The Apartment Unit Bubble is Forming

After the economy began to dip in 2007 and 2008, financing for apartment building development and investment virtually disappeared from the marketplace. With no financing, most developers could not and did not move forward on projects. This is evidenced by the almost two-thirds drop in multi-family building permits that were issued in 2009 . Builders were also holding off because of the slowdown in the economy, as real estate development is not necessarily a field of dreams and the concern was, “If we build them, they may not come." However, the U.S. population was still expanding and that meant the halt in building could result in a possible shortage of rental housing units a few years out.

Many developers and real estate investors realized this in late 2010, so every investor, builder, landowner, and developer who could spell “apartment building” charged forward to buy and develop units in hopes of earning a fair rate of return on their invested capital. These real estate buyers included large real estate investment trusts, foreign buyers, wealthy families, local developers, private equity firms, and others, many of whom were spending other people’s money that they had raised via real estate investment funds.

Predictably, this surge in development meant that too many investor buyers lined up more investment capital than they could place into real estate deals at reasonable returns. But since they already lined up the money, they were going to buy property anyway. Now, prices are heading north, and developers are sticking their shovels into the ground despite decreasing yields. This is causing real estate investors to become concerned about the possibility of an apartment building real estate bubble in the works.

Here’s what The Wall Street Journal had to say in the article "Apartments Lose Luster With Investors."

Basically, if you invest your hard-earned cash into a bond, stock, or CD, you hope to get a fair rate of return along the lines of 3% to 5% annual cash on cash return. It’s the same with real estate. If you pay $100,000 for an apartment unit, and the rent generated is $1,000 per month and all expenses are $500 per month, that leaves $500 per month (or $6,000 per year) in profit. Divide that $6,000 profit by the $100,000 investment and you have a 6% return on your money. That’s pretty darn good for an apartment building investment. Plus, you can bank on the property getting appreciation in value over time.

But with lots of buyers, let’s say that average local area rental unit value gets bid up to $110,000. Rents and expenses don’t change much in shorter periods of time, so this buyer earns $6,000 divided by $110,000, or a 5.45% return. And the next bidders, probably on a nearby unit, bid up the average unit price to $120,000. Again, with little change in rents, they'll only earn a 5.0% return. Then, prices hit $130,000 per unit, giving the investor only a 4.6% return. So as prices are bid up, returns are knocked down, and at some point, investors eventually decide that prices are too frothy for the risk.

And that’s where the market stands — too many buyers are now bidding up prices, so new buyers are curtailing their acquisitions because prices are getting too high while yields are getting lower. To add to that, since it takes about one year to 18 months to build a good-sized apartment building, there are lots of new buildings in process that will hit the market in the next year. This will increase supply, most likely reduce rents, and drop yields.

Does that sound familiar?

It’s the same real estate cycle that always happens. Overbuilding or overbuying occurs, then people shut off the money faucet, demand decreases, and prices dip. Then, with values down, too much real estate money is again thrown at the market, causing prices to overheat, which in turn causes investors to stop buying. So then prices drop, and it all starts again. As of right now, it looks like we are in the overheating phase and that usually lasts a few years. This is because the investors who are late to the game are still buying properties, and if the past gives us any indication of the future, and that should mean an apartment building value bubble will occur in the next few years.