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Robust Demand Eases Supply Slowdown Among Class A Apartments

Robust Demand Eases Supply Slowdown Among Class A Apartments

Among the U.S. apartment quality spectrum, Class A product has been the usual leader for occupancy rates and rent growth. But these top-quality assets are facing stiff competition from other luxury apartments being built at an unprecedented pace during the current supply wave. Competition has dampened Class A performance, but not severely, thanks to robust demand driven by demographic and economic tailwinds. Even in the wake of monumental delivery volumes, apartment demand has continued to edge out supply. In fact, that has been the case for nearly two years as economic tailwinds have fueled urban-centric job creation, which is where a bulk of the new deliveries are going.

Apartment developers build near employment hubs with easy access to transportation infrastructure, as these are the places where apartment demand is more robust and rent growth more sustainable. In turn, the ratio of new supply to demand has been less than 1.0 since the beginning of 2014, indicating positive net absorption. Despite more than 475,000 new units coming online since that time the amount of pent-up demand was strong enough to support the biggest supply wave in more than 20 years. Conversely, the supply-to-demand ratio was greater than 1.0 in much of 2013, implying weaker-than-expected apartment demand. The good news is that apartment demand continues to outpace mounting supply. But the question remains how much longer can this trend continue before the demand can no longer keep pace.

demand supply ratio

Occupancy rates in Class A units have been hovering in the low 95% range for most of the past three years, in the wake of rising supply. Meanwhile, occupancy rates in the more affordable Class B and C groups have risen steadily during that time. In fact, Class B occupancy surpassed Class A in 2nd quarter 2014 and has remained higher since. The good news is that apartment occupancy is increasing across the product spectrum. The increase is especially pronounced in Class C product. During the past four years, the vacancy spread between Class A and C units has narrowed from 300 basis points to zero. Most recently, occupancy in Class A units fell below Class C units for only the second time in over 10 years.

Class occupancy

Comparing rent growth by apartment type, Class A units have historically had a commanding lead over less expensive units. But that delta has gradually contracted. In early 2015, annual rent growth figures in Class A and B units converged around 5% and continued to increase at roughly the same pace through 3rd quarter 2015. And most recently, rent growth in the middle-tier Class B units surpassed the Class A performance. This again is probably due to the downward pricing pressure from enormous stock of new apartment deliveries. Increased competition among Class A units has driven stout revenue gains among Class B units. Meanwhile, rent growth in the less expensive Class C niche remains in the 3% range, up from 2% in 2014.

Class rent

This year will test the depth of apartment demand even further. MPF Research expects there to be more apartment completions in 2016 (roughly 315,000 units) than in 2015 (roughly 225,000 units). Metros that will see the largest number of new units include New York, Houston, Dallas, Seattle and Washington, DC. These five metros will account for about one-third of the anticipated supply nationally. Those deliveries will put further downward pressure on occupancy rates and rent growth levels in the Class A space. The gears driving the cogs of the economic machine will be the biggest unknown in 2016, as downside risks become more significant. The Class A investment strategy has many upsides but also some associated risks. And the consensus of the CRE investment community is shifting toward higher value, more productive assets, even if the investment requires more active management.

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