Chase Q&A Series Part 1: An Economic and Demographic Perspective

By Kurt Stuart, Chase Commercial Term Lending

I recently had the opportunity to speak with Reis economist Victor Calanog, PhD, to examine a number of trends shaping the commercial real estate sector. Our discussion about the economic and demographic factors that are at play today help paint a vision of where the market may be headed.

Kurt: Let’s talk about where the multifamily sector is today on a national basis and what the outlook is for 2019.
Victor: In general, multifamily is actually going to turn the corner in 2019, when it comes to the supply growth situation. Depending on the metro or the neighborhood, starting around 2015 we broke around 200,000 units per year of deliveries in multifamily. It’s no surprise that it was the first sector that emerged and recovered from the previous downturn. Once developers see rapidly declining vacancies and rising rent growth they will build, build, build.

Kurt Stuart Head of the Northeast, Chase Commercial Term Lending

We have not seen that threshold of 200,000 units crossed at our top 82 markets since 1999, so you can imagine that this was a somewhat heavy time of building and somewhat overbuilding. In 2018, we will welcome close to 280,000 units of new apartment properties across the largest 82 metropolitan markets. To give you a sense of magnitude, that’s a 2.6% increase in inventories, and we have not seen that in a long, long time. We actually haven’t seen it since the late 1980s.

Kurt: Those are revealing statistics, how do you think they will affect underlying fundamentals?
Victor: Number one, vacancies have been rising fairly consistently at the national level starting at around mid-2016. We bottomed out at 4.1%. We hit 4.8% as of the third quarter of 2018, and since we are looking at the 2019 outlook, the expectation is that we would top out at 5.2% as vacancies continue to rise. But I don’t think that means that the sky is falling for multifamily.

In fact, if anything, if you take a look at the five, 10, or 20-year long term average, your long-run vacancy rate is closer to around 5.1% to 5.2%. So, in essence, the market has become so tight that we are really just reverting to the long- run historical averages.

Kurt: We’ve been tracking that trend as well and we are monitoring how it is affecting underlying rents.
Victor: And rents are still positive. In fact, we are projecting something in the mid-4s (4.5%) to the low-4s (4.2%) for those asking and effective rents for this year, although that’s down from a high about 5.8% at its peak in 2015. Looking back at the previous cyclical peaks of multifamily fundamentals, the peak was around 2015. If you bring a new project to market, it will be leased up in three to six months really quick because demand is strong but then we over-built a bit.

We’re actually at that inflection point right now, where things are beginning to turn. So we interpret that as an optimistic note for multifamily at the U.S. level.

Kurt: Let’s shift to the metro level.  What’s your perspective on the New York Market?
Victor: The New York market as a whole broke historic records. The situation here is bigger and more magnified than what’s going on at the U.S. level. In 2017, we welcomed close to 13,500 new multifamily rental units in New York City. That encompasses multifamily buildings 40 units or larger.

Victor Calanog PhD CRE®, Chief Economist & Senior Vice President at Reis

The previous record was around 8,600 units set in 1986. We’re breaking records in New York City because the vacancy rate fell to a low of about 2.8% in 2015, much like the nation. Since then, it has risen to an historic high since we have been tracking the New York market in 1980, to a record 5.4% vacancies in 2017. We expect it to be at or around 5.4% as well this year, and for 2019 we expect things to pop out at around 6% vacancies.

Traditionally speaking, New York vacancies have hovered between 2% to 3%. It’s a very low vacancy type market, and for New York to get to 5.4%-6% has a lot of brokers losing their heads I think, when it comes to fundamentals. Rents have slowed to 2.7%, 2.5%. It’s still positive, it’s still growing, but that’s around half of the market peak of 5.6% and 5.7%.

New York is seeing a lot more building, a little more softness relative to the U.S. market. However, like the U.S. market, we actually see conditions turning in 2019 where there will be far less projects than 2018. Then, after that, it actually normalizes quite a bit. I think 2019 is an interesting turning point as long as demand holds steady and strong.

Kurt: There are clearly interesting shifts that will play out in the near term. What are some of the key trends or factors you think will have an impact on multifamily, and what should owners and operators do to prepare in order to be best positioned?
Victor: Larger trends tend to move a little bit more slowly than you might see in the numbers. One of them, for instance, is the general decline in home ownership rates. That’s a positive tailwind for the multifamily sector.

