February 28, 2024

JF3464: Rents Are Cooling, but Not Everywhere: How Class A ‘Luxury’ Supply Is Putting Pressure on Class C Rents ft. Jay Parsons




Welcome to the Best Ever midweek news brief, a new series where we will highlight the top headlines CRE investors should be paying attention to this week, followed by a deep dive on a larger news topic or trend alongside a CRE expert.

Today’s Headlines:

    • Self-Storage Boom Set to Peak: A recent report from Yardi Matrix predicts a surge in supply for 2024 and 25, followed by a decline in later years, signaling a major shift in what’s become an attractive asset class for investors.

    • ‘Cause for Optimism’ in NNN?: Triple-net-lease average closing cap rates declined in January while inventory dropped for a second consecutive month, to signs that Chris Lomuto of Northmarq says could be “cause for optimism.”

  • Rents Are Cooling … Sort of: New “luxury” Class A supply is putting downward pressure on rents at all price points. It’s a phenomenon called “filtering,” and there are 12 U.S. markets where Class C rents are falling at least 6% year-over-year. All 12 of those markets have supply expansion rates ABOVE the U.S. average.

Today’s Guest: Joining host Paul Mueller on the Best Ever Show today is Jay Parsons. Jay is Head of Economics and Industry Principals at RealPage. As a rental housing economist, Jay is one of the leading voices in multifamily real estate. He’s an author, speaker, and an expert in market trends and forecasts, rental housing policy issues, property management, and more. If you want to read more from Jay on this story, he’s posted on Twitter and LinkedIn about it recently. You can also follow him on LinkedIn and on Twitter @JayParsons.

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Paul (00:02.306)
How you doing today, Jay?

Jay Parsons (00:04.109)
I'm doing well. Thanks for having me.

Paul (00:06.034)
Of course. Thanks for taking the time to join us today on the Best Ever Show. Jay, we're here today to talk about some data that you've come across recently, and I'd love for you to dive right into it and tell us what it is that you're seeing and how this is impacting affordability right now.

Jay Parsons (00:24.932)
Yeah. So I think the biggest surprise that I've seen over the last year in the apartment market is the impact of all this supply and going into this last year, you know, my view was that because all this new, you know, quote, unquote luxury supply was higher rent, that it really would insulate these more moderately priced B and C assets. But it's, uh, what instead we're seeing is what academics call the filtering process that's happening much faster than I anticipate. Typically these things take a number of years.

We're seeing it much faster. What that means is that as these new properties are being built, they're offering rent concessions and rent cuts and whatnot, and they're luring higher income renters out of the more moderately priced, older Class B properties who can afford these, but now they're able, there's more supply out there, they can afford that. That opens up availability at the moderate Class B standpoint. That then, they have more vacancy, they're cutting rents. That pulls in Class C renters and on down the line it goes.

And so we've seen vacancy increase across the board. In turn, operators are cutting rents. But it's important to note that this is only happening in these very high supplied areas. It's not happening where supply isn't going, which is why we know this is really all about supply and not about any other issues that sometimes come up.

Paul (01:40.534)
What are some of those markets, Jay, where you're seeing this the most?

Jay Parsons (01:44.528)
Well, I'll tell you, it's a lot of the sunbell. So we're seeing this especially in places like Austin and Phoenix, we're seeing it now in Florida. But it's also happening in pockets of even the West Coast that are lower supplied. We're seeing it in certain parts of Los Angeles and even Seattle. So typically more higher high barrier entry markets, lower supply in the big picture, but you still see it in kind of micro basis where the supply is actually going. And so, it's really happening in quite a large number of markets at this point.

Paul (02:18.446)
So what impact is this having on general affordability?

Jay Parsons (02:24.912)
Yeah, it's interesting is we're tracking the rent income ratios of renters coming in, and it's actually been stable, and we're seeing actually rent to income ratios come down a little bit. So what's happening is that when these renters are moving up, they're moving up to something they can afford. And so it doesn't really change the affordability story in terms of what renters pay. What really changes though is that as Class C starts to cut rents as a response to all this happening that widens the demand funnel for who can qualify to live in an apartment.

