By Dwight Unti
I would like to warn you of a pending Market Explosion and to invite you to consider the question: Are We Ready?
Keep in mind of course that you are about to hear the opinions of a developer, observations of an investor and reflections of a property manager. Given that caveat, you would be well advised to measure my comments with caution. I, on the other hand, fully believe the case I am about to make and will be developing, investing and managing accordingly.
The Market Explosion I am referring to emanates from the growing imbalance between apartment supply and demand, an imbalance tilting heavily in favor of landlords and an imbalance which cannot and will not be readily corrected over the near term future. The explosion I refer to will occur as demand overwhelms supply in the months ahead and as the broader public comes to realize we are woefully short of adequate multifamily housing supply to meet both near term and future demand.
Let's set the table for understanding this pending explosion by first looking at where we've been and where we are today. To do so, we need look no further than the Winter 2010, Barry Apartment Report and the Spring 2010 Metro Multifamily Housing Association Apartment Report where we find statements of fact that point directly to the pending explosion.
Statement One: "2009 will go down as one of the toughest years for the Portland economy since the early 1980's, with only the Great Depression causing noticeably more pain." (Source: Winter 2010 Barry Apartment Report.)
Statement Two: “Employment in the Portland metro area peaked in March 2008 and over the next 20 months we lost 87,000 jobs. Our unemployment rate shot up from 5% to 11% in a little over a year.” (Source: Metro Multifamily Housing Association Apartment Report, Spring 2010.)
Statement Three: “Current apartment vacancies 5.1%.” (Source: Metro Multifamily Housing Association Apartment Report, Spring 2010.)
Let me say it aloud again... worst economy since the Great Depression, 87,000 jobs lost, current apartment vacancies 5.1%.
Oh my goodness, sound the alarm and sound the alarm we should! We have just passed thru a period marked by some of the weakest apartment demand in our history, we are barely on the other side of the deepest economic trough since the Great Depression and current apartment vacancies are 5.1%. In other words, our inventory of multifamily housing is approaching nearly full capacity in a market defined by weak demand!
What then will be the consequence as the economy improves, job growth resumes, the rate of population growth accelerates and other demand factors turn positive?
And just how short of adequate supply are we?
A Looming Supply Shortage
A measure of understanding about the supply shortage is garnered from historical perspective. Consider with me, historically we have added an average of about 4,000 new multifamily units to the market place each year just in order to keep pace with historical demand. Now consider that since 2005, multifamily housing permits have dropped well below the 4,000 mark, every year, reaching a low in 2009 of just 850 new multifamily units. And when we strip out high rise, high end condominiums from the counts, it is even more evident, that the production of conventional multifamily housing has fallen seriously behind the indicated need by historical measures. By my analysis, we are now 12 to 14,000 units short of adequate supply and that is only the beginning.
The supply picture moving forward is even more problematic. First, there are financial barriers to the production of new multifamily rental units and second, land use policy has forced a fundamental shift in the type of multifamily housing that will be produced going forward; and this shift in production will hold down supply and significantly increase cost for the foreseeable future.
Let's start with a look at the financial barriers to new production:
- There is simply an insufficient supply of capital for construction lending as capital markets remain constricted and lenders adverse to commercial real estate in general and construction lending in particular.
- Lenders have changed the construction lending rules by requiring developers to pay a much larger portion of project cost in cash. For example, in the recent past lenders required a developer to pay 15% of project cost in cash and would lend the balance. Therefore, a developer two to three years ago, with $3,000,000 of available cash could produce a $20,000,000 multifamily housing development.
Today, that developer will be required to provide cash equity of at least 35% with maximum borrowing of only 65%, and as a result the same $3,000,000 of cash infusion will barely leverage enough to produce an $8,600,000 multifamily housing development i.e. a 57% decline in the in dollar amount of multifamily housing production.
I see no substantial relief from these financial barriers over the near term and you should expect this factor alone to hold down production below historical levels until at least 2014.
The Effects of Our Land Use Policy on Development
Now let's examine how land use policy has created a permanent shift in the type of multifamily housing which will be produced. Bear in mind I am not rendering judgment about the pros & cons of our approach to managing urban sprawl and sustainability, but I am reporting on the consequences of this policy as it relates to the production and cost of new multifamily housing.
