Booming home sales over the last fifteen months are a typical cyclical response to the US Federal Reserve’s aggressive cut in interest rates which sought to counteract the Covid-19 recession. That policy pushed home mortgage rates to historic lows and promoted home sales to historic highs. With older millennials representing a significant share of renters, we ask whether there is a shift from apartments to single-family homes to take advantage of low mortgage rates noting that millennials are now approaching 40 and in their prime “nesting” years. We examine whether Covid-related work-from-home is shifting renters from high-density, more expensive metros to lower density, more affordable metros and whether there has been a shift to quality as rents on over-supplied apartments decline. With our findings we evaluate the attractiveness of a middle-income apartment sector investment strategy.
As the US Covid-19 shutdown took hold in March 2020, the US Federal Reserve (Fed) moved quickly and decisively to loosen interest rates and provide liquidity to counter the recessionary effects of the virus. On March 3, 2020, the Federal Funds rate was cut by a ½% and on March 15, it was chopped again to essentially zero where it remains today. That mid-March meeting also announced a revival of the Fed’s securities buying program that helped to assure financial market liquidity during the 2008 Great Financial Crisis. These policies filtered into the residential mortgage market pushing the 30-year fixed rate to an all-time low of 2.65% from 3.45% at the end of February 2020 (Exhibit 1).1
Exhibit 1: 30-year fixed rate mortgage rate (weekly average)
Source: Federal Reserve Bank of St. Louis, Freddie Mac as of October 28, 2021.
Exhibit 2: US home sales (seasonally adjusted)
Source: Moody’s Analytics, National Association of Realtors as of September 30, 2021.
As mortgage rates declined, existing home sales took off, jumping from a 3.9 million annual rate for existing home sales in the second quarter of 2020 to a 6.1 million rate the following quarter (Exhibit 2).2 The decline in mortgage rates stimulated home purchases in typical cyclical fashion but it was not the only force encouraging home purchases. Demographics helped as the huge millennial cohort born between 1981 and 1996 matured into their mid-to-late-thirties. Homeownership among millennials improved markedly in 2020 to 47.9% leaving 52.1% renting.3 According to CoreLogic, “the double-digit growth in millennial homebuying is responsible for more than 60% of rising home sales in 2020.”4 A surge in millennial homebuying is understandable as millennial women are in their prime childbearing years with 55% of them having already had a child by 2018.5 Children bring hunger for space and often lead to moves from rented apartments to homeownership.
Moreover, growth in the total number of households also contributed to home purchase demand. As shown in Exhibit 3, the number of households grew sharply in early 2020 reflecting millennial maturation as the youngest millennials reached their twenties.
Exhibit 3: US Household Growth (January 2019-June 2021)
Source: US. Census Bureau, Current Population Survey as of July 2021.
Covid-19 amplified home demand further as work-from-home became the norm when offices shut down. As the months of lockdown ticked by, the stress of work-from-home, especially when home included young children and home schooling, further accelerated home buying appetite.
With home sales soaring and homeownership rising among millennials, we believe it is obvious to ask whether apartment rental markets are suffering.
Apartment Fundamentals Overall
A review of data updated through the third quarter of 2021 shows no evidence of apartment markets suffering. Vacancy rates on the highest quality (4&5 Star) apartments increased to breech 10% during the first few Covid-quarters and rents declined. However, those developments reflected strong deliveries of new high-quality apartments beginning over the second half of 2019 and continuing through 2020. Absorption of the inflow was compromised as Covid-19 hit producing downward pressure on rents. The price adjustments were effective as shown by the decline in high-quality vacancy rates in the fourth quarter of 2020 (Exhibit 4) and into 2021 when rent growth rebounded (Exhibit 5) and new deliveries slackened (Exhibit 6).
Exhibit 4: Vacancy rates by quality segments
Source: CoStar Realty Information Inc. as of September 30, 2021.
Exhibit 5: Effective rent growth by quality segments (year-over-year change)
Source: CoStar Realty Information Inc. as of September 30, 2021.
Exhibit 6: Net delivered units by quality segments (trailing 12 months)
Source: CoStar Realty Information Inc. as of September 30, 2021.