And as I'm sure you know, and all the viewers know is, whether you're a mom and pop operator or an institution, everyone's using some version of screening to make sure people can afford the rent that they're actually leasing for, which I think that nuance sometimes gets missed in the headlines. And so it's not so much, and so again, I think the biggest story here is the widening of demand funnel as a result of falling rents and still rising incomes. In fact, incomes have grown faster than rents 13 months and I think they'll continue to do that this year, which is a great thing both for renters and for apartment investors.

Paul (03:29.258)
And Jay, when you say the widening of the demand funnel, explain what you mean by that and explain what the direct impact is.

Jay Parsons (03:35.268)
Yeah, okay, so anytime you have wages growing faster than rents, that means that now there's more people who qualify to rent that apartment or that single family home. And so when we talk about widening the demand funnel, it's just that the potential demand in any given market has widened as a result of more people who are qualified to rent, whether the criteria is less than 30% of income or whatever it is, incomes growing faster than rents allows a large number of people to qualify to rent, especially at that lower price point.

Paul (04:05.602)
Right, and When you look at the pipeline right now for these class A luxury apartments, especially in the markets that you specified, what does that look like? And are you concerned, might not be the right word, but are you concerned about these, when these pipelines dry up, what's gonna happen to these rents? And are they just gonna level out and how that's gonna impact affordability? Or is it just gonna sort of re-stabilize to where we've been over the last couple of years?

Jay Parsons (04:28.952)
Yeah, well, I mean, history tells us that supply is always cyclical. And so right now we're seeing this massive surge in supply. Starts have dropped off about 40% and they'll probably drop off further. Now, supply is not completely going away. There's still going to be some supply, but it is going to be much more limited. And so I think as we go forward, you know, this will peak this year, first half of next year in terms of actual completions, deliveries. But now with fewer starts than completions, by the time we get to second half of 25 and 26, there will be substantially less supply.

And so our view is that, again, there'll still be some supply, but they're also, assuming the economy is still in good shape, we should start to see a little bit of a return to balance here. We think the demand tail end is still quite strong, so that should lead to kind of aversion to average or slightly above average rent growth, maybe mid single digits in most markets. But certainly nothing like the inflationary period we went to just a few years ago. I think that er you know, year or two ago, that's really, I think, more of a once in a generation event akin to what happened in the 1970s.

Paul (05:35.65)
And for those of us who might not know what happened in the 1970s and how does that mirror what's happening today or not?

Jay Parsons (05:43.268)
Yeah, so the 1970s is really, especially the mid to late 70s and going into the early 80s, that was really the peak inflation period where we saw very rapid rise in consumer prices for all things, including rents and home prices and all the other things. And we went through a period of 40 years of very low inflation and very predictable, modest inflation even rents had been growing at, you know, there'd been up and downs, but it'd been pretty consistently in the, the load amidst single digit range and recessions, it would go slightly negative.

And so it had been a fairly tight band. And so then we got to, you know, we really saw that until the COVID era and getting into especially 21 and early 22, where we saw that real spike in both home prices and in rents and a lot of other costs. And so there's a little bit of lag effect. I think we talked about this before and how the CPI tracks rents, but the bottom line is we know peak rent inflation is in the rear view mirror. But again, the only other period that's similar in recent history is that 1970s period.

Paul (06:53.962)
And Jay, when you look at the data right now, what are you looking at most closely as we move forward? Obviously this puts a little bit of context behind what we're seeing today in terms of these oversupplied markets, or at least the markets where their supply is really high. What are you looking for as we move forward? What's the most important indicator for you?

Jay Parsons (07:12.9)
Yeah, that's a good question. So I think it's important to remember, you know, demand, we look at everything's about supply and demand, right? And supply is the easiest thing to forecast. We just look at what's starting. We know it's going to take one to two years to finish, depending on what it is and where it's going. So that's easy, right? We know what's happening there. We know it's going to peak early this year, early next year and then drop off from there. So demand is really what we're watching. We want to see how much demand is there for these apartments. And so we think there'll be pretty good demand. But some of the early indicators I'm looking for, obviously, the job numbers are always important.

