2012 Commercial Real Estate Outlook: Apartments

The new darling in the investment community has been the apartment market. Prices began to fall, along with residential single family homes, when the crisis hit back in 2007 – 2008.  Prices for apartments began to stabilize in mid 2009 and have since been on a tear upward.

The fundamentals are sound.  Home owners losing their homes will need to move back into apartments. The younger generation, facing high unemployment, does not yet feel comfortable making a home purchase and can't afford a down payment.  The baby boomers have found apartments are an attractive alternative to home ownership that provides them maintenance free living (and an asset that does not depreciate in value). I covered this discussion in great detail in the 2012 Real Estate Outlook: Demand - Willingness.

This means that demand is strong. Currently, the only hindrance for apartment demand is the younger generation whowx has moved back in with their parents.  It has provided the market an additional form of shadow demand.

The problem with the apartment market is obviously not in terms of demand.  It is also not a problem in terms of general supply (or shadow supply) on the market as real estate has not faced the same issues that office and retail have. 

The hidden supply for the market comes from the single family residential shadow inventory.  Millions and millions of homes currently being held off the market will eventually be purchased and rented out to compete with apartments.  See the 2012 Real Estate Outlook: Supply - Shadow Inventory for the magnitude of this market. 

Based on the prices (cap rates) investors are currently paying for apartment communities (in many areas the sentiment is higher than it was at the peak in 2007) they have not factored in this coming supply.

If the rents are both $1000/month, would a family of three rather rent out a single family home or an apartment?  In a home, you have a back yard for children and no attached walls echoing noise from your surrounding neighbors.

Fannie and Freddie have both begun the early stages of a foreclosure rental program - where they will bundle thousands of single family homes together for investors who will then rent them out.

I believe the fundamentals of the apartment sector are very strong and will continue to improve in the short term as more demand comes into the market based on the reasons just discussed.  However, I believe that investors are currently overpaying for buildings based on three key and often overlooked factors:

1.     1. Shadow Housing supply coming to the market
2.     2. The Availability & Cost Of Financing
3.     3. The Future Direction Of Cap Rates

The second and third extremely important factors are what we will look at in detail now.