“IT WAS THE BEST OF TIMES, IT WAS THE WORST OF TIMES, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of light, it was the season of darkness…” so starts Dicken’s famous book, A Tale of Two Cities. Set against the French Revolutionary War, the book highlighted the social inequalities of the era. 150 years later, the iconic quote still strikes a chord. While every recession is different, the pandemic-induced shelter-in-place rules quickly sent the U.S. economy into the deepest recession on record in the second quarter. Fortunately, economic recovery, at least thus far, is proving to be just as swift in the areas where it is occurring.
While unemployment rates dropped quickly from 14.7 percent in April to 8.4 percent in August, a more detailed look shows widening inequality that has yet to be resolved. For those with a bachelor’s degree or higher, unemployment peaked at only 8.4 percent in April and has since fallen to 5.3 percent – a rate that was once thought to be near the point of equilibrium for the economy. Unemployment rates for those with less than a high school education peaked at 21.2 percent and for those with a high school education, at 17.7 percent. More than one in ten people of the 42 million people in these segments of the labor force still remain unemployed as of August1.
To add to the current volatile environment, the contentious U.S. presidential election kept investors on edge, assessing political as well as economic uncertainty, at least in the near-term. Volatility indices remain somewhat elevated, although the stock market recuperated all of its March losses by August and interest rates remain at historic lows, a good support for real estate investors. Third quarter GDP increased at an annual rate of 33.1 percent, also showing an important recovery from the second quarter losses2.
However, the economy is far from being back to ‘normal.’ The federal reserve’s balance sheet increased by nearly $3 trillion this year as subsidies such as those provided by the CARES act backstopped businesses, individuals and farmers. That’s almost triple the subsidies provided in 2008 which have yet to be paid back, igniting a debate about whether the economy can grow out of its increasing debt burden, print money, or continue in a low interest rate environment to pay back the debt. Long-term, that could put upward pressure on interest rates and inflation; however, interest rates are expected to remain at historically low levels in the near term. Personal consumption expenditures (PCE), normally the largest part of economic growth, remain 5 percent below the January level after declining by a historic record amount of 18 percent in April. As comparison, PCE gradually fell to a low of a 2.5 percent decline from the peak in April 2009 after the Great Financial Crisis in 2008-09.
A good part of the government subsidies provided to individuals and businesses in the first part of the year was socked away in savings, which are now declining as people use those savings for expenditures such as groceries and rent. Top of mind for the near-term is whether employment rates will improve fast enough to replenish household wealth before savings run dry, or whether the government will fund more subsidies. This is particularly important for low wage earners, most impacted by the recession and generally with less ability to save. Fortunately, savings rates currently remain elevated and the pace of decline in savings is slowing. Nevertheless, at the current pace, excess savings could be depleted in three to six months, which could begin to have a larger impact on housing payments. Since May, the National Multifamily Housing Council’s rent tracker has shown slight year-over-year decreases in monthly rent payments, with the largest year-over-year dip of 1.8 percent in October and the smallest decline of 0.1 percent in June.
Overall, rent collection has remained better than most expected at the onset of the pandemic, but there are still an abundance of factors that will impact renters’ ability to continue to make payments in the months ahead, as well as persisting trends that will impact renters’ housing choices. The latter of which we will discuss in greater detail later in the report. The economy is disparate by location as well. Some of the hardest hit job markets recently are the larger high-cost, urban markets.
Unemployment remains above 10 percent in markets such as New York, Boston, Philadelphia, San Francisco, and Los Angeles. Similarly, unemployment remains elevated in tourism-related markets such as Las Vegas and Orlando. Conversely, lower cost markets in the south and Midwest have unemployment rates of 8 percent or lower, including Atlanta, Austin, Dallas-Ft. Worth, Kansas City, Indianapolis, and Cincinnati. Raleigh-Durham and Washington D.C.,as well as Salt Lake City and Denver, also have relatively lower unemployment rates.