But one that's really underrated is consumer confidence. Like, you know, there's been a real correlation between housing demand and consumer confidence, how people feel about the state of the world and their position in it. And that's for those who watch these numbers, that those numbers have been improving dramatically this year, and that's been corresponding to really good apartment demand numbers as well. Now, the demand isn't keeping up pace with supply, but those numbers are still quite good and they're kind of above historical norms. And so...

That's what I'm gonna continue to watch. If we see a snag in the economy, or the job market, or unemployment spikes, all of those things will then cause, obviously, reduced consumer confidence. And so we wanna see a win-win scenario where people continue to get jobs, we wanna see wages continue to grow, and we wanna see consumers starting to feel better and better about the world. And I think that's gonna be really, really important to watch, and hopefully it stays there.

Paul (08:38.178)
Yeah, I think with all the talk in December about the interest rate cuts that we were going to see in 2024 and then that not happening right away and a little bit of uncertainty around that. And then also just this past couple of weeks, we saw an uptick in inflation that I don't think people were expecting. So I think those things are injecting a little bit more anxiety into the climate that I don't think people expected to feel as early as February this year.

Jay Parsons (09:06.34)
Yeah, no, I mean, there's always going to be something to worry about. And I see a lot of skeptics about even the job numbers. Hey, these numbers aren't right. And frankly, too, I think it's also important to know there's always there's always pockets of challenge, right? There's always, you know, even if unemployment is at the lowest levels of record, there's still people who are unemployed out there. And everybody probably knows somebody who's unemployed out there. So that stuff is real. You want to downplay that and you want to help those who are legitimately need. So there's always going to be a challenge.

But I do think by and large, there's been some good articles on this recently. It's like the economy has been in better shape than most people recognize overall. And I think the more people recognize that, that the world is, that at least the U.S. economy is in stronger shape than is kind of widely perceived, that could be another, that does suggest some upside for housing demand as well. Because ultimately, I think people are more likely to go buy a house or sign a lease if they feel more optimistic about the state of the economy.

Paul (10:07.806)
Yeah, Jay, I want to circle back and talk about affordability a little bit, because obviously with the vacancy rates increasing in the class B and the class C communities and those rents coming down a little bit, making it a little bit more affordable. That's obviously a short term thing, right? How big of an impact can this filtering trend have on overall affordability, if at all?

Jay Parsons (10:33.456)
Oh, I think it has a massive impact, but again, it's limited to where it's actually going. So you look at what's happened already is rent growth was in the 10 to 20% range in a lot of markets at its peak. And now we're seeing these ultra hot markets like Phoenix and Austin, smaller places like Boise where they've gone negative and rents fell last year, they're going to fall this year. Now, people will point out, it's like, hey, they're not back to where they were or they're not lower than before.

And that's true, right? But what we want to see is normalization, these numbers. If, you know, for people to, for us to have everyone to be able to afford to have a place to live, to rent or buy, you'd have to have home prices and rents drop off like 50%. And that's going to cause a lot of other issues and no one's going to be building supply anymore. So that's not necessarily, which you don't want to see a, you don't want to see that big of a that big of a correction would suggest if rents fell that much, that's probably an issue of some broader challenge to the economy and unemployment is probably going up and whatnot. So let me get back though to your point though. I think the issue is that there's not, it's all about supply, but also I think we need a diversity of supply. Like it is true that luxury housing ultimately has this filtering effect that benefits lower and moderate income renters. That's not just me saying this. This has been well studied by housing researchers out there.

But also at the same time, I'm a big believer in the need for income restricted low income housing, and also middle income attainable housing. And so programs like the low income housing tax credit are absolutely paramount. We're also seeing, I think cities get more creative in offering tax abatements, other programs that incentivize development. So there's a carrot and stick approach. So it's essentially, hey, we're going to require a subset of these units be income restricted in exchange for reduced taxes and impact fees and whatnot.