The result of our land use policy, and specifically the impact of the Urban Growth Boundary, has been to shift the production of multifamily housing from its historical dependence on 2 & 3 story, stick built, garden apartments on large suburban sites to vertical housing construction on small urban lots. This change reduces the speed at which new supply can be added and greatly increases the cost per unit of production. Think it thru with me; past imbalances in supply could be corrected in a relatively short period of time because the supply of garden apartment sites was adequate, the number of developer/builders with the skill set to produce conventional stick built housing abundant and the low complexity of stick built construction kept permit processing time reasonably short.
Costs of Vertical Construction Development
Today and into the future the addition of significant new supply will be far more dependent on vertical housing construction. But here are the facts, vertical housing is vastly more complex to build than standard garden apartments and it is substantially more expensive because of structural requirements, fire life safety requirements and the cost of elevator service and structured parking.
Let's look at a quick example. Today, a new 1,000 square foot, stick built garden apartment costs about $100,000 per unit to produce including covered parking. In contrast the same 1,000 square foot space in a vertical housing project with structured parking will cost approximately $175,000 to produce or about 75% more than the conventional garden apartment.
To get the full measure of what we are facing however we need to combine the impact of the financial barriers with the impact of the shift to vertical housing. To do so let's go back for a minute to the developer who had $3,000,000 of cash to invest. As we know, just two or three years ago his $3 million investment could be combined with 85% financing to produce a $20 million project. Now, if the project were garden apartments at $100,000 per unit, the developer’s investment would yield 200 units of new multifamily housing for the community.
Contrast that with conditions moving forward, whereby Mr. or Ms. Developer will have to produce vertical housing. Now remember, due to changes in lending requirements, the $3 million cash investment leverages only an $8.6 million development today AND assuming vertical construction at $175,000 per unit, the developer can produce only 49 units of new multifamily housing. So the same developer, with the same $3 million of cash has gone from the ability to produce 200 units of new multifamily housing to being able to produce only 49 units for a drop in production of 76%. How than can we expect to keep pace with needed production, under these circumstances?
The answer is, we cannot.
And how will residents afford the significant increase in rent, which will be required to support the increased cost of vertical housing? The answer is they cannot. Indeed, new financial incentives and tools will need to be identified to offset the cost differential between these housing types.
So the conclusion on the supply side is clear. We are currently short of the units needed; there are significant financial barriers to new production and the shift to vertical housing will hold down supply and increase cost.
How Future Demand Contributes to Market Explosion
Where then is demand headed and how will it contribute to a Market Explosion. I believe that demand will be moving up swiftly and that we’re headed for a period of sustained high demand for apartments in the Portland Metropolitan Area.
Here are the reasons why.
The First Important Demand Factor: Economic Growth
Both real and perceived improvements are occurring in the economy. Fact and opinion are coalescing around the theme that things are getting better; that we have survived the economic crises and that lifting our eyes to the future is OK again. In fact consumer spending is increasing, manufacturing is up, the high tech industry is hiring and corporate profits increasing. As this forward momentum continues, job growth will result and feed apartment demand.
The Second Important Demand Factor: Shadow Market of Renters
The Shadow Market of Renters includes individuals who exited the rental housing market over the past several years due to real or perceived economic uncertainty, individuals who reduced their rental exposure by doubling up with a roommate, youth who have postponed leaving the nest pending a signal the way is clear and elderly individuals needing and desiring a lower maintenance life style, but unable to shake the economic burden of a home which will not sell.
While hard to quantify in terms of total numbers, I believe, this market is deep, capable of rapid re-entry into the rental market and very much ready to go. Indeed, the Shadow Market has already begun to emerge, contributing to recent improvements in vacancy, and will in and of itself, drive near term vacancies to well under 5%.
The Third Important Demand Factor: The Changed Dynamic of Home Buying
As history has shown the balance between homeownership versus rental can dramatically impact apartment demand. Indeed it was only a few years ago, that we witnessed a historic drop in apartment demand as renters migrated to homeownership in droves. Most Portland metro owners had the same experience we did, watching residents of our apartments who we could barely qualify for a one bedroom apartment, leaving after six months having magically qualified to buy a $250,000 home. There were few barriers to entry for homeownership and renters seized the opportunity by the thousands.
