treasury rates, the cap-to-T spread has expanded to the widest level we’ve seen (490 basis points).

One would think that investment funds would chase this NOI, forcing cap rates down.  Indeed, just the opposite is true.  Funds are looking for income, not future growth, and unlike the private equity and hedge funds of the past, aren’t trying to buy low and sell high.  They’re perfectly contented to buy a cash flow and hold forever, thus allowing cap rates to float upward.

Add to this the demographic part of the equation — America forms about a million new households per year, but we’re only building owner-occupied homes for about a third of them.  M&M notes that we’re currently only building about half of the units needed to meet demand.  They project occupancy rates by year end at about 95.6%, far above optimum levels.  As such, they expect rent growth of about 5% by year end.  This will flow straight to the bottom line, pushing up both transaction prices AND cap rates simultaneously.

Apartments were grossly underbuilt during the last decade, so what we have is a pure supply-and-demand play.  With constrained supply, and demand pushed both by population growth (particularly in the key 20-t0-34 age bracket) and shortage of new owner-occupied housing, this trend appears to have legs.