And so it incentivizes development of affordable and attainable housing. And so those things are really, really important parts of the puzzle as well.

Paul (12:37.174)
And with the historic rent growth that we've seen, Jay, in your opinion, do you think that we've seen rents in general peak?

Jay Parsons (12:44.656)
Well, I think rent growth has peaked. I don't see how we can get rent growth back to those peak numbers anytime again in my career or our careers. I think that's again a once-in-a-lifetime event that was kind of resulting from our perfect storm of factors. Now, in terms of rents, like the actual nominal rent peaking, the price of everything continues to grow over time. What you want to see is it growing at a more modest and predictable pace.

Same thing with home prices and foods. Food prices peaked today and they went down every year from now and through the next 20 years. We'd have a food shortage in our country. So you don't necessarily want that. Again, you want to see more predictable, sustainable increases over time in line with the Fed's target for 2% to 3% inflation.

Paul (13:37.514)
Jay, our audience is accredited investors, mostly in the multifamily space. So if I'm an investor right now and I'm looking at some of these key markets, whether they are those high supply markets or those ones with more moderate supply, how does information help me? What am I looking for within this data to help me inform my investing decisions, whether that's the geographical market that I wanna invest in or choosing which class of apartments I wanna invest in?

Jay Parsons (14:04.496)
Yeah, that's a great, great question. I think a couple of things. Number one, you know, we've seen a lot of issues with investors who came into this market these last few years and had very unrealistic expectations about what is normal. And so I think first and foremost, the best advice is you gotta be realistic in what's normal. Like you can't think that you're gonna get, you know, 10% rent growth every year just because it happened one year. And so be realistic in your expectations. And then in terms of, at the same time, the other side would tell you is that the data is very clear that you look at like the core demand derivers, job growth, wages, demographics, et cetera, the overall and just the need for housing.

You can work anywhere, you can shop from anywhere, but you need a home. And the overall demand for housing is not going away. So there's still a lot of upside in multifamily. I've seen a lot of office capital, obviously shifting into multifamily and SFR. So that's not gonna change. Now, in terms of markets and whatnot, I'm a big believer in just following the people, right?

And so I think you want to go where the people are going. And there's opportunities everywhere. Real estate is local, local. But so you can be successful with the right strategy in any market. But broadly speaking, I think you follow the people and I think there's going to be opportunities of all of these asset classes across the board. But I do think that this last cycle is teaching us to be careful about these big value ad strategies, just because right now we're seeing a lot of people who bought these classy properties thinking they could turn them into A's uh, within increase the, put a lot of capex into it, increase the rents. Like that's, it's not that it can't work, but that's going to work less and less and less, um, you know, going forward in the short term. So, um, I think it's just, again, being realistic, um, and finding assets that, that really, um, you don't require substantial increase in rents in order to make them pencil out.

Paul (15:54.262)
Jay, what are some questions that I haven't asked that you think investors would be asking about this kind of data right now?

Jay Parsons (16:02.596)
Yeah, I think the question that I get asked the most right now, other than what you've covered, is really more around distress in the market, both in terms of renter distress and investment distress. And I think that a lot of investors are expecting more of both, and they're really not seeing that yet. And I'm not sure that we will. Renters tend to be more resilient than we've given them credit for. And we're seeing that owners are being more resilient than expected to be as well. And so, you know, lenders are generally working with these borrowers to, you know, on workouts and restructures and whatnot. There are going to be pockets where we're seeing already some examples of distress and foreclosures and whatnot. But otherwise, there seems to be more, you know, stress than distress at this point.

Paul (16:51.726)
What are some of the other questions you're getting the most from investors right now?

