The parallels to the years preceding the 1972 “Apartment Recession” are startling. If history repeats itself, the outcome will be hugely damaging.
Class-A Loses Glamour
Real estate investors could use a straightforward generalization for decades. In prosperous times, Class A apartments—the newest, priciest, and with the highest rents—performed the best and suffered the least in bad times. After that, Class B (older properties with moderate rents). And then there’s Class C. (older properties in challenging neighborhoods with lower rents) came in last. As a result, investors paid a premium to be in class A. But in 2014, something odd occurred.
Class B appeared to take off for the first time and began outperforming class A significantly. Then, in 2017, class C surpassed class B. What had happened? A 2002 investor would look at today’s chart and think they must be in an upside-down reality.
The “Waves of Change”
So, what caused the abrupt change in the decades-long order of things? The main reason is that construction has become so expensive in building new Class A, so this glut will cause Class A quality to suffer.
Many markets are deteriorating. (Austin, Texas, even made history a few months ago when it became the first major city to record year-over-year rental declines because of an oversupply.) What is causing this?
Construction Difficulties
First, the cost of materials has skyrocketed due to increased demand from faster-growing developing countries in a global marketplace. Labor costs are also rising. Since the low in 2005, construction costs have increased by more than 25%. (This is also higher than during the Great Apartment Recession.)
Why? After the Great Recession, many skilled workers left the construction sector and never returned. The immigrants who took their place were then encouraged to leave by aggressive immigration policies. These are all long-term trends that are not likely to change anytime soon. The price of building materials like concrete and steel has also skyrocketed due to recent trade war tariffs. The trade war will undoubtedly cost more and more to build for many years to come, even if it is resolved at some point relatively soon.
The builder must charge a higher rent to recoup the additional construction cost. They would never make a profit if they built low-income housing for renters in classes B and C. The only new construction feasible to construct economically in many markets is top-of-the-line, opulent Class A, which is especially true in the downtown areas of most cities. Most are gleaming new top-of-the-line apartments.
So, what’s the big deal? The issue is that not everyone can afford to pay high rent. As a result of the oversupply, rents may fall, and vacancies may arise. Class B has recently started acting similarly, suggesting that there may be a trickle-down effect. Profits are declining, and projections have error results. Many people are now pondering how the entire story will end it.
“Don’t be alarmed. Be joyful! “Many developers claim there isn’t a problem and everything is fine. They claim this is due to a once-in-a-lifetime demographic shift. A sizable portion of the millennial generation is approaching renting age, so demand will continue to soar. Although these developers admit that the fundamentals may appear to be deteriorating in some areas, they contend that this will only cause builders to slow down. The situation will eventually correct itself, and everything will be fine.
Are they right?
“How Come This Seems So Familiar?”
History provides us with one possible solution. I don’t believe we need to return too far to find many unsettling parallels. The year was 1969, and another (ostensibly) “once-in-a-lifetime” demographic opportunity presented itself. Instead of millennials, baby boomers were approaching the renting age. Similar to today, there was a significant boom in apartment construction concentrated primarily in urban areas.
The stock market had stagnated, which was advantageous for real estate (much like today, when we’ve been in a correction since January). As a result, people began to sell their stocks and invest in real estate. In addition, tax policy (The Tax Reform Act of 1969) increased the profitability of real estate investment relative to other assets (the 2017 tax reform, which will lower many real estate investments’ tax rates by 20%).
And for a while, everything went according to plan and was perfect. Between 1969 and 1972, the baby boomer generation drove up demand and apartment prices, and investors were ecstatic with the massive profits. Similarly to today, prices began to accelerate faster than rent growth at the time (see “Multifamily Rent Growth Stalls in Top Markets”). But that didn’t slow the apartment train down.
Every Cool Kid Is Doing It
Everyone wanted to invest in apartments because they became profitable, making it the newest fad. As a result, Wall Street developed a novel concept called REIT (real estate investment trust), which allowed ordinary people to invest in apartments. Due to its enormous success, assets increased from $2 billion in 1969 to $20 billion in 1973. Commercial mortgages increased dramatically, from $66.7 billion to $213.6 billion. “Traditional care and chronological standards are no use, and money flowed out like a swollen river,” written by the authors of “The Coming Real Estate Crash” (a book that studies real estate bubbles).
What Goes Up Must Come Down
But then everything came to an abrupt and disastrous end. Boomers were tired of living in apartments, wanted to start families, and were tired of paying rent. The demographic surge that had driven the years-long self-fulfilling promise of growth ended as they moved to single-family residences, “prompted without in any small measure by the high priced rents they to pay for their apartments.” And, “suddenly, the vacancies that began to appear in apartment buildings across the nation prompted many investors to question how an apartment could keep escalating in price while it was empty.”
Coming up with a solution didn’t take long. Investors “realized it with sickening speed”: Atlanta and other cities that had risen the fastest and farthest were the first to decline. But, in the end, no one was immune.
It didn’t help that the Federal Reserve had to raise interest rates to combat a sudden spike in inflation. The industry uses finance through cheap credit and low-interest rates, but they suddenly disappeared. Surprisingly, “the apartment crash cost more money than any of the more famous crashes,” such as the Great Depression. As foreclosures increased, rental property prices fell to $0.50 on the dollar.
Even by the end of 1976, $1.2 billion of apartments were foreclosed upon by 19 of the biggest banks in the country. And 42 percent of the remaining “good” loans were problematic, with landlords failing to pay interest or reducing their payments. Due to the collapse of REITS and the delisting of their stocks, many builders filed for bankruptcy. Some companies, like Wells Fargo Mortgage, were fortunate enough to “only” fall from $26 to $2, taking truckloads of investor funds with them.
“Please Inform Me That There Are Now Some Differences!”
Yes, there are some significantly different between then and now, which is good news. In 1972, the level of excitement and borrowing in apartments was off the charts, far exceeding what is happening today. That’s fantastic, although most people (including myself) believe both utilize to create a bubble and a burst. So, in my opinion, 2018 is unlikely to be a repeat. But I’m not sure about the years 2022-2025. We all know that the final part of the generation y demographic wave will result in a massive influx of Class A apartments. I believe that many individuals will be surprised. And if this occurs to plenty of people, I think it will spark a crisis.
Defensive Playing
I, therefore, take a few precautions as a cautious investor. To protect my portfolio from the worst risks, I first keep an eye on events to see what’s happening and plan defensively. In general, I’m not willing to take part in Class A or a new construction project. However, suppose I do invest in class A real estate. In that case, I will do it in a location where there is some restriction on overbuilding or excess supply (like California, which has many rules making it difficult to build for contractors, but excellent protection for an investor in the already existing property).
And I always put my multifamily investments through a stress test to see if I could survive a situation like it. Because data from the 1970s is challenging to obtain, I usually multiply the pressure of the Great Recession by 1.5 or 2. If the deal can withstand that, it will allow me to sleep better at night.
Offense Playing
Second, I think there’s a solid chance to benefit if and when a crash occurs. I like the Chinese idea of a “crisis” translating into “dangerous opportunity.” It happened with single-family homes in the aftermath of the Great Recession when a few people with cash snatched up the best deals in decades. So I’ll hold more than enough cash on hand if I get lucky.
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