Industry Downplays Fears of Multifamily Housing Bubble

Construction of new apartment units is climbing at a rapid clip. Nationwide prices for multifamily housing are rising back toward their pre-crisis peaks. Meanwhile, the market is getting a boost from low interest rates that no one considers sustainable over the long term.

To some, these factors suggest that a bubble is forming in the multifamily market and that, a few years from now, developers will be sitting on so many empty apartments that they will be unable to pay their bank loans.

But others who follow the rental housing market closely argue that worries about a multifamily bubble are overblown. They described some reasons for concern, but they also expressed a belief that the supply of rental units is in balance with market demand, except perhaps in a few geographic areas.

"With unemployment rates still high, we are only starting to see household growth rebound from very suppressed levels," Eric Belsky, managing director of the Joint Center for Housing Studies at Harvard University, said in an email. "Many [newcomers to the market] will rent first and, given that so many are young, single adults, multifamily housing will get an extra lift."

"I think overall our take is that it doesn't appear to be an outright bubble at the moment, but it could be in individual markets," added Matthew Anderson, an analyst and commercial real estate expert at Trepp LLC.

There is no doubt that the current demand for rental housing is strong, with multifamily vacancy rates around 5%, their lowest level in a decade. One key question today is whether that strong demand is sustainable.

Questions have also been raised about a potential oversupply of apartment units. A recent op-ed in American Banker, which raised concerns about a potential bubble in multifamily lending, noted that multifamily starts rose by 54% from 2010 to 2011, and by an additional 36% in the first quarter of this year, suggesting that some markets are in danger of becoming overbuilt.

What the op-ed did not say was that multifamily construction fell off a cliff in 2009. And even following last year's solid increase, rental housing starts remain far below their pre-recession level, in part because of constraints on the availability of credit.

Among industry participants, perhaps the biggest cause for concern involves the Fed's low interest-rate policy. With rates depressed over the last several years, some real estate investors have bought buildings that are providing fairly narrow returns. When interest rates eventually rise, and higher-yielding investments are available, the value of those properties should drop.

"So the question is when will that happen, and will that create another debacle in the apartment market?" asked Ronald Johnsey, president of Axiometrics Inc., an apartment market research firm.

Patrick Simons of Strategic Property Economics agreed that ratios between an apartment building's annual revenue and its market value are currently at a low level, in part because of low interest rates, and said those ratios have led to higher property values.

"But don't get complacent — these levels are not the historical norm," Simons warned clients in a recent newsletter.

There is currently $849 billion in multifamily mortgage debt outstanding in the United States — or about one-twelfth the level of debt outstanding on single-family homes, according to the latest data from the Federal Reserve Board.

While a bubble in the multifamily sector would not pose the threat to the U.S. economy that last decade's housing bubble did, it could threaten the balance sheets of banks that specialize in multifamily loans. Several banks in urban areas have significant exposure to multifamily real estate.

As of the third quarter of 2012, U.S. banks had $227.8 billion in multifamily loans outstanding, up 4% from the fourth quarter of last year, according to data from the Federal Deposit Insurance Corp. and Trepp.

Whatever the national trends, real estate is a local business, and conditions in the multifamily sector vary in different regions.

Downtown Seattle and downtown Denver are both places where Simons is concerned about the potential overbuilding of new apartment units, despite his more general optimism.

In the New York market, which is responsible for more than 20% of the nation's multifamily lending by banks, competition for loans is hot, which has put downward pressure on prices. One multifamily lender, Dime Community Bancshares Inc., announced recently that it would forgo any significant growth in its loan portfolio.

Mark Fitzgibbon, an analyst at Sandler O'Neill & Partners LP, voiced concern that New York-area pricing is approaching the point where multifamily loans don't make economic sense for banks, particularly in the event that interest rates rise.

But Fitzgibbon said that he has not yet seen underwriting standards drop, which would be one sign of an asset bubble. And if multiparty property values were to drop, New York-area lenders would be well protected, because they typically lend out only 50%-55% of a property's value, he noted.

Plus, there are other factors that distinguish the multifamily property market in New York from markets elsewhere, including the city's rent-control law, which contributes to its rock-bottom vacancy rate.

"There's really almost no vacancies," Fitzgibbon said. "And it's the greatest city in the world. People want to live in New York City."

Elsewhere, vacancy rates tend to be higher, and with more sites available for construction, developers and lenders face a greater risk of overbuilding.

But Stephen Gordon, chairman and chief executive officer of Opus Bank, a multifamily lender based in Irvine, Calif., argued that America is undergoing a shift toward renting. "It is entirely possible that some people aren't supposed to own a home, and some people are supposed to rent," he said.

That upbeat prediction about future demand for rental housing was echoed in a report last month by Freddie Mac, which plays a key role in the multifamily finance sphere. Freddie estimated anywhere from 1 million to 1.7 million new multifamily renters between 2012 and 2015, depending on economic conditions.

"Considering that the long-run 30-year average increase in multifamily households is 200,000 each year, all of our scenarios are strong relative to history," the report stated. "Our scenarios also suggest that at the national level the increases in multifamily rental demand will be sufficient to absorb the new units coming on line over the next few years."

Even if the trend in favor or renting over owning is short-lived, there are reasons to think that demand for rental housing will remain strong over the next few years.

Chris Herbert of Harvard's Joint Center for Housing Studies said that much of the recent growth in demand for rental housing has come from older Americans, many of whom had been homeowners. Meanwhile, many younger Americans, plagued by high rates of unemployment, have been forced to live with their parents.

But in recent months, household formation has picked up speed as the economy has recovered, which augurs well for demand in the multifamily housing market, he argued.

Still, despite what appears to be sufficient demand, bankers need to remain cautious about who their borrowers are. Opus' Gordon expressed concern that multifamily properties are being purchased by people without a sufficient background in real estate — at one point he referred to "the jeweler who owns 300 homes" — and that some recently arrived lenders lack expertise in multifamily housing.

"So now all of a sudden, people want to lend on multifamily," Gordon said. "We make sure that we're really focused on seasoned professionals who really do this for a living."

Chris Spoth, a former senior executive at the FDIC who is currently a director at Deloitte & Touche LLP, said that examiners of banks that do multifamily lending will be looking to make sure that they stick to the core principles of good underwriting.

"What the examiners would be looking for is an adherence to fundamentals through the cycles, in good times and bad," Spoth said.