The apartment market reflects similar trends to the broader U.S. economy. While work-from-home (WFH) accommodations have kept many white-collar employees on the job, ‘home’ does not necessarily have to be close to an office anymore. High cost, dense cities lost many of the attractions of urban amenities such as walkable restaurants, bars and entertainment venues due to pandemic-related shelter-in-place orders. Consequently, the worst-hit this year have been the San Francisco and Manhattan apartment markets where effective rents fell by more than 9 percent year-over-year as tenants either condensed households or moved to outlying areas3 - e.g., Long Island, Northern New Jersey, and Sacramento where rents are up.
With firms such as Google, Facebook and Microsoft announcing that employees will be able to work from home at least until Summer 2021, sales in second home destinations are also soaring. For example, in the Bay Area home sale volumes are up by more than 50 percent from a year ago in Santa Cruz and Monterey counties4. Nationally, nearly half of CBD spaces are currently providing some sort of concessions in terms of free or reduced rent. Low cost, drive-to markets are doing well in contrast. In terms of number of units absorbed, demand over the past twelve months has been strongest in Dallas, Houston, Atlanta, Phoenix, Charlotte, Washington D.C., Austin, San Antonio, and Minneapolis.
Tenants, now with higher work-from-home needs, are also looking for larger spaces. Rent growth is strongest for two-bedroom and three-bedroom units. Studio apartment rents are declining as vacancy rates soared from near 6 percent in mid-2019 to near 8 percent currently. The lowest vacancy rates are recorded for two-bedroom units, which provide maximum flexibility for working from home or roommate sharing.
More broadly, the apartment market remains fairly stable. 62 of the 80 largest markets continue to post positive effective rental growth as of September. True to its reputation as a defensive investment in times of economic weakness, stabilized apartment properties have maintained vacancy rates under 6 percent as compared to 13 percent for office, 7.6 percent for industrial and 10.2 percent for retail5. Multifamily delinquency rates also remain low at under 4 percent, up only slightly from a year ago6.
Despite all of these positive signals, the apartment market will face some downside risks going forward. An aggressive construction pipeline that already delivered 200,000 units in the first half of the year will further stress the market; another 600,000 units are currently under construction (equivalent to 3.5 percent of inventory). Two-thirds of these units are expected to be completed in the next 18 months. Consequently, markets such as Austin, Boston, Charlotte, Denver, Raleigh-Durham, Miami-Ft. Lauderdale, Long Island, Nashville, Northern New Jersey, Orlando, Palm Beach, and Seattle will increase in size by 5 percent or more. U.S. net absorption averaged 1.7 percent of stock over the past five years and is expected to be equivalent to about 1 percent of stock in 2020, indicating that vacancy rates are likely to continue increasing in the near-term. The impact of excess construction is already being seen as U.S. vacancy rates, including projects that were recently delivered, average 6.8 percent, up from 6.4 percent at year-end 2019. Including newly delivered properties, Class A vacancy is even higher – at 10.2 percent, up from 9.2 percent at year-end 2019. Comparatively, Class B vacancy is only 5.7 percent.
Interestingly, the lowest quality units – those that theoretically are most exposed to the lower income and higher unemployment segments of the labor force – have the lowest vacancy rates, measuring 5.4 percent as of September. This segment will be most exposed to the unemployment to savings rate balance risk previously discussed.
While many can shop online and work remotely from home, everybody needs to live in a physical space. Despite increased vacancies and construction, as we have seen in other periods of economic instability, we believe multifamily will remain the most stable, resilient, and likely to create lasting, long-term value. As we have seen already, higher income locations may not be the fastest to recover, both because of supply as well as demand weakness, but the apartment sector continues to chug along, offering an attractive investment that has proven once again that it can withstand an economic downturn.
1BLS Table A-4
3Source: San Francisco-CoStar as of September 2020 and Manhattan- Miller Samuel as of August 2020
4Source: Compass as of June 2020
5Source: Costar, CBRE and REIS for shopping center retail.
6https://www.cpexecutive.com/post/cmbs-delinquency-rate-declines-again-trepp-finds as of August 2020