On Friday, the housing market received a strong bullish jolt from the latest starts and permits data, which however showed that while traditional single-family units barely budged, there was another sharp spike higher in multi-family, i.e. rental unit construction.
And, in light of prevailing asking rent prices, this rise in multi-family supply is a welcome development: with most Americans (and certainly Millennials) unable to afford traditional housing, demand for rental housing is off the charts, pushing average asking rents to all time high with supply sure to follow, which in turn will eventually push prices back down again.
All that is Econ 101. There is just one problem: developers are putting up the wrong kinds of buildings, focusing almost entirely on the luxury segment. However, as discussed here recently, the luxury market is by now largely overbuilt, while the shortage of affordable rental housing is growing, as developers remain hamstrung by the now record-high cost of construction.
Here are the facts: in 2017, apartment completions in the 150 largest U.S. cities jumped to 395,775 units, higher than 2016 production by a staggering 46% and more than doubling the long-term average, according to RealPage. However, instead of focusing on the mid-range, luxury, upscale buildings accounted for between 75 and 80% of the new supply in the current cycle.
Why is the sub-luxury segment being ignored? Simple: the need to maintain high margins amid rising input costs:
“It’s really tough to deliver product at those lower price points. The cost of land, the cost of building materials, the cost of labor. It’s really about the same regardless of what product you’re doing and it’s just tough to make a deal work financially if you’re going toward that middle-market price,” Greg Willett, chief economist at RealPage, told CNBC.
To be sure, demand for luxury apartments remains strong, but that “is by choice, not necessity.” Tenants in luxury buildings are often renting a second or third home or perhaps downsizing from a larger suburban home. They are not struggling to afford the monthly payments. It’s everyone else that is in trouble, in this polarized world of two extremes.
The outcome? An “acute crisis” is headed our way as a result, according to the head of one of the biggest regional developers.
“In our portfolio, which represents 70,000 units mostly in the luxury space, we’re seeing that our renters are spending a relatively low amount of their income on rent despite rents being perceptively high,” said Toby Bozzuto, president and CEO of The Bozzuto Group, a multifamily management and development company operating in the Northeast and Mid-Atlantic. “That being said, it is a tale of two cities. In the middle income and the lower income markets, people are spending proportionally more on their rent — so much so I believe there’s an acute crisis headed our way.”
How much are they spending on rent?
Well, despite the so-called recovery and rising incomes (although as we showed last week, real incomes adjusted for inflation are once again falling), nearly half (47%) of all renter households (21 million) pay more than 30 percent of their income for housing, including 11 million households paying more than 50 percent of their income for housing, according to a late 2017 report from Harvard’s Joint Center for Housing Studies…
… which also found that soaring rental costs have rapidly eroded overall disposable income for the US middle class.
“While the market has responded to rental housing needs for higher-income households, there are alarming trends that suggest a growing inability to supply housing that is affordable for middle- and working-class renters, let alone those with very low incomes,” said Christopher Herbert, the center’s managing director.
Meanwhile, as the sub-luxury segment is facing an imminent crisis, the luxury segment is about to crack as rents on the high end flattened in the last year, and landlords are starting to offer concessions, like high-end amenity packages or a month’s free rent.
“We’re getting a pretty competitive leasing environment in select locations at those really high-end price points, and we’ve already gotten to flat to slightly declining rents,” said Willett.
To be sure, none of this is happening outside the luxury market, where rent increases are still strong due to low supply. Developers say they simply can’t afford to add anything but luxury.
“The two-by-four doesn’t care whether it’s in a luxury building or in an affordable building. It costs the same,” said Bozzuto. “The differential of course, is the rent and there’s a huge disparity in high-end rent versus low-end rent. So the issue is for us to develop an economically viable, feasible project, it has to be, by its very nature, high end. The rents have to be high to support the cost.”
And for those who have troubling finding input cost inflation, here is where it’s hiding: the cost of that two-by-four, lumber, is now at a record high. Other products like steel and concrete are more expensive, but the real cost spikes are in land and labor. Skilled construction labor is not only expensive, it is extremely difficult to find.
The biggest problem, for developers, is passing on these soaring input costs to renters, something which is virtually impossible when nearly half have zero incremental capacity to absorb even higher rents.
That’s why developers are battening the hatches in anticipation of an inevitable pricing crisis that will sweep the entire rental industry.
“Those are finite and many, many of us are competing for those very finite resources,” said Bozzuto, adding that the luxury market is, “on the precipice of oversupply, but I think macroeconomic conditions are actually going to keep us this year from developing much further. Costs in particular, land costs, hard costs mostly driven by labor, will ultimately make it harder to build new buildings.”
Investors, according to Bozzuto, are now moving away from new construction and instead rehabbing older rental stock. These so-called value-add projects just raise the rents on current tenants even more.
Meanwhile, the Fed is unable to find inflation anywhere it looks or, as Janet Yellen recently said, it “remains a mystery.”