To state the obvious, it has been an extremely challenging twelve-month period for the residential REIT sector of the market. Are things looking up?
Spotlight on Coastal Apartment Operators Going Into Second Half 2023
Coastal apartment REIT leadership is feeling “cautiously confident” as the summer leasing season progresses, and we transition into the second half of 2023.
Coastal apartment REIT leadership is feeling “cautiously confident” as the summer leasing season progresses, and we transition into the second half of 2023. Key indicators of demand are healthy and, in most cases, either meeting or modestly beating expectations according to Equity Residential (EQR) CEO, Mark J. Parrell. The big worry on the part of apartment operators going into 2023 was that unemployment would rise and wages would deteriorate as central bankers put the brakes on monetary policy. Thus far, the employment market has proven to be highly resilient, and this has buoyed consumer confidence. The consensus view from a recent industry conference (NAREIT’s REITWeek) was that rent growth and seasonal demand drivers have now normalized in a post-pandemic world, which bodes well for forecasting and predictability.
A recent report by Yardi Matrix, a national provider of multifamily data and market research, concluded that multifamily rents continued to increase through the first half of 2023, and they anticipate that rents will continue to increase modestly over the course of the year as demand has firmed, though at a rate in line with historical growth levels. They are forecasting full-year rent growth at the national level to be roughly 2.5%. Among major metros, Central New Jersey is expected to lead the nation with rent growth at 3.7%. [i]
Demand and rents for the year are expected to peak around the first week of August and all signs are pointing to a successful close to the season. Foot traffic (which includes walk-ins and on-line inquiries) is up 3% for EQR thus far in 2Q23 and rents are up 6%, modestly above the company’s initial guidance. Rent renewal notices to existing residents stipulate rent increases of 7.25-8% and lease signings are coming modestly below this level at approximately 6.0%. With portfolio occupancy of 96% and new residents disclosing rent-to-income levels of approximately 19-20%, the company is confident in its stance on pricing.
Fellow blue-chip apartment REIT AvalonBay Communities (AVB) reported that April/May rental revenue increased 6.5%, roughly 80 basis points above expectations put forth earlier in the year. Their stabilized portfolio is 96% occupied and renewal notices for later in the summer were going out in the low 7% range, while bad debt is on the decline. AVB is also experiencing lower new unit deliveries in their markets with an early June presentation highlighting deliveries as a percent of existing inventory in their markets is 1.6% compared to 3.6% in sunbelt regions and an overall national rate of 2.7%. [ii]
Operating fundamentals for coastal apartment landlords are expected to outshine sunbelt markets in 2023 primarily due to the larger volumes of new construction that are coming on stream in many sunbelt metros. These deliveries are expected to peak in late 2023 or early 2024 before moderating to a more manageable level. A key governor on new development can be at least partly attributed to the disruptions at several regional banks earlier in the year which caused an outflow of deposits and some forced sales. This resulted in most smaller lenders curtailing risk, including the financing of new construction.
Research from Equity Residential confirms that new development starts are being impacted by elevated construction costs, high financing costs and a lack of debt capital, especially from regional banks which have traditionally been material lenders to apartment developers. [iii]
Based on recent feedback, we glean that east coast markets are outperforming west coast markets, and within these two regions, suburbs are performing better than urban cores. The New York region is receiving accolades for being one of the strongest major metro areas in the country right now with rents that are roughly 20% above pre-pandemic levels. Urban Washington D.C. is one of the weaker east coast markets due to a heavy load of deliveries which are pressuring rents. Of the major west coast markets, Seattle is said to be the weakest right now due to new supply and a lack of any material in-migration to the central business district (CBD). San Fransisco is starting to see improvements in apartment fundamentals yet is still lagging other major metros. Concessions on rents have come down from their peak but remain elevated. The South Bay market is also achieving better performance than the city center. The Los Angeles region is the best performing of the major west coast markets with solid demand and pricing power to raise rents. The bad debt expense challenges resulting from pandemic-era policies are now abating and while bad bet expense remains elevated at EQR, it is expected to normalize around the end of 2024. [iv]
Inflationary pressures on operating expenses began to weigh on the industry in the latter part of 2022 and while some of these pressures have begun to moderate, there remains challenges from several larger line items, with one of them being property/casualty insurance. The rise in frequency and severity of natural disasters has caused pressure to mount across industry and few if any regions are immune from the impact of water, fire, temperature, wind and earthquake events. With some coastal landlords reporting increases in annual insurance premiums of upwards of 50-100%, even very large and diversified public companies are seeing premiums go up by 20-30%. We are told that there is a cyclicality to the insurance ecosystem which should alleviate some of the pressures in coming years, but overall, insurability will be a topic of discussion for years to come and will likely have an ever-larger impact on capital allocation decisions at the REITs. [v]
AvalonBay is projecting operating expenses on their “same-store” pool of assets will rise by 6.5% in 2023, driven by large bumps to utilities (20.3%), insurance (16.1%) and property taxes (5.9%). The 6.5% expected increase in operating expenses does include approximately 1.7% in “initiative” expenses for programs including Avalon Connect for broadband and a furnished housing launch. The number is also skewed higher by the projected phase-out of property tax abatement programs. Equity Residential typically leads the pack when it comes to expense management, and they are out front for 2023 as well having provided initial guidance of 4.5% (midpoint) “same-store” growth for this line item and the company has recently reaffirmed this guidance.
With apartment company earnings scheduled to start being reported in late July through early August, the next round of incremental data from the industry will cover the bulk of the summer leasing season and companies will be well positioned to provide insights that should carry forward through the end of the year. Outside of the apartment industry, we will keep a close eye on the office REIT sector for signs that utilization rates could gain traction towards the end of the summer as any shift in sentiment in favor of employees returning to the office on a more consistent basis will bode well for coastal apartment landlords and the major cities which they call home.
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[i] YardiMatrix: U.S. Outlook 2023 – Market Analysis Summer 2023; Jeff Adler, Vice President & General Manager
[ii] AvalonBay Communities: June 2023 NAREIT Presentation
[iii] Equity Residential: Investor Presentation – May 2023
[iv] Equity Residential: June 2023 NAREIT Presentation
[v] Camden Property Trust: Management Meeting – June 2023 NAREIT Conference