As Multifamily Construction Starts Slow ‘Dramatically,’ REITs See Opportunity
The dynamics of the U.S. apartment market have begun to turn upside down. After struggling to raise rents during a rapid development boom, the nation's largest publicly traded landlords now say they have seen new construction starts come screeching to a halt.
The combination of rising interest rates and construction costs were already making it more difficult for developers to start new multifamily projects, and then the sudden failures of three regional banks over the last two months further disrupted the debt markets. This led to a significant slowdown in new developments breaking ground during the first four months of this year, several REIT executives said on earnings calls over the last week.
These executives, whose companies own tens of thousands of apartments across the country, said they actually stand to benefit from this slowdown. The cooling development pipeline will make it easier for existing buildings to raise rents in the coming years, and the inability of smaller regional players to finance projects could put development sites on the market that the better-capitalized real estate income trusts can swoop in and purchase.
“In terms of starts, I mean, they're dramatically down,” Equity Residential Chief Investment Officer Alexander Brackenridge said during its first-quarter earning call last week. “Already this year, what we were thinking in our markets would be, say, 110,000 starts is now looking like it might be half of that today, and I expect even more things that we thought might start will drop off the list through the rest of the year.”
Most REIT executives blamed the slowdown on rising construction costs and interest rates that are making it increasingly harder for deals in the market to pencil out. Building costs are still 39.5% higher than they were in the months before the pandemic, according to an Associated Builders and Contractors analysis.
“You just can't get there with costs that may not be rising as high as quickly as they used to a year or so ago, but they're still going up, and obviously, financing costs are higher,” Brackenridge said. “It's just really hard to make a development underwrite. So we expect to see more and more deals drop out.”
In the first quarter, residential construction starts were down 29% year-to-date, according to Dodge Data & Analytics. In the 12 months ending in March 2023, starts were 11% lower than the year ending March 2022.
As supply begins to decrease in the market, landlords might begin to feel the pressure subside, as rapid construction in recent years has brought hundreds of thousands of new units onto the market.
“I do think that any relief on the supply side of the equation will benefit existing landlords in any given market just by lower supply and them being able to see a little bit more pricing power,” Green Street analyst Alan Peterson said.
Still, new buildings continue to open that had broken ground in prior years. In the last quarter, 58,600 new units were delivered, which brought the 12-month total starting in Q2 of 2022 to 332,200, according to CBRE. Nationwide rent growth last quarter was 4.5%, well below the 15.3% increase during the first quarter of 2022.
“We expect new supply in several of our markets to remain elevated in 2023, putting some pressure on rent growth,” MAA Chief Strategy and Analysis Officer Tim Argo said.
While it is still too early to tell just how much the slowdown in construction starts will affect the industry, multifamily REITs like AvalonBay Communities, UDR, MAA, Equity Residential, Essex Property Trust and AIR Communities reported strong first-quarter results.
MAA saw an increase in overall property revenues by 11% from the same period last year. The REIT, which owns 101,986 apartments in 16 states, recorded $140M in net income last quarter. Equity Residential, with 301 properties and 79,351 units, had a net income of $220M in the quarter.
UDR, with 58,411 apartments and 415 under development, saw $31M in net income. AvalonBay, which has 295 apartment communities consisting of 88,826 units, had a net income for the quarter of $147M.
AvalonBay started construction on $100M of projects in Q1. Its full-year 2022 total was $730M. During the fourth quarter, its construction starts totaled $65M.
Private developers that have relied heavily on regional and smaller banks may be the most likely to see a sharp decrease in construction starts because of the lack of financing options that has been exacerbated by recent bank failures, Peterson said.
This week’s seizure and sale of First Republic Bank, which followed the collapses of Silicon Valley Bank and Signature Bank, marked the second-largest bank collapse in U.S. history. Around $141B of the loans on First Republic's balance sheet were tied into the real estate sector.
Developers that typically obtain debt from regional banks remain under stress about where they will be able to get financing for projects.
“It is a concern, especially when you think about just the potential of credit availability that is out there,” Peterson said. “I do think, particularly that on the private side, the developers who rely on regional banks would be concerned in that case. While construction loans are largely at a standstill at many regional banks, it could be that we potentially get some relief later this year.”
UDR Chief Financial Officer Joe Fisher also raised the impact of the regional bank disruption on the firm's first-quarter earnings call last week.
“What we're seeing in terms of new deals, it's off dramatically, which tells you because of what's going on in the regional bank space, what's going on with the ability to raise equity, you're going to start seeing way fewer starts on a go-forward basis,” Fisher said. “We do think that's going to be a future tailwind.”
REITs are well-positioned to weather this storm, as their balance sheets tend to be bigger and don’t rely as heavily on the regional banking sector to help finance deals. Some executives said the recent collapses might open the door for new opportunities for buying property and upping rents.
"We are starting to see some situations where deals are breaking," AvalonBay Communities CEO Ben Schall said on the REIT's earnings call last week. "Our expectation is that there is more to come."
He said AvalonBay is able to capitalize on these opportunities because it doesn't rely on banks to finance new projects in the way that smaller regional developers do.
“An environment where capital is scarce and certainty of execution becomes more critical, both to land sellers and subcontractors, plays well to our strengths as both the developer and the general contractor,” Schall added. “We have traditionally seen some of our most profitable investment opportunities when these more challenging cyclical conditions have prevailed.”
However, the REITs with private partnerships that are struggling through the banking crisis might see a bit of pain as their own projects begin to slow down.
“Most of our partners use bank financing for their developments,” MAA Chief Investment Officer Brad Hill said on the REIT's earnings call. “I'd say that's the biggest concern at this point, given the last few weeks and just the restriction there in capital with banks, it's more acute than it has been. First quarter, it was difficult. Equity was difficult. Debt was difficult. I'd say the debt piece has gotten even more difficult for them.”
Peterson said that only time will tell how the decrease in construction starts will impact the apartment market as a whole. With waves of supply still coming on the market from the past couple of years, Peterson said that the coming quarters will help to better assess the health of the market.
“I do think that 2Q and 3Q during peak leasing season is going to be a lot more telling on the health of apartments fundamentals over the next 12 to 24 months,” Peterson said. “Just the overall strength that we've been seeing, just given the amount of apartments repriced in 1Q is a rather low amount versus the ones that do reprice in the summer months.”