To what degree does demand drive supply, and is there a point of equilibrium?
Several years into the recovery from the Great Recession, apartment development activity has picked up across the country. In the core 100 U.S. metros, about 195,000 apartment units were completed in the year-ending Q2 2014. That’s about two and a half times the number of completions seen just two years ago, when rent growth was peaking. Since then, there have been widespread declines in rent growth levels, especially in the Midwest and Northeast regions, where weak employment growth adversely affected apartment demand. On the flip side, some of the nation’s hottest construction markets (particularly in the West and the South) are still posting big rent growth due to strong demand for lease-ups. Because of that, the U.S. apartment market overall has generally seen demand increase with supply for more than a year.
How do these supply and demand forces interact? Is there an equilibrium point between the two variables for the experienced investor to leverage its predictive power in their decision making? Those are big questions worthy of white papers. But for the purpose of today’s short blog post, we’ll keep it fairly simple.
Economists have long debated the driving force of the supply and demand relationship. It’s a question almost as old as the “chicken and the egg.” Some economists argue supply can’t create demand. Others point out that demand tends to follow supply. In the apartment sector, the data clearly shows that supply and demand – barring inelasticity, low utility and limited competition – tend to be highly correlated. Demand is limited by product availability, but as new supply surpasses another 10-year high, the two primary economic forces continue in tandem.
Nationally, apartment demand has continued to increase further into the expansion cycle. If we use occupancy as a function of the supply/demand relationship, we see that all regions are exceeding their long-term averages. Although the relationship between new supply and demand remains highly correlated, the equilibrium point in each market is different given its economic and demographic drivers. It should also be pointed out that supply generally goes heaviest into markets where demand can reasonably be expected to follow. For instance, robust job growth will likely continue to help the Texas markets absorb big levels of new supply. And core markets like New York and Washington, DC, are generally under-supplied markets that should continue benefiting from pent-up demand. On the flip side, the supply/demand relationship remains protected in low-demand markets like New Orleans simply because supply tends to be very limited.
Additionally, supply tends to drop off when demand drops off – such as what occurred following the last recession. But as demand returns, supply is then slow to follow – allowing demand to catch up with previously built supply.
Nationally, the apartment market (even early recovery metros) has not reached equilibrium, as development and demand drivers remain too volatile and are well outside of normal activity. Supply is on track to peak in late 2014 and early 2015 – winter months when demand tends to be seasonally weaker. The short-term mismatch will likely lead to some erosion in fundamentals. But assuming moderate economic growth continues and assuming supply doesn’t re-accelerate (which isn’t a sure bet), the supply/demand relationship should correct further into 2015 and 2016.
In the next blog we will explore the supply/demand relationship by examining whether any individual markets are at risk of short-term overbuilding.
Did you miss part one of this four-part series? Check it out.