“Everyone needs a home,” a song goes, encapsulating the innate strength of multifamily housing even in trying times. The COVID-19 outbreak has to some extent changed the way the sector ticks, and while it may see some ugly numbers soon, the overall picture remains steady.
Note that throughout this series we will be following 5 listed multifamily housing REITs: AvalonBay Communities (AVB); Camden Property Trust (CPT); Equity Residential (EQR); Essex Property Trust (ESS); and Mid-America Apartment Communities (MAA).
This report at a glance:
Upbeat Q1 environment of strong rent growth, low vacancies, & brisk development activity put the sector into a much better space moving into the pandemic period.
COVID-19’s onset by late March spoiled a supposedly-brisk summer rental season. Social distancing & stay-at-home restrictions put onus on landlords to make operational adjustments to adapt to deteriorating fundamentals.
Indicators of comeback were noted as early as May but the recovery is not uniform: variability of markets & tenant profiles are largely dictating the shape of Q2 & Q3.
Uncertainties due to the pandemic have encouraged rightsizing. With 2020 starts already being deferred, there may be an inflow of stacked supply over the next few years.
Healthy occupancy & rent growth across the board prop-up Q1
If the first weeks of Q1 were of any indication, 2020 would have been another stellar year for multifamily housing. Same store revenues were 2% higher YOY, driven by 2-3% expansion in effective rents & strong 95% occupancy (+30 bps higher on average). Rates continued the trend of being higher every spring season, although there was a sharp 50 bps reduction in rental rates beginning mid-March as a result of COVID-19. Absorption remained high in Q1 (110-115% based on completions), particularly in New York, Los Angeles, and Dallas, although similar to rates, this has since deteriorated heading into Q2.
COVID-19, the great disruptor
The entry of COVID-19 and the accompanying stay-at-home restrictions by late March spoiled what would have been another brisk summer rental season starting May. AVB reported a sharp 40% YOY decline in leasing volumes during March which spilled-over to April, dragging physical occupancy by 75 bps MOM. This was a noticeable event across the sector: a 50-200 bps erosion in occupancy over the weeks following March.
Rents have been taking a hit as well. Historically, accelerating rents characterize second quarters as demand peaks during the summer season. Needless to say, this would not be as pronounced this year (ESS eyes about 3% contraction in rents for 2020). Expectedly softer demand in the short-term is the prime suspect, but lessor-lessee rent dynamics also contributed, as owners decided to pause on rental escalations for current leases; outside of the social aspect of having to support their tenants, rate hike freezes and other concessions (flexible payment terms, waiver of late-payment fees, among others) were also implemented to encourage renewals, which is important at a time of weak March-April applications. Coupled with tepid volumes as it is, the trade-off, of course, is on margins.
Social distancing & repressed mobility also called for operational adjustments. Virtual tours and online channels are becoming staples, to recoup lost traffic, although consensus agrees that on-site tours have more success at closures than virtual ones (at about 50-70% running rate). Thus, while virtual touring is a respectable placeholder, physically visiting units seems to still weigh heavily on the rental decision-making process, and we expect some ramping-up in here soon as more quarantine restrictions get relaxed.
There is also a non-quantitative aspect that is being challenged by the pandemic: home design & amenities. For most of Q2, social-centric amenities (e.g. gyms, pools, lounges) were essentially non-operational; those that did open were subject to only a limited number of users at any given time, reducing overall fees collected despite running operating costs on these amenities as normal, on top of the additional disinfecting expenses & labor required. Meanwhile work-from-home schemes call for design changes of units, with a push for dedicated spaces for office work in just as much as kitchen or living room spaces are key components of a unit’s layout. While the pandemic did not necessarily herald an apocalypse in shared spaces, we do think that there will be greater rethinking on common area development moving forward.
Not all markets are created equal, and it will show in the recovery numbers
Preliminary indicators for May showed an uptick in rental activity post the initial weeks of lockdown, loosely implying that demand has to some extent normalized and moving on from the initial shock. Renewals are returning above the 60% range across our coverage universe, and while occupancy is still down by about 50-200 bps relative to pre-COVID levels, conversion rates for tours have also been anecdotally improving which will help address subpar occupancies. MAA’s tail-end of May leasing volume has already expanded by about 6% versus prior years, an achievement considering the same number fell by 43% during the last week of March; ESS’s applications over the final weeks of May soared by 60% relative to April; EQR is receiving about 900 applications during the last week of May, versus the 375 per week average during the early days of the pandemic. Overall, some tangible strength is returning, at least on the volume side, even if rents have to take a hit as firms acknowledge the need to incentivize rentals.
The recovery, however, is observably uneven, even disproportionate. Market characteristics are playing a big role in how demand is behaving. For instance, CPT’s tourism-dependent South California units have been experiencing elevated delinquencies and lower collections versus their more tech-inclined counterparts in Northern California, given the disruption in employment in tourist traps of the former. ESS corroborates this somewhat, recording 8% delinquency in L.A. while Seattle & Denver both posted 3%. Meanwhile, recent expansions of tech firms in New York contributed to slightly rosier outlook over there, which is on top of the state’s already sticky retention even prior to the pandemic. Note that more than being geography-based, the uneven pace of recovery is most tied to the distribution of income & quality of employment in these areas—high-income tenants employed in low-risk-of-lay-off industries tend to be less sensitive to downturns after all. Finally, in terms of asset class, owners are reporting close to zero significant disparities outside of slight differences in April delinquencies of garden-style suburban versus high- and mid-rise, although whether this is ultimately COVID-caused or just a timing issue remains to be seen.
Cooling-off of supply expected, but ‘for how long’ is the question
Views are mixed as to multifamily supply in the coming quarters. For one, January & February completions were robust (about 3% higher than 2019-close) before starting to backtrack in March (-4% YOY). This means sentiment has turned tentative, after years of starts just scaling new highs. And while most development projects that have begun construction prior to the pandemic will still progress to completion, factors such as construction moratoriums, social distancing of contractors and builders, permitting & inspection delays, will all contribute to a general cooling of supply for likely the rest of 2020. Better visibility on the labor market will also be important to monitor moving forward, as the terrain for expansion opportunities will be more favorable in some parts of the map than others. On the other hand, initial Q2 numbers are implying some head-up in demand and that housing fundamentals are not in such a bad place as expected during the initial rout in March-April. It will be an interplay of these push-pull factors that will shape the development cycle over the next quarters.