Jay Parsons (16:55.908)
Well, I mean, everybody, I get asked a lot about the crystal ball around and around CPI and inflation. And I always tell people, you know, the crystal ball is fuzzy and, you know, forecasting, you know, interest rates and is like forecasting gas prices. It's a fool's errand, you know, and when rates will go down and those kind of things. I mean, obviously, you know, I think the consensus view is that rates will decrease this year, but they're not going back to where they were a few years back. And so I think directionally, though everyone's kind of looking for that kind of sign on them. I think the real takeaway that I have is that investors don't like uncertainty. So what they're really looking for is they want to know that rates have peaked and that first rate cut I think is going to be a big confidence booster for investors.

Paul (17:43.33)
Yeah, I know everyone's waiting on that. There's been a lot of talk on this show about that. And when that day comes, I'm sure there'll be a lot of rejoicing. Jay, you talked about this current trend that we're discussing today. You talked about what the data that you're looking at most moving forward is regarding that. What about in general? What are the key metrics that you're looking at in the market right now to help you determine the right answers for when people come to you and ask you about that crystal ball?

Jay Parsons (18:09.5)
Well, like I said, I mean, I look at the demand side metrics most and first and foremost. I look at things like leasing traffic and guest cards. I look at consumer confidence and obviously jobs. But in terms of other KPIs, I mean, the one thing that you can watch closely right now is the is loss to lease. And that's the, as many of you probably know, that's the difference of today's market rent versus your average in place rent of what renters are paying.

And, uh, and that's really interesting because, you know, those big loss to lease numbers, uh, which basically meant your current renters are paying substantially less than when they come through the front door. You know, we saw, you know, that number being 10% plus a couple of years ago. And that was a big part of the acquisition strategy. Hey, you know, we could buy these properties. There's, there's, there's a lot of upside having big loss to lease. And that's just, again, not the case anymore. You know, loss to lease has come way back down to, you know, the low single digits and, um,

And so in part, we're also watching renewals. We're finding, you know, I think that in some cases, a lot of investors are wanting to still see renewal rent growth, where it's just not realistic, because you're gonna have, you're trying to push renewals above your market rents on the, you know, the people, your renters go to the website and they say, hey, it cost, you know, $1,500, somebody to move in here new, why are you charging me 1,550, right? I'm a renter in good standing, I rent on time every month.

But we've heard about a lot of investors, hey, we just want to see positive renewal rent growth, whatever it takes, but that's very short-sighted because you're taking on now more turn costs. It's going to take longer to fill that unit. And so ultimately it's going to impact your revenue and your rent roll values. So those are things I'm watching really closely to.

Paul (19:48.406)
Yeah, I'm sure a lot of these B and C class owner operators have fallen into that trap here recently with these decreasing rates.

Jay Parsons (19:56.972)
Yeah. Well, yeah, it's honestly, it's all asset classes. I mean, you see the same thing with class A luxury lease ups where someone offered a two month concession and they think they could burn it off and that the end of the lease term, and they can't because the rents are still lower than what they would be without the concession. And so it's a very, this is an environment right now that's very favorable to renters. The balance of power has shifted to renters. And I think operators and investors need to be very uh, you know, realistic about, about that reality. This, I mean, again, things are cyclical and a couple of years ago, the balance of power is in the favor of operators, investors, and it's shifted dramatically. And, uh, we, I think if you try to pretend otherwise, um, it's going to hurt you.

Paul (20:39.394)
Yeah, it sounds like your best ever advice to our listeners would be to be realistic and just keep harping on that fact and take the data for what it's telling you, not for what you want it to tell you.

Jay Parsons (20:49.962)
Absolutely, yeah.

Paul (20:52.066)
Great. Well, thanks so much for joining me today on this Jay. I really appreciate it. Obviously a wealth of knowledge when it comes to this data and the trends that we're all looking at as investors in the multifamily space. So is there anything we didn't discuss that you'd like to touch on before we jump off?

Jay Parsons (21:06.842)
No, we covered it. And thanks again for having me on, Paul.

Paul (21:09.834)
Yeah, of course, hopefully we can do it again soon. And thank you as well, best ever listeners. As usual, follow, subscribe, and have a best ever day.

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