Thursday, December 29, 2011

Apartment Building Bubble

If your city is like mine, you see lots of cranes on the horizon building apartment buildings.

Five years ago, those same lots were destined for condo towers.  But today those very same buildings with very little interior modification are being put up as apartment towers.

Do you see the problem?

The same out-of-whack forces that drove condo prices into the ground are destined to do the same for apartment building owners.  Simply put, there are too many apartments being added to a supply of apartments that is already too large.

I know there's a bubble in apartment building valuations when I read that large NON-RESIDENTIAL developers are started to get the apartment itch.  In Seattle the bubble is obvious even to the lamestream media which usually can't find an pink neon elephant in a conference room.  When developers are chasing yields you know the bubble is in its last days.

I recently wrote about a sweet apartment building deal in Seattle where investors probably made 100%+ on their money in about a year flipping a building.  Returns like that are not possible outside of bubbles.

Apartment REIT valuations are high---and headed higher.  The industry currently reflects a P/E of 21, way too high for a real estate sector facing major headwinds.  That said, most of the individual REIT charts look less than stellar.  Here is EQR as an example.

What is the logic of apartment building ownership?  Simple.  People can no longer afford to buy homes or are unwilling to do so in previous numbers.  Since people have to live somewhere, the choice is either rent or buy.

Sounds good, right?  WRONG.

The first problem is that the number of households in the United States is shrinking.  The growth rate has been NEGATIVE for FORTY YEARS.

These figures are from the official U.S. Census Bureau Population Profile of the United States.

In the 1970s, on average 1.7 million new households were created each year.
In the 1980s, the number fell to 1.3 million per year.
In the 1990s, down to 940,000 per year.
In the 2000s, down again to a mere 716,000.

Remember the issue is not population growth but the number of people living together in households.

In downtown Seattle where I live, for example, it is common to see three or four people living in one apartment due to the high cost of rent in the city.  What does this mean?  Demand for SOLO apartment living is not as high as could be estimated.  Unless there are two, three, or four roommates/workers/employees available to fill each of those new and existing apartments you have a vacancy problem.

Guess what?  There aren't.  The city of Seattle itself says that just two of every five households in the city is made up of one person.  A full 15% of the city's households are made up of people who live together but are not related by marriage or family.  In other words, roommates.

So 60% of the new apartments you see being built better have more than one person supporting the lease or the rent is likely not to be paid.  NOT the way it is supposed to work for rental property investors.

I fully expect the apartment building bubble to grow and finally burst when either too much supply comes online (in late summer or fall 2012), when the economy dips again (in early 2013 after the U.S. Presidential election).

Of course, with historically low interest rates the moment condos are in demand those apartment buildings will begin languishing on the market.  Remember 2004 and 2005 and all those FREE RENT incentives?  The slightest loosening of underwriting standards will pop the apartment building bubble.

In the meantime, sell those buildings if you own them.