Is Multifamily Housing the Next Lending Bubble?

Editor's note: A version of this blog post first appeared on the Property Management Insider blog.

The apartment industry is riding high these days. Sales volumes are at peak levels. Prices have jumped to all-time highs. Capitalization rates have dropped to long-time lows. And buoyed by strong demand and easily accessible funding, apartment construction has surged to the highest levels since the 1980s.

All these high-water marks suggest an obvious question: Is multifamily housing reaching a bubble?

This question is especially important for banks because they have quickly become major players in the multifamily business. Since the start of 2013, banks have funded 82.5 cents of every new dollar, on net, loaned for multifamily housing, based on data from the Federal Reserve. And since the second quarter of 2008, multifamily loan volumes have ballooned 33% to an all-time high of $281 billion on bank balance sheets, according to Federal Deposit Insurance Corp. filings compiled by BankRegData.com. No other bank loan category has grown faster over that time period; it's not even close. Multifamily now comprises 3.5% of all outstanding bank loans, the highest level since 1992.

There are several theories as to what's driving the apartment industry's hot streak — but first, let's look at the fundamentals.

The apartment sector recovered quickly from the last recession. The period between 2010 and 2012 was one of the best on record for the industry in terms of net operating income growth. This growth was fueled by big gains in both occupancy and rent prices and aided by very limited new supply. Since then, new supply has ramped up. As of the second quarter of 2014, new supply levels on a trailing 12-month basis are at decade highs. Yet demand for apartments remains robust, tracking above supply. Occupancy hit a seven-year high of 95.7% in the second quarter of this year.

So what's behind the multifamily surge? One popular view is that the foreclosure crisis drove millions of people out of single-family homes and into apartments, creating a short-term, unsustainable lift for the sector. But the data shows that foreclosures turned single-family owners into single-family renters, not apartment inhabitants.

It's true that the crisis slowed the tide of first-time homebuyers. However, the evidence suggests that a large swath of today's young adults — even without the foreclosure mess or the resulting tighter underwriting standards — would still wait longer to buy homes. Millennials' so-called prolonged adolescence has them waiting longer to get married and to have kids, both of which provide an impetus for purchasing homes.

In fact, demographics, rather than the foreclosure crisis, has been the key driver behind the apartment industry's success. The U.S. is seeing its highest growth rate in the population of 20- and 30-somethings since the baby boom. Population trends clearly show significant growth through the next decade that will fuel a steady demand stream for apartments, even as the oldest millennials start to buy homes in greater numbers.

Young adults' prolonged adolescence isn't just delaying home purchases. It's also delayed apartment lease signings for some young adults — suggesting that there is still pent-up demand for apartments. The Pew Research Center estimates 21.6 million young adults between the ages of 18 and 31 lived in their parents' homes in 2012, up 3.1 million from 2007. Once this group leaves the nest, the next, most logical step will be to rent an apartment.

Simply put, lots of young adults are renting apartments today — and more of them are coming. Moreover, these young adults are better equipped to deal with future rent hikes than many realize. Millennials are widely portrayed as underemployed and poorly paid. But the data suggests that is untrue for the generation as a whole. Millennial households command greater inflation-adjusted incomes than previous generations did at the same age, according to a recent study by the Pew Research Center. But all of that income growth has come from young adults with college degrees, while income for those without degrees has fallen.

Beyond demographics, it's worth comparing the conditions that led to the busted single-family bubble of 2008 to those of today's multifamily market.

The most obvious problem in the single-family bust was that banks lowered lending standards during the mid-2000s, inflating homeownership rates to historic — and artificial — highs. The fact that borrowers lacked sufficient skin in the game drove the nonperformance rate of first liens for single-family homes held by banks to a peak of 10.1% in the first quarter of 2010.

The apartment industry doesn't have a comparable driver. Banks today are generally getting attractive terms for multifamily loans, with loan-to-value ratios typically around 70%. Moreover, the nature of lease terms allows apartment owners to quickly remove delinquent tenants. And apartment prices haven't shot up to the degree seen in single-family homes in the run-up to the crisis — not yet, anyway. Multifamily housing prices would have to plunge even further than in 2008-2009 before a bank's investment could become exposed.

There is one more important comparison to make between single-family homes in the mid-2000s and multifamily housing today: construction.

The sharp rise in multifamily development has made headlines and inspired some to start crying "bubble." But the data shows that while multifamily construction has surged upward, it's still well below levels seen in the 1980s, 1970s and 1960s. And it's highly unlikely to return to those levels. Single-family construction, by comparison, fed the bubble by shattering all kinds of records in the mid-2000s. In fact, both Fannie Mae and Freddie Mac have published research suggesting that current apartment construction volumes are actually insufficient to meet demand — although those proclamations warrant some nuance.

All that being said, the apartment market is almost certainly past the peak for this cycle. There's less room to grow occupancy today, so bigger rent hikes would be required to sustain NOI growth levels. The same is true of loan yields, since the marketplace is becoming more competitive, and of cap rates. Early in the recovery, apartments were so hot that pretty much any deal was a good one. Today, as yields are normalizing, strategy is becoming more important.

While the multifamily housing is not near bubble status, it would be wise to adapt to the changing cycle. The biggest risk to the multifamily sector, like any sector, is the macroeconomic environment. If the economy weakens materially, multifamily is vulnerable. Banks can prepare themselves for such an occurrence by narrowing their focus to specific market segments that meet acceptable risk thresholds and by continually upgrading underwriting techniques. At a market's high point, the best strategy is not to sit pretty or to backpedal — but to continually sharpen processes and adjust to changing conditions.

Jay Parsons is the director of analytics and forecasts for MPF Research, the market intelligence arm of RealPage, Inc., specializing in the multifamily housing industry.