Feature
by Harvard University's Joint Center for Housing Studies
Rental markets softened in many parts of the country in 2003 as the combination of weak labor markets and rising homeownership took its toll. While house prices climbed nearly everywhere, rents fell in 9 of the 27 metros tracked by the federal government. Nationally, real contract (asking rents) and gross rents barely increased last year.
Still, the upward creep in rents along with recent income losses pushed the median share of income that renters spend on housing back up to 29 percent—about where it stood in 1994 (figure A). The recession was especially hard on renters in the bottom two income quintiles, whose median incomes dropped 4 percent in 2001-02.
Broad rental market measures mask the fact that average real effective rents (contract rents, less concessions offered by landlords to attract tenants) for larger properties actually fell in 2003. At least in this segment of the market, rents have declined modestly since 2001 after several years of strong growth—particularly in areas where the technology bubble formed and then burst.
In response to the drop-off in demand, producers of multifamily (two-plus units) rental properties cut back on construction last year. Starts of multifamily rentals edged down from 275,000 units in 2002 to 262,000 units in 2003. This reduction was not enough, however, to stop the multifamily rental vacancy rate from climbing to a record-setting 10.7 percent.
Despite the softness in rents, property owners increased their spending on improvements and repairs last year. Expenditures were up 7.5 percent in 2003, on top of a 6 percent gain in 2002. However, this spurt of investment follows a prolonged period of cutbacks and sub-par gains in rental improvement and repair spending.
The Uneven Recovery
In general, the rental markets that held up the best
in 2003 were in areas experiencing the strongest
economic growth, including those in Florida and Southern
California, and especially in metros with strong
ties to the defense industry, such as Baltimore,
Jacksonville and Los Angeles. The hardest-hit markets
include places with large technology sectors, such
as Austin, San Jose and Seattle—all of which
saw real effective rents drop by more than six percent.
Although rents for units in larger properties declined on average last year, they did so at a slower pace than in 2002. Rents for newer and especially higher-end units were under the most pressure. In 2002, only 59 percent of newly completed units were leased up within three months. While the absorption rate began to improve in 2003, it fell off again in the second half of the year. Vacancy rates on rental units built since 1990 continued their ascent, edging up from 15.3 percent in 2002 to 16.5 percent in 2003.
To fill units, many landlords resorted to rent concessions. A survey by M/PF Research conducted in the fourth quarter of 2003 reveals that 41 percent of the properties surveyed were offering some kind of concession, typically a discount of 11.5 percent off market rents. Concessions were most common in markets with high vacancies and falling effective rents, with more than half of the surveyed properties in Atlanta, Houston and the San Francisco Bay Area (including Oakland and San Jose) reporting rent breaks.
With the economy improving, however, some soft rental markets have begun to revive. In particular, the decline in average inflation-adjusted effective rents slowed to near zero in 2003. Indeed, it appears average rents nationally will eke out some gain this year even with concessions. Furthermore, 32 percent of developers surveyed by the National Multi Housing Council in April 2004 reported that rental markets were tightening, while only 14 percent reported loosening conditions—the best showing in four years. While welcome news to property owners, stronger rental markets will likely erode affordability in a growing number of locations in the coming years.
Changes
in the Rental Stock
Despite the slow growth in rental demand since homeownership
demand took off, nearly 3.3 million new rentals were
built between 1992 and 2001. However, most of these
units were built to offset losses from the existing
stock. Indeed, for every three rental units added during
this interval, two were removed. In the Midwest, new
construction did not even fully cover the loss of one
million rentals, while in the Northeast additions only
exceeded losses by 100,000 units (figure B). Rental
demand grew more strongly in the South and West, where
new construction added substantially to rental stocks
in many metro areas. As a result, the shares of rental
housing and renter households in these two regions
have increased.
These changes have altered not only the geographical distribution of the rental housing stock, but also the distribution of units by structure type. Over the decade, more than 1.3 million apartments in two- to four-unit buildings were lost nationwide while only 450,000 were added. Net losses were concentrated in the Northeast and Midwest, where the stock of rentals in these small structures shrank by more than 15 percent. Along with these losses went many opportunities for resident landlords to own homes while also generating income from their properties.
In contrast, nearly 750,000 single-family rentals and 1.3 million units in buildings with five or more apartments were gained on net in the 1990s. Construction of larger properties added 1.7 million apartments, while both new construction and conversion of owner-occupied homes fed the growth in single-family rentals. Indeed, despite the strength of homeownership demand over the decade, conversions of single-family homes to renter occupancy outnumbered conversions of single-family rentals to owner occupancy by 270,000. The recent pattern of rental additions and losses has also served to shift the stock toward the higher end of the rent distribution, since newer units tend to provide more amenities than older ones. In 2001, nearly half of the units built since 1990 were renting for at least $750, compared with only 29 percent of those built earlier.
While depreciation of the stock clearly accounts for some of the lower rents on older units, the difference in the features that older and newer units offer is also a key factor. In 2001, for example, only 15 percent of rental units built before 1990 had two or more bathrooms, while almost half of the units built since then had multiple bathrooms. Similarly, the share of older units with central air conditioning was 40 percent, while that of newer units was 75.
