Apartment construction starts in the first half of 2020 were the lowest since 2014. And while it is not surprising that developers delayed or canceled plans to start projects in light of recent weak lease-up trends, it is surprising that roughly 20% of the new apartments are being started in downtown locations, referred to here as prime urban areas. This is a similar share to the previous three years, but well above the roughly 13% of units that currently exist in those submarkets.
This despite the fact that new suburban apartments outperformed their urban counterparts in both lease-up and rent growth. It appears from recent construction trends that developers see the marked decline in downtown apartment demand growth as temporary, and are betting that renters will flock back to downtowns post-pandemic.
Although demand growth in the third quarter of 2020 outstripped any other third quarter this cycle, it came on the heels of a weak first and second quarter, and CoStar’s forecast projects weak net absorption through the end of 2021.
While third quarter demand for apartments did outperform, it did not translate well to properties that were still in the initial lease-up phase. Buildings that completed construction in the third quarter had average vacancies of over 70%, in line with the first two quarters of the year but considerably higher than in the third quarters in the pre-pandemic years of 2017 and 2018, when vacancies in newly built apartment buildings averaged 61% and 63%, respectively.
Meanwhile, apartment buildings completed in the third quarter of 2019 are also still under-performing in terms of lease-up, four quarters after reaching completion.
Much of the recent under-performance in lease-up comes from new projects located in prime urban areas, where developers have, and continue to add more units. And while third quarter absorption did come in strong, it did not make up for recent weakness in these prime urban areas, reversing an uninterrupted seven-year stretch that saw submarkets with a prime urban designation outperform suburban submarkets in quarter-over-quarter demand growth from 2013 to 2019.
That changed in 2020 as suburban apartments have experienced stronger demand growth in each of the first three quarters, driven by a mix of more people working from home because of concerns over the virus in densely populated areas.
This stronger suburban demand growth coincided with more limited supply increases of about 3% in prime urban areas, against 2% in suburban submarkets. As a result, apartment vacancies in prime urban vacancies have risen while suburban areas have seen vacancies decrease.
There is some incongruity in supply-and-demand trends when analyzing individual markets, however. Demand in California’s Inland Empire has held up fairly well through the first three quarters of 2020, for instance, but starts in that market were down significantly through the first half of 2020. On the other hand, New York, San Francisco, the East Bay and San Jose all experienced declines in apartment construction starts far sharper than the national average through the first half of the year.
Six months is a bit of a short timeline to analyze construction starts, since they tend to come in big chunks, but the declines in the Bay Area and New York are too coincidental with big rent declines to dismiss.
Average apartment rents are down over 3.1% in New York since March 15, and by around 13% in San Francisco, compared to only about 1.5% for an index of the 54 largest markets. Given this trend, construction starts will likely slow in those markets more than the national average, as CoStar’s forecast suggests.
Similarly, many of the markets that experienced increases in construction starts through the first half of 2020 are growth markets, such as Orlando, Florida, Charlotte and Raleigh, North Carolina, Salt Lake City, Utah, Tampa, Florida and Phoenix, Arizona, or markets that experienced net rent gains since the start of the pandemic, such as Norfolk, Virginia, Memphis, Tennessee and Cleveland and Cincinnati, Ohio. These slower-growth cities had much lower levels of new apartment construction through much of the last cycle, which helps explain their recent apartment rent gains, even while rents nationally have declined since the pandemic started.
While developers may be right to view the marked decline of demand growth in prime urban areas as temporary, there are ample reasons for developers to reconsider the suburbs. An increase in work-from-home rates will not wholly replace the need for offices, but it will play a larger role in the job market going forward, which will likely increase suburban apartment demand. At the same time, more modest supply growth compared to the level of development seen in prime urban areas contributed to better rent growth in the suburbs.
Both conditions, the lower supply threat and the higher rent growth, persist today. For those reasons, investment and development in the suburbs increasingly looks like a winning strategy.
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