The Covid-19 recession produced more minor effects on medium 3-Star and lower quality 1&2-Star apartment market segments. Vacancy rates on both segments meandered down through 2020 and 2021 to date. Rent growth eased somewhat during the worst of the Covid-19 recession in 2020 but 2021 has brought very strong rent increases. New construction had little impact on these market segments with some additions to supply of medium-quality stock along with a minor reduction in lower-quality stock.
Varied Results Across Metro Markets
Examining market data for the largest 50 US metros shows that almost all of them enjoyed lower vacancy rates and higher effective rents by 3Q2021 compared with pre-Covid 4Q2019. Exhibit 7 shows averages for the 50 largest metros by quality segments. It also shows the extremes for the ten markets with the largest vacancy rate changes within each segment and for the ten markets with the smallest vacancy rate changes within each segment.
Exhibit 7: Metro market results by quality segments* (December 31, 2019 - September 30, 2021)
| 4 & 5 Star | 3 Star | 1 & 2 Star | |||||||
| Rent Growth | Vacancy Rate Change | Current Vacancy Rate | Rent Growth | Vacancy Rate Change | Current Vacancy Rate | Rent Growth | Vacancy Rate Change | Current Vacancy Rate | |
| Average | 14.8% | -3.0% | 6.3% | 12.4% | -1.8% | 4.3% | 5.9% | -1.7% | 4.3% |
| Top 10 vacancy decline | 16.9% | -5.5% | 5.3% | 15.2% | -3.2% | 4.3% | 8.2% | -3.4% | 6.4% |
| Bottom 10 vacancy decline | 12.3% | 0.2% | 8.7% | 7.9% | -0.1% | 4.3% | 3.2% | -0.2% | 3.9% |
Source: CoStar Realty Information Inc.; Aegon Real Assets US as of September 30, 2021. *Based on a selection of 50 most populous markets.
In general, the market data reported in the table shows that the highest quality (4&5 Star) segment enjoyed the strongest tightening (3 percentage points) in vacancy rates over the 4Q2019-3Q2021 period. That tightening was accompanied by the strongest rent growth (14.8%) as well. But current vacancy rates in that segment remain the highest on average at 6.3%. The medium-quality (3 Star) segment had a weaker degree of tightening in vacancy rates (1.8 percentage points) with still strong rent growth (12.4%) bringing current vacancy rates to 4.3%. The lowest-quality segment (1&2 Star) had a slightly weaker vacancy rate improvement (1.7 percentage points) and substantially weaker rent growth (5.9%) bringing vacancy rates to the same 4.3% average.6
Within these segments, vacancy rates did not improve on average for the bottom ten metros of the highest-quality metro segments bringing vacancy rates to 8.7% currently but rent growth was still very substantial at 12.3%. In the medium-quality and lowest-quality segments, the bottom ten weakest vacancy improvements hardly moved the needle at all, yet those segments also enjoyed rent growth though at substantially weaker rates, 7.9% and 3.2%, respectively. Both segments have tighter current vacancy rates than top-quality segment, 4.3% and 3.9%, respectively.6
The conclusion here is that the surge in home-buying did not compromise apartment market fundamentals. There is evidence of flight to quality shown in the relatively strong decline in vacancy rates in the highest quality segments but no evidence that it created distress in the two lower quality segments. Overall, strong growth in the number of households plus moderating delivery of new units in 2021 likely offset both the flight to quality and the pull into home purchases.
Medium-Quality Segment Doing Well in a Variety of Metros
Drilling down into individual metro medium-quality apartments offers insights particularly relevant to workforce housing. Medium-quality apartments are typically older properties, generally around 25 years old, with unsubsidized rents affordable to households earning up to 120% of local median income. These properties may present attractive investment opportunities because there is very little new construction leaving supply constrained. Higher-quality properties age into this medium-quality segment over time as newer properties with more modern amenities and higher rents lure away tenants who can afford them.
Investors are often attracted to medium-quality apartment properties because demand is bolstered by “tenants by necessity” who cannot afford newer more expensive units or homeownership. Yet, such tenants often can afford the modest rent increases that allow for property improvements especially improvements that prolong a property’s useful life and quality.