I think a lot of renters these days remember the impact of the last housing crash, and a lot of folks, given how mobile jobs tend to be, tend to postpone home buying until much later. Now, that might be changing, as market rates begin to rise when finally, they realize they can’t wait if they want to buy a home.

These are slow moving demographic trends, which favor multifamily, particularly in cities.

Kurt: We recognize those demographic trends will likely have a positive effect on the multifamily sector as well. We’re seeing investors continue to want to invest in New York specifically. Renters want to be close to transportation, their workplaces and at the center of everything. What specific NYC demographic changes are you seeing?
Victor: When you take a look at the largest growth in renter households in New York City, it will be the younger folks, between the ages of 25 to 29.

You’ll actually see a little bit of a drop-off when it comes to the absolute number of renters over the age of 29 because as you might intuitively expect this is around that age when you make life decisions that might require more space, like getting married and having kids.

In terms of overall rental household patterns, it seems like a lot of the young folks are migrating to the city, which drives demand for apartments. There is an incredible statistic that shows that 50% of households of New York City pay more than half of their take home income in rents. I don’t think that’s a surprise. How do people manage that? Well, they get two-three roommates, and this is very characteristic of the younger renter demographic.

However, when it comes to specific neighborhoods, I’m going to lean on the supply side of stuff we are seeing to a lot of the new buildings that’s actually happening in Brooklyn and Queens. There are a lot of Brooklyn properties that came up last year. About one-third of all new construction in the New York metro for 2018 is in Queens County.

I don’t think that’s a bad claim necessarily, because you would expect that unless you want to compete in the ultra-high-end segment in Manhattan, it does make sense to create more affordable housing. In general, a lot of the outer boroughs are doing okay when it comes to the New York metro.

Kurt: Let’s shift gears Victor, and discuss capital market trends. What are the cap rate and interest rate environments like, and how is that affecting investment in commercial real estate?
Victor: The capital markets really play a key role in determining a property’s value. For the longest time, our low interest rate environment has basically encouraged investment in commercial property and real estate assets.

Basically, it’s what you expect on properties for cap rates, those have been trending very low as well because of low interest rates and especially in markets like New York. Low cap rates mean high values. So, if you have cap rates of around 3% to 4%, which is not uncommon in New York, multifamily investors are expecting that cap rates at some point will begin to raise, in light of the higher interest rate environment.

The 10-year treasury, which is typically the risk-free benchmark when it comes to options vis-à-vis risk gearing investments like commercial real estate or multifamily, has been above 3% recently. This is the first time that has happened in years. A lot of investors are going to start considering whether they should still be investing in a riskier asset like multifamily with a yield or cap rate of 3% to 4%, or should put money in a ‘safe government asset’ like treasury bills, which are trading at 3.2%.

That is the trade off, but I think that’s what the market is saying right now.

Kurt: We have seen a downshift in spreads. What are you seeing, and how might that affect cap rates and future exit strategies?
Victor: We’re actually seeing on our end a systematic increase in cap rates across the property side, and my suspicion here is spreads are filling out, meaning the spread between risk-free rate and risk geared asset or risk premium is filling out and then there will be pressure on cap rates to rise. Then, properties and/or assets will be revalued for prices to somewhat full once we hit 10-year treasury rates of 3.5% or above. That’s just the way it is going to go, not just for commercial properties but also for risky asset types like equities.

The higher interest rate environment is exactly what the Fed should be doing at this point in the business cycle. We are at 3.7% unemployment, we’ve got a little bit of wage inflation, and we’ve had lower rates for a long period of time. We need to unwind that, and start raising rates in a sustainable way without crashing growth.

The impact on apartment evaluations in general suggest though that a lot of investors should be preparing for a future, where they might have entered at a 3% cap rate but they might have to exit or sell at a higher cap rate or a lower price.

I think in the meantime, because multifamily is an income-generating asset, owners can earn money on investments in returns, and continue to collect rent.

The discussion of trends shaping the market between Reis economist Victor Calanog and Chase’s Kurt Stuart will continue. Look for the second part of their conversation in the coming weeks on Connect Media.

For comments, questions or concerns, please contact Dennis Kaiser