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Brisk Building Pace May Dent Apartment Market Momentum

Multifamily housing analysts remain upbeat about growth prospects for the U.S. apartment market, despite signs that demand will moderate in coming months amid a rapid rise in inventory.

For now, demand for apartments is still strong four years into the sector's recovery, especially in large urban markets such as New York, Southern California and the San Francisco Bay Area.

The industry continues to benefit from an improving economy and job market, as well as newly completed Class A properties with higher-than-average rents.

The question is how long the apartment market can sustain its momentum, especially in light of a growing supply of units.

While nobody sees a big dip in apartment demand soon, some experts see signs of weakening.

"The substantial increase in construction activity dampens the outlook somewhat for 2014," said Victor Calanog, vice president of research & economics at Reis (REIS), a real estate research firm.

Calanog made the comments in a quarterly briefing last week. He noted that more than 160,000 apartment units are expected to be completed this year. That's one-third higher than the long-term historical average for yearly completions.

This year's projected growth comes on top of rapid expansion in 2013, when around 127,000 units were delivered, Calanog says. That was the highest annual total since 2009; 41,651 units came online during the fourth quarter alone — the highest quarterly total in a decade.

Building Boom Effects

While demand for apartments "will not implode" this year, it will "struggle to keep pace with escalating completions," Calanog said.

Jed Kolko, chief economist at Trulia (TRLA), says that overall rental apartment construction in 2013 reached its highest level in 15 years. He cites Census Bureau data that track construction starts rather than completions.

"Since the typical multiunit building is under construction for a bit more than a year, the jump in rental starts in 2013 means lots of new rentals coming onto the market in 2014," he wrote in an email.

The rise in inventory will likely affect apartment vacancy rates, experts say. Calanog anticipates that national vacancy rates this year will rise for the first time since 2009, when the multifamily housing market began its recovery.

"It will be a slight increase, of roughly just 10 basis points, but an increase nonetheless," he said.

In 2013, the national vacancy rate was 4.1%, according to data from Reis. That was down 50 basis points from a year earlier. The final rate for 2013 was 390 basis points below the cyclical peak of 8% recorded in late 2009.

Already, signs reflect apartment market conditions weakening. Calanog notes that growth in effective rents was lower in 2013 than in 2012. Effective rents — which landlords charge after concessions — grew 3.2% in 2013, he says. That was down from 3.9% growth in 2012.

"Given a vacancy rate that is over 100 basis points below the 20-year average, rent growth this weak is unprecedented," Calanog said. "In prior historical periods when vacancies dipped below 5%, rent growth was at least 100 basis points above current growth rates on an annual basis.

The National Multi Housing Council reported in January that its Market Tightness Index declined to a reading of 41 from 46 three months earlier. The index, which measures the availability of apartments, uses input from industry professionals to gauge market conditions. Readings above 50 indicate improving conditions. Fifty-six percent of respondents reported unchanged conditions for January, the most recent month data are available; 31% said conditions were looser than three months earlier.

"New supply is finally starting to arrive at levels that will more closely match overall demand," Mark Obrinsky, NMHC's chief economist and senior vice president for research, said in a statement. In a few markets completions have come in "a little higher" than absorptions.

"But this is likely to be short term in nature," he added. "Fundamentally, demand for apartment homes should be strong for the rest of the decade and beyond — provided the economy remains on track.

Apartment REITs

Rod Petrik, an analyst who covers apartment REITs for Stifel Nicolaus, has a similarly positive outlook. In a Feb. 12 note, he said apartments are outperforming expectations despite the continued deceleration of rental revenue growth and the increase in supply.

"Although revenue growth has more than likely peaked and has now decelerated for the past five quarters, any year that apartment operators can push rents more than inflation is a good year," he noted.

Among REITs Petrik follows are Essex Property Trust (ESS), which owns, develops and manages properties mainly in California and Washington; Camden Property Trust (CPT), an apartment REIT with mostly Sun Belt properties stretching from Washington, D.C., to California; UDR (UDR), another Sun Belt-focused apartment REIT; and Home Properties (HME), an apartment REIT with communities along the East Coast and in the Midwest.

Essex and Camden have been the top performers in the group, delivering consistent double-digit gains in earnings and revenue. Yet both REITs have seen top-line growth decelerate in recent quarters.

UDR has posted seven straight quarters of single-digit or no revenue growth. Home Properties saw revenue growth all but dry up the past couple of quarters after a long run of mostly double-digit gains.

Despite the slowdown in top-line growth, shares of the four REITs have risen 8% to 14% this year, above the Finance-Property REIT industry group's 6% rise through Thursday. The group ranks No. 132 of 197 that IBD tracks.

"Relatively in-line guidance and pockets of accelerating or stabilizing fundamentals could shift investors back into the apartment sector," Petrik noted.

He sees the San Francisco Bay Area and Seattle as the top markets for apartment REITs this year, with Texas markets potentially "surprising on the upside," thanks to strength of energy and biotech in the Lone Star State.

"Likewise, Los Angeles, a large market that has underperformed in this recovery, would appear to be poised to turn the corner in 2014," Petrik said. "This supports our thesis that Essex will outperform in 2014 as the only pure-play West Coast apartment REIT.

Data from Reis show several big markets had vacancy rates below 3% in the fourth quarter: New York and the California markets of San Jose, San Diego, Orange County and Oakland/East Bay. A few others had rates around 3%: Los Angeles, San Francisco and San Bernardino/Riverside in California and New York's Westchester County.

Not surprisingly, year-over-year rents in many of these markets rose above the national average of 3%.