As Economy Picks Up, Rental Market Slowly Improves

Two forces have buffeted the rental market since 2001. First, the recession and so-called "jobless" recovery have particularly hit young and lower-income workers, a major segment of the tenant population. These low-income or unemployed workers have been forced to "double-up" with friends or family. Second, the 40-percent drop in mortgage rates since 2000 and technological advances in loan underwriting have fueled a surge in first-time homeownership for many families who have kept their jobs and maintained their credit rating. The resulting outflow from the tenant pool has led to a deterioration of rental market conditions across much of the nation since the market peak in 2000. The latest economic indicators show that the market has stabilized during the second half of 2003, and a gradual turnaround may be in store during 2004-05 with the return of a vibrant economy.

Vacancy Rise Reduced Rent Receipts

The outflow from the tenant pool has only partly been made up for through immigration, an important source of new tenants. The recession of 2001 and weak recovery reduced economic incentives to migrate and stay in the United States, and the Sept. 11 tragedy has led to tighter border security, both factors working to reduce immigration flows.

As a result, vacancy rates have risen across the nation. As measured by the Census Bureau, the vacancy rate in apartment buildings (buildings with 5 or more apartments) has risen from 8.9 percent during the fourth quarter of 2000 (the last full quarter of economic expansion before the recession) to 11.5 percent during the third quarter of this year. There are about 14 million rental apartments in multifamily buildings, which means that approximately 400,000 additional apartments remain vacant because of the rise in the vacancy rate. Even in professionally-managed and "A"-quality apartment buildings, the vacancy rate has risen from just above 3 percent at the end of 2000 to almost 7 percent in the third quarter of 2003.

Increased vacancies have resulted in a sharp slowdown in rent growth, as shown in Exhibit 1. According to the rent measure in the Consumer Price Index (CPI), rent growth slowed dramatically from 4.7 percent (year ending fourth quarter 2001) to 2.9 percent (year ending third quarter 2003). The doubling in vacancy rates in better quality buildings has led to an even sharper downturn in rent growth. The professionally-managed properties tracked by M/PF Research or surveyed by Reis, Inc., two national real estate research firms, have seen a drop in rent growth from about 9 percent at the market peak to slight declines over the past year. Property managers have used rent concessions to attract tenants to their buildings.

Exhibit: 1 Vacancy Rise Has Led to a Fall in Rent Growth

Rental Market Conditions Have Stabilized

Apartment developers have seen a slowdown in lease-ups for newly-constructed apartments over the past few years. During the market peak in 2000, 72 percent of new apartments were rented within three months, but by the beginning of 2003, the 3-month absorption of newly-built units had fallen to 57 percent. Some builders have adjusted by shifting more production to condominium ownership to appeal to the strong first-time buyer market. More condos were built in apartment buildings (of at least five apartments) during 2002—60,000—than had occurred since 1989. The absorption rate for new condominiums remains strong: 78 percent of apartment condos started in 2000 were sold within three months, and the pace has been nearly the same in 2003, with 75 percent of units started in the first quarter sold within that time frame.

In recent months, the rental market has turned from steady deterioration to a market that appears to have stabilized. One measure of this stability is the fact that effective rents have been largely unchanged over the past year. Confirmation that the market has indeed stabilized also appears in the National Multi Housing Council's quarterly survey of market conditions. As shown in Exhibit 2, property managers reported looser conditions throughout 2001 and 2002, but in the third quarter of 2003, the conditions were about the same as three months earlier. The acceleration in economic growth that began in the second half of 2003 will provide the means for young workers to form new households and provide a stronger magnet to attract immigrants to the United States. These inflows to the tenant pool will gradually reduce the vacancy overhang in the rental market over the next two years.

Exhibit: 2 Apartment Market Conditions Have Stabilized