What's that in our stockings?

Coal for Christmas is code for recession.

By BRUCE MCCLENNY, ApartmentData.com

Not since 1982 has the Headline Consumer Price Index (CPI), which measures inflation by comparing prices paid for goods and services, registered as high as 8.2% as it did in September. Core Inflation, which excludes energy and food from the Headline rate, registered at 6.6%. The Federal Reserve has vowed to fight Core Inflation until it reaches a rate with a 2% handle. It appears the Fed has taken on the role of Bad Santa with the sure prospect of putting coal in our stockings this Christmas. This symbolic punishment materializes in the form of interest rate hikes designed to lower inflation and slow the economy to the point of recession.

With recession, expect an increase in unemployment and a lower wealth-effect through diminished property and equity values. In addition, lending and liquidity will become harder to find. Those in the office real estate market have been in decline since the pandemic changed the acceptance of remote work. The singlefamily market is in fast retreat. In October, HAR.com reported closings are down by 22.4% compared to last year. According to the National Association of Home Builders, a mortgage of around 7%, double last year’s rate, translates into a monthly payment of $2,000 on a $300,000 loan. Last year, that payment would have been $1,265 per month.

The Houston apartment market has begun to experience a reversal of fortune after 21 straight months of rent gains. The graph on the next page shows those rent bumps that began in October of 2020, when overall average monthly rent was $1,042, continually rising through August 2022, when rent topped out at $1,262. The rent train finally ran out of steam in August 2022 as occupancy steadily fell from its highpoint of 91.6% to its current October 2022 position of 90.7%. This nine basis points of faltering demand sent rent $8 lower, moving from $1,262 in August to $1,254 at the end of October. Even as the rent level rolls over, the rent trend over the 24-month period from October of 2020 to October 2022 is 20.3%. On a linear basis, this is growth greater than 10% over two consecutive 12- month periods which is two and one-half times greater than Houston’s long term average annal rent growth of 4%.

This graph of occupancy and rent levels going back to December of 2019 represents a period of time like none other. The Pandemic wielded death, fear and isolation on a world-wide human level and wild extremes economically. The economic lockdown of 2020 played havoc with demand, stunting occupancy for the year around 88% and driving rents lower, from $1,061 in March to $1,042 in October. The Houston Metro experienced historic job losses during 2020 of 185,000 jobs. The U.S. Government, to keep businesses, consumers and the economy afloat, immediately enacted and funded a multitude of assistance programs. In addition, the Federal Reserve lowered interest rates to near zero to increase the money supply and keep liquidity flowing. All these fiscal and monetary policies were necessary to avoid catastrophic collapse of households and businesses.

2021 ushered in the economic reopening and pushed Houston job growth to a record high of 159,700 jobs. Such exceptional growth in jobs pushed absorption of over 38,000 units in 2021, a local industry metric never seen before. This absorption propelled occupancy, as seen on the graph, from what was a range-bound level around 88% to 91.6%, which is a level not seen since June of 2015 at the height of the Fracking Boom. The rise in occupancy level escorted rents to new heights as mentioned above.

This rise in rents is a contributor to inflation, along with prices of food, energy and wages. Monetary and fiscal policies have been too generous for too long and have also contributed to inflationary pressures and the Fed is doing something about it. The six Fed rate hikes this year have begun to weigh on the apartment industry, as well as many other industries. There are two more rate increases pending. One in December and one in January. Our economic wellbeing for 2023 rests in the balance. The salutation of have a Merry Christmas and a Happy New Year seems at risk and illusive this year as the Fed pursues its current mandate of lowering inflation and increasing unemployment.

The Market by Class

The overall statistics of rent, occupancy and absorption are an aggregation of these statistics for each class of property. Classes are determined by a bell curve distribution of market rates or price. The table at right breaks out how each class differs in performance and contributes to the overall market statistics as of October 31, 2022. In addition, Class A has been divided into two groups. One group is those Class A properties that began leasing in 2021 & 2022. Since properties in this group are in a wide range of lease-up, occupancy is understandably low at 59.3%. Due to the ever-increasing supply of this group over the time frames analyzed, rent trends cannot be properly calculated. Filtering out the lease-up properties of 2021 and 2022 from Class A creates the Class A Stable group.

In general, all classes are exhibiting varying degrees of weakening demand which is expressed in this table as absorption. Scanning the 3- Month column of absorption shows that overall absorption registered minus 955 units. Absorption is a net number of move-ins versus moveouts over a period of time. This negative absorption performance means that more people have moved out of apartments than moved in over the last three months. Classes A-Stable, B and C are significant contributors to the exodus, whereas Class A 2021 and 2022 experienced substantial lease-up velocity, with 3,230 units of positive absorption. The 12-month absorption numbers show the same trends, with Class B claiming the largest group of move-outs by a wide margin.

