The impact of the 2008-2009 recession and subsequent tepid recovery on commercial real estate (CRE) has been immense. Developers, investors, lenders, and the entire ecosystem of myriad advisors have been devastated by the crushing losses, both realized and unrealized, of many high-profile CRE investments. The attendant slowdown in new activity has been nearly as calamitous. Recent trends suggest that some of the bad habits that led to the current downtrodden state of the industry have crept back into the market in the form of newfound enthusiasm for multifamily developments.
The investment thesis for multifamily real estate has created enthusiasm among professionals across the industry. Justifications for the intense interest surrounding such building projects include historically low apartment vacancy rates, tightened lending standards that led to a shifting of natural homebuyers to renting, and the availability of financing for these projects.
Multifamily housing certainly presents an interesting case for investment. However, many of the points used to support this thesis have been misconstrued, while a number of serious challenges have been overlooked. This article discusses a number of those issues.
Low Vacancy Rate. Reis reports that the Q4 2011 apartment vacancy rate of 5.2 percent, down from a peak of 8.0 percent in Q4 2009, is driving up rents. It must be remembered, though, that the reported vacancy rate is biased toward metro areas. The extent of this bias is clear when comparing the reported asking monthly rent of $1,064 cited by Reis to the U.S. Census Bureau’s reported median rent of $712.[1,2] Veterans of the real estate industry believe that reporting bias is a constant problem, with pro-cyclical forces always focused on “selling sunshine.”
Pent-up Demand. The reduction in the rate of household formation offers a stark illustration of the impact of the recession and subsequent weak recovery on the real estate market and society in general. In the wake of a recession caused in large part by overinvestment in housing, there has been a strong upward trend in per capita household density. If that trend proves to be a long-term aspect of the economic landscape rather than a temporary response to problems caused by the recession, the anticipated demand that is driving enthusiasm for multifamily projects could fail to materialize.
Tenant Quality. It is also worth noting that developers currently may be building for the wrong class of renters. The U.S. Census Bureau reports that as recently as 2009 the percentage of rental units with gross rent in excess of $1,000 was about 33.4 percent. Additionally, for 58.5 percent of households, gross rent accounted for more than 25 percent of household income. Developers and lenders may live to regret the lack of attention paid to the limited number of relatively affluent renters, the market segment many are depending on as the basis for increased demand for new multifamily construction.
It is also reasonable to suggest that only an inability to procure a down payment for a single-family home is a valid justification to rent for this more affluent sector of the housing market. A tenant who has walked away from potential home equity and skipped payments to a bank and/or other federally chartered institution and therefore may not be eligible for a new mortgage would probably find it easier to skip rent payments when hard-pressed. It can be almost as time-consuming to evict a tenant as it is to foreclose on a homeowner.
Location. There is anecdotal evidence that multifamily complexes are being built where it is easy to build them rather than where there are concentrations of affluent renters. The rush to convert failed condo developments into high-end rentals could simply prove to be an exercise in delaying an inevitable recognition of a disconnect between where these developments are located and where those who might rent the properties are willing to live.
Rising Costs. Developers may not be experiencing robust demand, but they are undeniably facing higher costs. Recent trends in construction wages (Figure 1) highlight the extent to which developers find themselves at a structural cost disadvantage.
Challenging Employment Picture. Given the cost challenges facing developers, as well as the natural inclination to target the most attractive areas of a given market, multifamily projects are targeting relatively affluent renters. The problem with this approach is that there is a very real possibility that those involved in this mini boom are greatly overestimating the number of available affluent renters. While the U.S. is technically no longer in recession, the number of long-term unemployed remains distressingly high and the precipitous decline in the labor force participation rate suggests that a still-challenging employment picture has pushed millions of Americans out of the labor market (Figures 2, 3).
Downside Risk. The challenges inherent in multifamily development are highlighted by the January 2012 Morningstar CMBS Delinquency Report (Figures 4, 5). The report indicated that multifamily property types have experienced the second-highest severity of loss, behind only retail. With less than 12 percent of multifamily developments currently on the master servicer watch list, a case can be made that this particular property type could weaken substantially in coming years.
Operational Complexity. Multifamily developments are being built today based on current historically low vacancy rates. Those with experience working with multifamily landlords can attest that a certain level of vacancy is inevitable due to churn. Inexperienced or overly optimistic developers may be positioning themselves for a rude awakening by ignoring the challenges inherent in managing prospective multifamily developments.
Political Theater. Most new construction financing is coming from government-sponsored entities (GSEs), such as Fannie Mae and Freddie Mac. By financing multifamily developments, these entities can meet their affordable housing mandates and show a modest profit to offset significant losses in their single-family portfolios.
Reliance on the Greater Fool Theory.
The structure of debt is conducive to new building; that is, a high percentage of all costs and fees can be funded with a minimal equity contribution in the form of fees and hard cash. Increasingly, it appears that the investment thesis for multifamily properties may be dependent on the greater fool theory of investing. Of course, any such thesis should be extremely conservative in its estimate of the number and availability of greater fools.
The pro-cyclical bias in the finance community drives observers to grasp for reasons why each bubble is not really a bubble but a harbinger of a new economic reality, while at the same time viewing each recession and subsequent recovery as following a rigid script. Despite this tendency, evidence to the contrary is piling up that demand for multifamily housing may not prove to be as robust as some believe, and those involved in the CRE space should take note.
The Federal Reserve has done nearly all it can to stimulate demand, yet demand remains tepid. The issue of shadow inventory makes a mockery of official housing inventory numbers. Many multifamily developers are building for a small segment of the rental market while working at a severe cost disadvantage, given the large stock of shadow inventory that could be rented in the interim. Challenges abound, and there is little reason for confidence that building first and letting demand take over later will result in anything but losses.
 “Reis: Apartment Vacancy Rate falls to 5.2% in Q4, Lowest since 2001,” Calculated Risk Blog, January 5, 2012. www.calculatedriskblog.com/2012/01/reis-apartment-vacancy-rate-falls-to-52.html
 “Housing Vacancies and Homeownership,” U.S. Census Bureau, Fourth Quarter 2011.
 “The 2012 Statistical Abstract: Renter Occupied Housing Units,” U.S. Census Bureau.