Those home buying dynamics have changed and now heavily favor rental versus home ownership. Indeed, the perceived value of home ownership has been tarnished by the recent boom/bust cycle and real barriers to entry to homeownership are now present in the form of higher underwriting standards for borrowers and higher cash down payment requirements. These factors will hold the home buying vs. rental equation in favor of renting for a substantial period of time.
The Fourth Important Demand Factor: Population and Demographic Trends
The Portland Metropolitan Area has been marked by a sustained growth in population and remarkably even at the depths of the downturn and with one of the highest unemployment rates in the country, in-migration continued at a positive rate. As the economy continues to improve, it is safe to project the rate of population growth will be stimulated as people migrate to the area, not only for lifestyle, but for jobs. This will translate to increased demand for apartments.
Finally, two key demographic factors are about to drive further increases in apartment demand.
- Aging baby boomers will be exiting homeownership and seeking low maintenance, one level living in urban areas with significant services.
- A large body of the population is rapidly approaching the prime rental age of 18 to 25. Given the increased barriers to homeownership, we should expect the majority of this demographic to seek a rental opportunity and further drive apartment demand.
I Return to the Question: Market Explosion - Are You Ready?
I can almost hear some of you thinking: “Heck yeah I'm ready! Ready to have our apartments full and fill my pockets with gold! I sure hope you’re correct. When did you say that explosion will happen?”
Well that's not really where I'm coming from. In fact, let's set aside our personal financial aspirations for a moment, and consider the higher question of the impact of these pending conditions on the health of our community and health of our industry.
Are We Ready, All of us, as an Industry?
Are We Ready?
To take leadership and get out ahead on this issue by sounding the warning that we're facing a significant shortage of rental housing and the serious consequences it will bring? We need to be, as our community will be looking to us as the housing experts for answers and for leadership.
Are We Ready?
For robust engagement with tenant advocacy groups who will use the demand/supply imbalance to push for rent control or other restrictions on our business activities? We need to be. We're going to have to defend our industry and demonstrate our integrity as responsible and professional owners and managers who care about housing the needs of our community.
Are We Ready?
To strengthen the self policing of our industry in order to weed out and pressure unscrupulous Landlords who will use the supply/demand imbalance to exploit those desperate for housing and who are the same Landlords who elect not to maintain their properties? We need to be or we will find ourselves on the evening news, represented by Mr. Slumlord and we'll find ourselves facing a host of new and expensive rental housing inspection programs which will mandate the standard of maintenance and care at our properties.
Are We Ready?
To partner with our regional government, METRO to identify new tools and new incentives for closing the gap between the cost of vertical housing and the cost of conventional stick built apartments? We need to be, or the growing supply/demand imbalance will exacerbate and the housing shortage will move from a short term positive benefit for Landlords to an affordability crises and serious drag on economic expansion.
Are We Ready?
To lobby our US Senators and State Legislators to find the appropriate tools, find the solutions and find them now to get capital flowing for construction and permanent financing? We need to be, as you can't have capitalism without capital and you surely cannot ramp up the production of multifamily housing without construction and permanent financing.
Are We Ready?
To expand housing opportunities for the most vulnerable members of our community? We need to be as these are very people who will be most stressed by the affordability equation and the most likely to be subject to exploitation as market demand overwhelms supply.
Are we ready?
To continue the strong support of our industry groups and associations? We need to be, because addressing these issues alone is not going to cut it. We will need every smart mind in the industry working together to address what is going to be a very challenging housing market for many years to come. And so I make one final appeal to you this morning, know that the dynamics in our industry are likely to provide each of us significant financial benefit moving forward, but with this benefit, let's also remember the awesome responsibility we have, and to look after the housing needs of our community.
Are we Ready?
I am confident that working together we can be and I am certain, that our community is counting on it.
Dwight Unti, CPM is President of Tokola Properties, a real estate development, construction and property management company focused on multifamily and mixed-use development in Oregon and Washington. Mr. Unti is a Past President of the Columbia River chapter of the Institute of Real Estate Management and past board member of the Metro Multifamily Housing council.
