Is the demand for apartments beginning to fall again?

"Where are our tenants going? This much we know it's not to another complex." So said the owner of a local, well-maintained, suburban garden style apartment property. Evidence is accumulating that marginal apartment demand is falling again in the Reno market. A glance at the dispersion of apartment vacancy rates tells an interesting story. At the best-run, well located properties, occupancy is at or slightly below 95 percent. Smaller properties quickly adjust rental rates and concessions to eliminate vacancy and run full most of the year. But a large fraction of the apartment market is now facing chronic vacancy exceeding the threshold of unstabilized occupancy 15-20 percent.

Tenants who lose employment or unemployment benefits cannot qualify or afford to live independently and will move in with relatives, take additional education or leave the region seeking work. But employed tenants, especially younger workers, are opting for an abundant and reasonably priced housing choice that may be available for years the single-family rental. They may well become a generation who will never have lived in an apartment.

The Reno apartment market is a commodity market, unconstrained by limits to supply forced by geography, politics or housing prices. Historically, rents have risen in tandem with population growth, cyclical swings in supply are temporary and developers are especially cautious of building into a downturn. Locally, the supply of new units, once absorbed, will leave no new construction in the pipeline beyond infill projects with negligible impact on aggregate supply. Good news for existing owners? Perhaps, when brisk employment and population growth return, because the pricing advantage of their debt structure, operating costs and acquisition basis will be substantial. But several secular trends threaten that picture.

Growth in apartment demand has largely been driven by household formation rates, but younger tenants are deferring that commitment in favor of communal housing until they can own. In addition, a generation of construction workers and even service workers have owned a single-family residence, expect to own when employment returns and prefer to rent that product if the price is right. And the price is right. Currently, single-family rentals make up about 25 percent of the total available housing locally. This is the only housing segment that's growing, and that growth exceeds 10 percent annually. Moreover, the rental house with two or three bedrooms lodging unrelated adults replaces one to three apartment units.

The buyer's market in single-family homes is likely to continue for years. The Urban Land Institute estimates that the national fraction of owner-occupied dwellings will decline by 10 percent or about 14 million homes. In addition to the slow-motion cascade of regional housing in default, foreclosure, and homes transferred to a lender (more than 4,300 in Washoe County for the 12 months trailing May, 2010), recent polling finds that a large fraction of owners not in default would sell at once if the market price of their home rose 15 percent. Wyatt and Experian put the ratio of strategic defaults at 20 percent (borrower has no equity, could pay but won't and is keeping all other credit obligation current). The same study estimates that the rate of strategic default will increase by 2 percent for every six-month interval until negative equity is eliminated. Finally, the boomers who resisted home equity debt during the housing boom still plan to fund retirement by liquidating their equity and such home sellers may not have the leisure to wait out the downturn. Both the owner and the tenant of a single-family home now see it's substantially cheaper to rent than own and may remain so for years. Altogether, these factors amount to a powerful drag on apartment demand.

A baseline of rental demand that will grow steadily is the senior and disabled market, but the tenants will be older, poorer, less mobile and more resistant to rent increases. The future apartment tenant is likely to be more transient, more dependent and less upwardly mobile than ever before. The single biggest complaint rental managers express today is the scarcity of qualified tenants, even with materially relaxed qualification standards.

The preconditions for the return of normal apartment demand are employment, population growth and conversion of single-family rentals into owner-occupied housing. At present, cash buyers for distressed homes are accepting low yields in anticipation of large appreciation when the property is sold into the next rising for-sale market. By contrast, the investors in apartment property have discounted all appreciation in their acquisition models because financing rates are expected to rise over their anticipated holding horizon, which is normally seven-10 years.

As the private sector works through an agonizing cycle of deleveraging, owners and investors are carefully watching the public sector take on more and more debt for income supports, incentives to home ownership, preservation of affordable housing and public agency mortgage finance. Public debt is largely held by creditors unwilling to risk that capital in private market investment on which private sector employment largely relies another trend powerfully bearish for apartment demand.

In the recession of 1990-1991 and continuing through 1995, the Reno labor force grew modestly and unemployment ranged from 5-7 percent. State and local debt levels were low and in some cases in surplus. Thirty-two commercial apartment properties (eight-plus units) changed hands at an inflation-adjusted price of $80 a square foot and a median cap rate of 8. Then the boom years began.

Today, unemployment in our region now exceeds 13 percent (without regard to discouraged workers, part-time employees seeking full-time employment or the involuntary entrepreneur). The labor force is not growing. The state budget shortfall may reach $3 billion in the next legislative session. Apartment operators are struggling as never before, in competition with a shadow market of rental dwellings whose growth is rapid, steady and a very attractive housing choice for the most qualified tenant.

Morgan Walsh is a multi-family specialist with NAI Alliance. Contact him at 336-4646 or mwalsh@naialliance.com.