Although new construction over the past 10 years has been disproportionately concentrated in the top fifth of the rent distribution in individual metropolitan areas, building for the middle market (units with rents between the 40th and 80th percentile) has also been robust. Indeed, when summed across metropolitan and non-metropolitan areas, the middle-market share of new construction nationally is in line with its 40 percent share of the overall rental market.
Middle market rentals provide a vital source of new housing for those seeking relatively modest rents—primarily low- and moderate-wage working families. But in the lower market (the bottom 40 percent of the rent distribution), new construction is highly constrained by the amount of government subsidies available to make this production economical. As a result, only about one-fifth of all new rental construction over the past decade has been targeted to the bottom tier of the market.
Demographic and Income Changes
While the number of renter households has grown only
slowly since 1990, the composition of the renter
population has changed dramatically. Over the course
of the decade, the minority share of renters jumped from 31 percent to 39
percent, while the foreign-born share grew from 12 percent to 17 percent.
With incomes of minority and foreign-born renters generally lower than those
of white and native-born renters, this shift has lowered the median income
of renters overall.
Indeed, the growth in minority and foreign-born renters increased the number of low-income renters by 400,000 over the decade. Meanwhile, the homeownership boom encouraged millions of higher-income renters to buy, reducing the number of upper-income renters by 10 percent. As a result, the already large income gap between owners and renters widened from $18,700 in 1991 to $22,100 in 2001.
Within the renter population, though, the income gap between whites and minorities narrowed significantly. Given the decrease in the number of white renter households of all incomes, the median income of white renters remained essentially unchanged from 1991 to 2001. In the meantime, minority renter incomes increased by a strong 13 percent as the booming economy drove up the share of minority renters in the middle-income quintile. In combination, these shifts reduced the difference between white and minority renter incomes from 26 percent in 1991 to 17 percent in 2001 (figure C).
Rental Property Finance
As with financing for homeownership, rental property
finance has changed dramatically over the past 10 years.
Most notably, the share of multifamily mortgages (defined
in the industry as loans to properties with five or
more apartments) bought and sold in the secondary market
has increased. Nonetheless, the multifamily share of
loans sold as mortgage-backed securities and traded
in capital markets still stands well below the so-called single-family share,
defined as one- to four-unit properties. The growth of the secondary market
for multifamily mortgages brings many advantages, including greater liquidity,
better diversification of risk for investors and a larger and more stable
supply of capital.
While investment banks and others have led the way, Fannie Mae and Freddie Mac are becoming increasingly important players in the multifamily market. The two companies now account for nearly 25 percent of total multifamily mortgage debt outstanding, up from just 13 percent in 1997. The participation of Fannie Mae and Freddie Mac has also transformed multifamily finance by standardizing underwriting practices and loan documents. Greater uniformity in turn reduces costs and further enhances liquidity. In addition, because of their public charters, the two companies often provide capital when others might not.
Within the multifamily mortgage market, though, smaller loans mostly bypass the secondary market. Instead, bank and thrift portfolio lenders remain the principal providers of loans for properties with 5 to 49 units. In 1999, for example, more than half of all multifamily loans financed by banks and thrifts had balances of $1 million or less, compared with about 15 percent of the multifamily loans financed by Fannie Mae and Freddie Mac.
In contrast, financing for rental properties with fewer than five apartments is much better integrated into secondary markets. Loans to resident landlords of two- to four-unit properties are treated much like those for owner-occupied, single-family properties. Although Fannie Mae and Freddie Mac’s reserve and down-payment requirements may be higher for these loans, the interest rates are no different and credit scores remain an important element in underwriting. For investors in single-family rentals and non-resident landlords of two- to four-unit properties, however, Fannie Mae and Freddie Mac impose larger down payment requirements and a 1.5 percentage-point delivery fee (sometimes rolled into a slightly higher interest rate).
Despite these advances, after-tax rental property financing in most cases is still more expensive than after-tax financing for owner-occupied properties. In particular, the depreciation allowances and losses extended to investors in rental housing are less generous than the mortgage interest and property tax deductions extended to investors in owner-occupied housing.
Looking Ahead
Buffeted by the recession, sagging labor markets, and
strong demand for homeownership, growth in rental
demand has been weak for the past 10 years. Rents
in many markets have been under pressure, with newer
properties especially hard hit. Nevertheless, more
markets saw rents climb than fall in 2003, with a
few reporting hefty increases. Any imbalances between
supply and demand may, however, prove temporary if
the economy continues to expand and generate new
jobs. In fact, rental demand could even surge if
interest rates and/or house prices rise, making homeownership
less affordable. Independent of the economy, the
age distribution of the US population will soon start
to favor rental markets. The foreign-born population continues to swell
the ranks of young adults, and the echo baby-boom
generation will soon be old enough to form their
own households. Because both young adults and the
foreign-born are more likely, at least initially,
to rent than own their housing, these demographic trends point to
strengthening rental markets over the coming decade.
The opinions expressed in this article are those of the author and do not necessarily reflect the viewpoint of the SFAA or the San Francisco Apartment Magazine. This report serves as an essential resource for both public policy makers and private decision makers in the housing industry. To read the complete report, please visit the Joint Center’s Web site at www.jchs.harvard.edu. Reprinted from the State of the Nation’s Housing 2004 with permission from the Joint Center for Housing Studies of Harvard University. All rights reserved.