Stephen Duffy on
multifamily development.

Ronald Reagan said in a famous presidential debate, “There you go again!” and that is the thought on many minds about the emerging apartment market: Are we already overbuilding again? Given the surprisingly rapid recovery in multifamily asset performance and values, clearly a development cycle has begun, more strongly in some markets than in others. 

Yet we are far from conditions of “There you go again.”   The market data, leading indicators and market experience are actually pointing to the beginning of a development cycle in which demand is accelerating and developers who move quickly will be poised to capture the expansion.

Fears about overly bullish activity, at this point in the cycle, are simply unfounded.  We may end up getting to a robust increase leading to oversupply in multifamily supply at some point, but that would take quite some time, plus a full-on expansionary economy, plus a return of easy credit.  We are far from that point.  

My central conclusion is that we are at the beginning of a multifamily development cycle, and here’s why. 

First, the number of new multifamily units is significantly below the long term annual average of new units produced.

Secondly, the current lending market requires real equity, potentially significant guarantees beyond completion, for cost overruns and repayment. 

Third, the real estate developers who have participated in the development activity are generally substantial in capital capacity and development experience. Furthermore, the locations of the new multifamily development have been focused on the favored but limited geographic markets where the dive in cap rates for existing assets has made the development spread “interesting”.  The Class of 2011 multifamily developers who stirred last year or are now in full swing are exactly those who might be expected to lead the first wave of development after a life-altering Great Recession.

At the 2012 National Multi-Housing Council annual meeting in Boca Raton, FL, the new supply of permits for US multifamily units was estimated to be a seasonally-adjusted rate of 208,300 for this year.  That level marks a significant increase, 53%, over the prior year, but we are still well below the long term annual average of 325,000 permits, according to NAHB/US Census data. 

This low number of new permits is obviously very helpful in allowing a strong level of occupancy rates, a vanishing of concessions and a growth in rents for existing multifamily stock, in general.

Meanwhile, the National Association of Home Builders forecast approximately 175,000 new multifamily unit starts this year, compared to 140,000 in 2011 and 114,000 in 2010.  Said NAHB’s Sharon Dworkin Bell, “A more balanced market would be in the 300,000 to 350,000 range of new units started each year.  We are not really adding to the stock, but rather running in place.”

As for the still-growing rental demand, the U.S. population continues expanding, and faster than other industrialized nations, according to the NMHC.  U.S. population is expected to increase 33% by 2030 to 376 million.  That’s 94 million more people than there were in 2000, fueling a need for 60 million new housing units.

Demand trends also show a shift from single-family to multi-family as average family size falls with more singles and couples than ever, according to Census data.  The average US family size was 6 in 1790, then 3 in 1960 and 2.6 in 2010, reflecting the rising share of young people staying single longer and having fewer children, and the increase in aging baby boomers.

Another key factor: The Great Recession has dampened interest in for-sale housing, to the benefit of multi-family. 

Where are we headed, and who’s already on first?

The leaders in this development cycle are simply the who’s who of real estate multifamily operating companies.  The list of most-active national and regional developers — high caliber firms with significant experience and accessible capital –  is dominated in scale by the likes of Avalon Bay, BRE, Holland Partners, Irvine Company, Wood Partners, Mill Creek Residential, Western National Group, Bozzuto Group and others.  On the geographic side, the “sexy six” markets are receiving the preponderance of new units:  Boston, New York, Washington D.C., Southern California, the Bay Area and Seattle.   Clearly, there is no need to discuss any meaningful start to the development cycle occurring in secondary and tertiary markets, although niche plays will arise with local employment and demographic shifts.

Another reason to dispel concern about overbuilding is the tighter financial underwriting, which is creating a curb on growth.   The current multifamily environment requires the developer to be substantial enough to participate in the capital with significant responsibility, and have an existing well-funded operation, rather than the speculative fee-stream expected from the deal.  The current market for debt and equity is conservative in underwriting, structure, operator co-invest, and guarantee of support. 

And yes, the investment promoters are predominately subordinate to fair returns to the 90% equity partners.  Furthermore, the fee allowances are targeted at overhead levels and needs rather than service company profits.

Lenders are very focused on the developer’s balance sheet and the financial muscle to fulfill the co-invests, deliver the asset, and have the overrun and other guarantee support, as needed.  When non-recourse loans require 35% to 40% of equity, the 10% developer co-invest can get exciting real fast. 

The multifamily sector is leading the real estate industry through this unimpressive U.S. recovery.  The multifamily` development side generally opened up in 2011, and we are still in the early stage of a development cycle. Talk of a development boom and multifamily overbuilding is premature.