This is the second in a three-part series on the state of multifamily development and lending across the U.S. as credit quality concerns mount. Access the first part here.
New York City and San Francisco have the worst apartment rent growth in the U.S., a reversal of fortune for markets that were among the leaders in the recent commercial real estate recovery.
A flood of new construction is putting downward pressure on rents. As a result, some developments still in the planning stages could be delayed or cancelled, and the largest multifamily REITs, with heavy exposure to coastal urban markets, have trimmed earnings forecasts.
But for now, construction remains on the upswing: Axiometrics, a data firm, predicts the number of new apartment units coming online in 2017 will surpass 2016's already-high levels in both New York and San Francisco. And, while 2018's new-unit count could return to near 2016 levels, construction delays could further extend the new-supply peak.
In San Francisco, 2017 "is probably going to be pretty soft again" because of new supply, said Jay Denton, senior vice president of analytics for Axiometrics.
Executives at Equity Residential, the largest multifamily REIT, called New York the most worrisome market in their portfolio during a February 1 conference call, and said competing landlords are offering multiple free months of rent to attract tenants. Denton said the city has exhibited no sign of a slowdown in construction permitting — a shift that usually precedes a decline in actual building openings by at least two years.
Construction boom continues
Few asset classes have performed as well over the last decade as high-end apartment buildings in the top coastal cities. Apartment property values have roughly doubled in the five years through 2016, and New York City and San Francisco rental rate increases doubled the national average in 2015. Even through a financial crisis defined by a real estate collapse, multifamily properties in New York City and San Francisco largely performed well. Through the recovery, the markets posted double-digit rent growth, encouraging developers to ramp up construction.
But the party appears to be over. In the 2016 fourth quarter, effective rents in both cities were down year-over-year — by 0.4% in New York and by 1.5% in San Francisco — while rents rose by 3.3% nationally over the same period, according to data firm Reis. The two coastal hubs were the only markets among 79 covered by Reis to show negative year-over-year rent growth.
"What's happened in both New York and San Francisco is that landlords just raised rents a little too aggressively with all the new construction, thinking all these millionaires would keep paying higher and higher rents," said Barbara Denham, senior economist for Reis. Though renter demand remains high, she said, "tenants pushed back, to say, 'We're not paying these outrageous rents.' Tenants are just getting smarter."
Investors in REITs that own properties in both cities are prepared for a period of low growth and even decline in rents, said Ryan Meliker, an analyst at Canaccord Genuity. Yet the question is how long the lull will continue: If rents do not begin to recover by late 2018 or 2019, Meliker said, buy-side investors may get antsy and question their apartment holdings.
On top of softening rents, high-end properties under construction in San Francisco have to comply with new affordable housing requirements. In November 2016, local voters approved a measure that requires developers of properties with more than 25 units to pay a fee equal to the cost making one-third of the units affordable to households earning 55% of the area median income, or fulfill alternative options.
"It gets really hard to pencil, and that's going to dry up a number of the proposed plans that are in the pipeline right now," said Ed Ely, head of commercial term lending for JPMorgan Chase & Co.'s west region.
Among lenders, Bank of America Corp. has issued the most construction debt for multifamily properties in both New York City and San Francisco over the 12 months ended September 30, 2016, though the amount of debt is tiny relative to the bank's total balance sheet. Bank of the Ozarks Inc. might have more reason to worry as the Number 2 construction lender in New York City. With a smaller balance sheet, the bank has construction debt across the U.S. equal to nearly 200% of capital. Regulators warned in late 2015 that they will pay "special attention" to banks with construction debt greater than 100% of capital.
However, George Gleason II, chairman and CEO of Bank of the Ozarks, is not overly worried about his construction portfolio in New York City — or anywhere else. In an interview, Gleason said multifamily construction debt can be safe as long as the loans are conservatively underwritten. He said the bank's average construction loan to appraised value is 45.8%.
"We do business on really good projects for really strong sponsors at insanely low leverage. … We're allowing for such extreme levels of market deterioration that our projects work under just about any plausible scenario," Gleason said.
Reasons for hope, concern
Strong fundamental demographics potentially justify the large slug of oncoming supply. A decline in homeownership after the last decade's financial crisis pushed more Americans toward renting, and the trend has been particularly clear in the two cities, where sky-high costs put the homeownership rate at half the national average. Further, the markets continue to post strong job growth and boast some of the highest incomes in the nation.
In San Francisco, "there is still a huge difference between supply and demand," Ely said. "We need more supply, and it's not coming online at a fast enough pace."
Still, the markets may have exhausted the number of high-earners willing to pay $3,000 or more per month for a one-bedroom. Landlords in recent years have been able to supplement demand from well-heeled foreigners, but a strong dollar has shrunk that pool of renters, said Gary Otten, managing director and head of real estate debt strategies for MetLife Inc.
Some Manhattan landlords have even taken steps — rare in the borough — to cut rents by offering tenants free months. In the company's earnings call, Equity Residential COO David Santee cited reports of "crazy stuff" like landlords offering three or four free months on a 12-month lease.
"There's always an irrational person out in the marketplace that sets the price point," UDR President and CEO Tom Toomey called in a September 2016 conference appearance, "and we all have to wait them out until they get absorbed."