It appears that residents moved out reacting to the higher level of rent as shown in the 12-month trend column which at 8% comes in at twice the long-term average of rent growth over the last 19 years prior to the Pandemic. In addition to higher rent, residents are paying higher prices for food, electricity and gas. Anecdotally, residents are forced to find more affordable lifestyles and are behaving as they have during past recessions by doubling-up and moving in with relatives. As a result of this move-out activity, overall rent levels are in retreat by 1.9% as evidenced by the 3-month trend column, which is expressed in annualized terms.

The positive absorption found in Class A 2021 and 2022 is driven by two factors. One is the nature of this group as new construction, lease-up product, which is starting from zero and moving towards stabilization as fast as possible. The only way is up with positive absorption for this group. The second factor pushing absorption higher, which is economically driven, relates to those that are priced out of buying a single-family home and find their only alternative is to rent.

Looking Ahead

Rent growth for 2022 was expected to moderate from the 13.9% gain in 2021 and that has happened. The overall trailing 12-month rent trend as of the end of October is 8.0%. It is very likely that the trend will continue to fall over the last two months of the year. Expect overall rent growth for 2022 to come in around 6.0%. A very good level of rent growth, from a long-term perspective, even though it is lackluster compared to last year. Over the 36 years that ApartmentData.com has been collecting info on Houston, there have been only eight other times when rent growth exceeded 6.0%.

What was not expected was for occupancy to drop by almost a full percentage point from a high point of 91.6% in November 2021 to its present position of 90.7%. This weakness in demand happened as job growth remains at historically high levels. As of the end of September, The Bureau of Labor Statistics reports the Houston Metro has gained 188,400 net new jobs over the last 12 months. Traditionally, we could expect that, for every 5 jobs, a unit of overall absorption would be generated. The current overall absorption over the last 12 months is 6,914 units, which yeilds an absorption-to-jobs ratio of one unit of absorption for every 27 jobs (188,400/6,914).

It appears that the mounting number of move-out – negative absorption in Class B and C which are affordability/inflation based – have disrupted the traditional relationship of job growth to overall absorption performance. It is very intriguing to apply the 12-month absorption of the lease-up group (Class A 2021 & 2022), which is 13,637 units to the employment growth of 188,400 jobs, resulting in one unit of absorption for every seven jobs. This adjusted correlation of one unit of absorption to seven jobs restores confidence in the traditional connection of jobs to absorption. It places great importance on the would-be homeowner forced to become a renter driving this relationship.

With this cursory analysis of absorption by class, a dichotomy of renters is revealed. On one side are those that are moving out of of Class B and C, and those on the opposite side that are moving into new product that is leasingup. Both factions are making their living arrangement decisions based on affordability, which is always a major factor, but it seems to carry more weight in the current economic environment. It will be important to monitor these dynamcis for 2023 and whether there is any change in the movement of these two groups.

Speaking of 2023

It is a fool’s errand to forecast apartment conditions for 2023. Continued interest rate hikes by the Fed will surely break things financially. The breakage will most likely be found in non-banks that have little regulation. The breakage will cause some level of ripple effects impacting employment, valuations and liquidity. The war in Ukraine adds more elements of uncertainty. Continued conflict adds risk to inflationary pressures on fuel and food. These thoughts are worst case scenarios. Possibilities exist that the Fed may pivot from its current direction and ease off the hiking of interest rates, causing a soft-landing scenario with much less financial breakage. Apologies for the round-trip of speculation, but this exemplifies the uncertainty we face.

The level of new construction deliveries for 2022 and 2023 can be estimated with a much higher degree of certainty. Considering that 12,000 units have already been delivered this year, with another 4,000 units presently under construction anticipated to deliver, puts the total units delivered for 2022 at 16,000. Expect units delivered in 2023 to be in the same range of 16,000 to 17,000 units. These level of deliveries are around the sweet spot for a balance between supply and demand. Job growth, a major contributor to the success of lease-ups, falls into the uncertainty camp due to the economic dominoes that may fall. Demand from single-family sources should be another good contributor to leasing in 2023.

Rent growth for 2023 starts as a matter of attitude and then becomes a reaction to reality as time passes. A conservative approach for 2023 would be to hold on to the substantial rent gains achieved during 2021 and the first half of 2022. This “flat is good” position should build occupancy with the potential to increase rent. A more aggressive approach towards rent growth in 2023 would be to plan for increases in the long-term average range of 3% to 4%. If the exodus of renters continues with this approach, it would be time to course correct to a “flat is good” position.

Have a MERRY CHRISTMAS and a HAPPY NEW YEAR!

Bruce McClenny is Senior Director of ApartmentData.com From MRI Software. For more details, call 281-759-2200, email bruce@apartmentdata.com, see Marketline on Page 75 and subscribe to his YouTube channel at: https://www.youtube.com/channel/UCaPmY9AevdjCpqe4UeQU7x w/featured