By Roland Murphy for AZBEX
After spending a couple of years at the top of the charts for rent growth and asset appreciation, the Phoenix multifamily market’s rapid ascent appears to have built in a degree of buffer versus other markets in the ongoing normalization impacting commercial real estate in general and apartments in particular.
Data from Yardi Matrix shows rents across multifamily property classes went from $1,095 in Sept. 2018 to $1,667 at the beginning of Sept. 2023. A 52% increase in rents provides a great deal of inflationary cushion both to correct and to absorb corrections in the current market stall.
Boom markets can prove unusually troublesome. There is a tendency in investment circles, particularly among publicly traded firms, toward shortsightedness. Excessive optimism and a sense that the current cycle represents “a new normal” catches up even the most experienced analysts in the rising tide, and the rare voice that advises caution or dares to comment on the state of the emperor’s wardrobe often finds itself looking for a new job.
For those of us who have been around the block a few times, it’s easy to remember the time leading up to The Great Recession—now often rebranded as The Great Financial Crisis or GFC—when all the signs of a collapse were in place, but warnings were dismissed as Chicken Little fears that the sky is falling. Even as mortgage defaults started swinging upward, we were admonished to hold onto the statement, “Real estate always appreciates,” as though it were the 11th entry on Moses’ list.
Coming into the current slate of economic troubles, there were plenty of voices saying the incredible surge in rent growth was an unsustainable aberration. While that was inherently understood, it was not universally accepted, and many investors stayed too long at the party because they fell into the classic fear trap of not wanting to bow out too early.
Now, the music has stopped and the hangover has apparently settled in. The September 2023 Apartment List National Rent Report shows both annual and monthly rents have turned negative, according to a recent GlobeSt article. This is the first time the market has had a swing into negative territory since the beginning of the pandemic. As recently as early 2022, all 100 cities in the survey were showing year-over-year increases.
Adding insult to injury, prices generally go down in fall and winter. The drop came a month earlier than usual. At the end of August, annual rent growth was -1.2%. Most of the shakeup lies in the lack of balance between vacancies and potential renters, which has two main causes—one obvious, and one less frequently talked about in development circles.
GlobeSt reported the vacancy index has increased for 22 consecutive months and currently stands at 6.4, which is higher than the pre-pandemic average. Vacancies are expected to stay high for the immediate future. The obvious contributor is the surge in multifamily construction and deliveries. After decades of underbuilding, the development community took off like a rocket trying to capitalize on those rents that were soaring 18% nationally and hitting 40% in the boom towns like Phoenix. There are now more apartments under construction across the country than at any point since 1970, GlobeSt says, and landlords are competing for renters.
The thing is, those soaring prices pushed many prospective renters out of the market. Lease renewals went up, since the increase in renewal was usually less than leasing a new apartment, even a smaller one. More people took in roommates. Fewer people started to strike out on their own.
And it makes perfect sense. In 2021, the average person in Arizona made $55,159, according to the U.S. Census Bureau, and the average rent was around $1,250. We hear a great deal in the current economic climate about wage inflation, but that same individual is now making $58,620, while the average rent is nearing $1,700. That person is bringing home $288 more every month than they did two years ago while paying $500 more in rent. Now factor in inflation across all other aspects of life—food prices, gas, basic services, etc.—and those wages haven’t inflated nearly enough to offset cost of living.
Tunnel-visioned analysts can peer at increased deliveries all they want, but if those new units are still coming on the market at $1,650, they may as well have never been built at all. In the simplest of economic terms, if the pool of renters contracts, vacancy is going to increase even if the pool of units stays constant. It is, frankly, surprising the vacancy index isn’t worse.
Analysts have been using words like “plummet” so frequently this year that it has nearly lost its meaning. Rents fell in 53 of the 100 cities surveyed in the report. Rents in Phoenix have fallen 5% in the last year. While keeping in mind that averages and medians are different comparisons, also keep in mind that median rents in metro Phoenix went up 45.6% between Sept. 2021 and Sept. 2022. Dropping moderately after accelerating rapidly is not the same as “plummeting.”
Apartment Transactions Have Tanked
What has plummeted is the pace and scale of apartment sales. Just as the good news a couple of years ago fueled overreaction to Buy! Buy! Buy! every possible unit and raise the rents, the current downward trend has caused a staggering overreaction to avoid purchases.
In its Q2 2023 Phoenix market report, ABI Multifamily shows transaction volumes and values have, without hyperbole, plummeted. Total sales volume for communities larger than 100 units fell 85.4% from Q2 2022 to Q2 2023, going from $5.13B down to $747M.
The price/unit dropped 7.2%, and the price/SF dropped 14.3%. That price/unit, however, is still more than $331K, a number that would have been unimaginable just three years ago, considering the average year built for these apartments is 1998. Chalk it up to that boom town buffer.
The numbers for communities in the 10-99 unit size range are similar. Total sales volume dropped 81.2% falling from $569M in Q2 2022 to $107M in Q2 2023. The price/unit went up 1.8%, rising from $253,683 to $258,169. That could be, at least in part, a reflection of the change in the average age of the assets. In 2022, the average year built is 1972. In 2023, it was 1986.
Owner Costs Outpace Rents
Circumstances are shown to be even more grim in a separate GlobeSt article that reports owner expenses have started to outpace rents, according to data from Marcus & Millichap. Rents rose at twice the pace of expenses between June 2021 and June 2022, but inflationary pressures caused that trend to invert between June 2022 and June 2023.
Turnover, marketing and insurance costs all rose more than 10% year-over-year. Administrative, tax, management and payroll costs were up more than 7%. Insurance costs are up as much as 28% in some markets, with the national average sitting at 13.6%.
Where Are We Going?
There’s an old saying that in a turbulent market costs go up like a rocket and fall like a feather. Multifamily is in the hangover stage after an epic bender. The only cures for a hangover are time, water, food and acceptance that you hit it too hard in pursuit of a good time. In other words, a return to fundamentals.
We will get there, but not without going through the entire process. There’s no shortcut to normal.