How Will All the Apartment Overbuilding End?
The similarities to the years leading up to the “Apartment Recession” of 1972 are eerie. If history repeats itself, the end won’t be pretty.
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Class-A loses its shine
For decades, real estate investors could rely on a simple rule of thumb. Class A apartments (the newest and most expensive with the highest rents) performed the best in good times and went down the least in bad. Next came Class B (older properties with moderate rents). And Class C (older properties in challenging neighborhoods with even lower rents) brought up the rear. So investors paid a premium for the safety of being in class A. However, something strange happened in 2014. For the first time, class B seemed to catch fire and started outperforming class A by a wide margin. And then in 2017, class C overtook class B. What was going on? An investor in 2002 would look at today’s chart, and think they had to be in an upside-down reality.
“The Winds of Change”
So why has the decades-long order of things suddenly changed? The main answer is that construction has gotten so expensive that it’s impossible to build anything but new Class A. And this oversupply is causing Class A performance to deteriorate in many markets. (A few months ago, Austin Texas even became the first major city to register year on year rental decreases, due to oversupply). How is this happening?
First, the cost of materials has gone way up due to the demand from faster-growing, developing countries in a global marketplace. And the cost of labor is skyrocketing too. This has made the real cost of construction soar more than 25% since the low in 2005 (and now higher than the Great Apartment Recession as well).
Why? Many skilled laborers left the construction industry after the Great Recession and never came back. Then immigrants who originally took their place, were themselves encouraged to leave by aggressive immigration policies. All of these are long-term trends that are unlikely to change anytime soon. Then on top of it, recent trade war tariffs have caused the price of building materials like concrete and steel to explode even higher. Even if the trade war gets resolved at some point relatively soon, the bottom line is that it will probably get more and more expensive to build for many years to come.
So to recoup the extra cost of building, the builder needs to charge higher rent. If they built affordable homes for class B and class C renters, they would never make a profit. So in many markets, the only type of new building that is economical to do is top-of-the-line, luxurious Class A. This is especially true in the downtown areas of most cities. Most are filled with gleaming new top-of-the-line apartments.
So what’s the big deal with that? The problem is there are only just so many people who can afford to pay a luxury rent. So this can cause an oversupply problem which causes rents to drop and vacancies to increase. And recently, class B is now doing the same thing, which suggests there may be a trickle-down effect. This is causing profits to drop and projections to be missed. It’s also making many people wonder how the story is all going to end.
“Don’t worry. Be happy!” Many developers are saying there isn’t really a problem and all is well. They say the reason is that there’s a once-in-a-lifetime demographic shift happening right now. A huge new generation (the millennials) are coming of renting age and their numbers will cause demand to continue to skyrocket. These developers concede that maybe the fundamentals seem to be weakening in some places, but (they argue) builders will slow down because of this. And in the long run, everything will self-adjust and it’s going to all work out fine.
Are they right?
“Why does this seem so familiar?”
History gives us one possible answer. We actually don’t have to look too far back, and many of the similarities are eerie. The year was 1969 and another (supposedly) “once-in-a-lifetime” demographic opportunity was happening. Instead of the millennials, it was the baby boomers who were coming of renting age. Just like today, the focus was building apartments, and primarily in cities, and there was a huge boom.
Real estate was benefiting because the stock market had stalled (similar to our situation today where we’ve been in correction since January). So people pulled their stocks out and started investing in real estate. And tax reform (The Tax Reform Act of 1969) made real estate investing more profitable than other investments (similar to the tax reform of 2017, which will give many real estate investments a 20% tax cut).
And for a while everything went exactly to plan and was wonderful. From 1969 to 1972, the baby boomers caused demand to skyrocket along with the prices of apartments, and investors were delighted with the huge profits. Similar to today, the prices of that time started accelerating faster than rent growth (see “Multifamily Rent Growth Stalls in Top Markets"). But that didn’t stop the apartment train from moving faster and faster. All the Cool Kids are Doing It
It got so profitable that apartment investing became the newest fad, and everyone was doing it or wanted to do it. So Wall Street came up with a new idea: the REIT (real estate investment trust) which allowed ordinary people to invest in apartments. This was a huge success and assets rose from just $2 billion in 1969 to $20 billion by 1973. Commercial mortgages skyrocketed from $66.7 billion to $213.6 billion. In the words of the authors of “The Coming Real Estate Crash” (a book that studies real estate bubbles), “traditional caution and historical standards were abandoned and money flowed out like a swollen river.”
What Went Up, Comes Down
But then, it all came to a very quick and catastrophic end. Boomers got tired of apartment life, wanted to start families or were sick of paying rent. So they moved to single-family homes, “prompted in no small measure by the high rents they had been forced to pay for their apartments.” So the demographic boom that had fueled the years-long self-fulfilling prophecy of growth, ended. And, “suddenly, the vacancies that were appearing in apartment housing complexes around the country led many investors to wonder how an apartment building could continue to escalate in price when it was empty”. It didn’t take long to answer the question. “With sickening speed investors realized it”: the cities that had gone up the farthest and fastest, like Atlanta, were the first to fall. But no one was immune in the end.
It didn’t help that there was a sudden burst of inflation and the Federal Reserve had to jack up interest rates to fight it. Suddenly, the easy money and low interest rates (sound familiar?) that had financed the industry evaporated. Amazingly, “more money was lost in the apartment crash than in any of the more celebrated crashes,” including the Great Depression. Prices of rental properties collapsed to $0.50 on the dollar, as foreclosures soared. By the end of 1976, 19 of the nation’s largest banks had to seize $1.2 billion worth of apartments through foreclosure. And 42% of the remaining “good” loans were problematic, where landlords were not paying interest or were reduced. Many builders went bankrupt and REITS collapsed and their stocks were delisted. Lucky ones, like Wells Fargo Mortgage, “only” plummeted from $26 to $2, taking wheelbarrows of investor money with them.
“Please Tell Me There Are Some Differences Now!” Yes, the good news is that there are some major differences between then and now. The amount of euphoria and debt in apartments in 1972 was off the charts and far in excess of what’s happening today. That’s really good, because most people (including me), think both are necessary to create a bubble and a burst. So, personally, I don’t think 2018 runs the risk of a repeat. But I’m not so sure about 2022-2025. At some point, we know the end of the millennial demographic wave will cause a huge glut of class A apartments. I think the odds are that many people will be caught by surprise. And if it happens to enough people, I think this will cause a crisis.
So as a conservative investor, I do a few things. First, I keep an eye on things to see what’s happening and plan my portfolio defensively to harden it against the worst risks.
In general, I’m not interested in class A or new construction. But, if I do invest in class A, I do it in an area that has some sort of constraint on overbuilding/oversupply (for example, California has many regulations that make it difficult to build which are pain for builders, but great protection for an investor in an existing property).
And I always stress test my multifamily investments for a similar crisis and see if I can live with the results are not. Since it’s really difficult to get data from the 1970s, I will usually take the stress of the Great Recession and multiply it by 1.5 or 2. If the deal can stand up to that, then it lets me sleep easier at night. (Click here for more on how I select deals and do due diligence.)
Second, I like the Chinese concept of a “crisis” translating into “dangerous opportunity.” If and when a crash comes, I believe there’s a great chance to profit from it. This happened with single-family houses in the aftermath of the Great Recession, when a handful of people with cash scooped up the best opportunities in several decades. So I plan to keep plenty of cash on hand to hopefully take advantage.