The ten metro areas with the strongest declines in vacancy rates for medium-quality apartments are shown in Exhibit 8. Those vacancy rate declines were associated with the strongest rent increases in metros with the lowest current medium-quality vacancy rates. They include Las Vegas, Jacksonville, Inland Empire, and San Diego…all with vacancy rates below 4%. Salt Lake City has a slightly higher vacancy rate at 4.1% but produced stunning 20.2% rent increases. All are relatively fast-growing locations.6
Exhibit 8: Metro market details for medium-quality segment*
| Top 10 metros - 3 Star | |||
| Rent Growth | Vacancy Rate Change | Current Vacancy Rate | |
| Memphis | 13.7% | -3.9% | 7.2% |
| Jacksonville | 22.4% | -3.8% | 3.9% |
| Las Vegas | 24.9% | -3.3% | 3.6% |
| San Antonio | 8.9% | -3.3% | 6.4% |
| San Diego | 15.7% | -3.2% | 1.6% |
| Norfolk | 14.0% | -3.1% | 2.6% |
| Salt Lake City | 20.2% | -2.9% | 4.1% |
| Inland Empire | 16.1% | -2.9% | 1.7% |
| Houston | 8.4% | -2.9% | 6.5% |
| Louisville | 7.9% | -2.9% | 5.3% |
| Bottom 10 metros - 3 Star | |||
| Rent Growth | Vacancy Rate Change | Current Vacancy Rate | |
| Buffalo | 4.0% | -0.8% | 2.9% |
| Austin | 19.2% | -0.7% | 5.6% |
| Chicago | 8.0% | -0.6% | 5.3% |
| New York | 4.6% | -0.6% | 2.1% |
| Washington | 8.7% | -0.1% | 4.9% |
| Providence | 7.4% | 0.0% | 3.1% |
| Boston | 8.8% | 0.1% | 3.9% |
| Minneapolis | 3.6% | 0.2% | 4.5% |
| San Francisco | 5.9% | 0.4% | 5.5% |
| San Jose | 8.8% | 1.0% | 5.6% |
Source: CoStar Realty Information Inc.; Aegon Asset Management as of September 30, 2021.*Based on a selection of 50 most populous markets.
The ten metros with the weakest declines in medium-quality vacancy rates include five metros with slight increases in vacancy rates. Among them are tech-heavy Boston, San Francisco and San Jose. All have very high rents and high-priced homes. Their tech-focused workforces are amenable to work-from-home and work-from-anywhere schemes that Covid-19 has made more prevalent. All are high-wage locations that are perhaps best able to provide renters with the down-payments to buy homes. Yet the slight upticks in medium-quality apartment vacancy rates and the still-solid rent increases in these metros suggest that they have experienced relative but not absolute weakening in occupancy and rent growth over the Covid-quarters.
Looking ahead, mortgage rates are rising above their cycle low and home prices are at all-time highs indicating that the cyclical factors encouraging homeownership are ebbing. While the ongoing aging of millennials will continue to fuel home-buying demand, there is also an enormous backlog of millennials living with parents who will likely step out into rental apartments as they mature. Pew estimates that over 26 million 18-to-29 year old's, comprising 52% of that age group, lived with parents in 2020. For older millennials, impediments to homeownership remain.7 In 2020, 18.2% of millennial renters opined that they expect to be renters always, up from 10.7% in 2018. Of the forever renters, 74% cited affordability as their reason for not pursuing home ownership.3 These factors together demonstrate that medium-quality apartment performance can withstand cyclical pressures.
Conclusions
Homebuying has soared since the onset of the Covid-19 recession, but it has not materially compromised market fundamentals for medium-quality apartments. Demand within this market segment produced generally declining vacancy rates and growing effective rents pervasively across metro area geographies. The analysis described in this paper supports the expectation that demand for medium-quality apartments will remain solid for years to come and will continue to offer investors opportunities to add value and extend the life of the stock.
References
1Federal Reserve Bank of St. Louis, Freddie Mac. October 28, 2021.
2Moody’s Analytics, National Association of Realtors. September 30, 2021.
3Apartment List, Apartment List’s 2021 Millennial Homeownership Report. February 9, 2021.
4CoreLogic, Homeownership Accelerated Among Young Millennials During the Pandemic. August 18, 2021.
5Pew Research Center, As Millennials Near 40, They’re Approaching Family Life Differently Than Previous Generations. May 27, 2020.
6CoStar Realty Information, Inc. September 30, 2021.
7Pew Research Center, A Majority of Young Adults in the US Live With Their Parents for the First Time Since the Great Depression. September 4, 2020.