Tuesday, April 5, 2011

Rents will increase, but growth may be restrained in the short term

Vacancy rates have been surprisingly low in recent quarters. In spite of stagnant job creation, the demand for rental housing has nevertheless continued to be strong. This bucks a trend firmly established over the past decade in which vacancy rates have moved in tandem with the unemployment rate. Now, it seems that vacancies can fall even without job creation. This has been partially due to strong population growth, but has also been connected to a lack of recent multifamily construction.(See page 2 of the Year-End Housing Snapshot.) The state's real estate has also benefited from the fact that, until recently, Colorado's unemployment situation was better than the nation's.

While this indicates future rent growth and additional declines in vacancies, it is not yet clear how quickly rents will began to see substantial increases. Given the limited income growth in Colorado, there may still be downward pressure on rents in spite of tightening vacancy.

In this article, we'll analyze recent rent data in two ways that show limited upward pressure on rents right now.

Annual Increases

Market rents tend to slowly increase most of the time (although the increases don't necessarily keep up with inflation). To get a better sense of how much rents are increasing, I've plotted year over year increases in market rents (not inflation-adjusted)for the past three years:

Clearly, the recessionary period of 2009 and early 2010 shows mostly negative year-over-year increases in the state's metro areas. With the exception of Grand Junction, these numbers returned to positive territory, but note that annual increases in rents have not yet returned to the sorts of increases seen during 2008. 2008 marked the high point of rent growth following the 2002 recession in Colorado. Overall, the decade had been very lackluster for rent growth and occupancy, but the market was starting to show some strength before the 2008-2009 recession hit in Colorado.

Regional comparisons show that during this period, rent growth has been strongest in the Ft Collins-Loveland region and in Pueblo. A boom-bust pattern emerges in Grand Junction where the area posted some of the largest increases in rents prior to the recession, but has shown the largest decreases in recent quarters.

Overall, however, rent growth remains behind the rates seen in 2008, so the question arises of whether or not strong year-over-year increases in average rents will appear as expected by many in the industry.

Rental Losses

So far the analysis has centered on market rents, which is the "official" rent amount one's lease. Of course, this is not always the amount that is actually collected from the tenant. Actual rent can be diminished through concessions (such as "free rent" promotions) delinquencies and bad debts.

One way of anticipating increases in market rent levels is to look at changes in these rental losses. In the second graph I have included regional numbers for rental losses. An analysis of rental losses is helpful because increases in market rents are often presaged by declines in rental losses. Naturally, owners seek to decrease losses and eliminate concessions first, and then turn toward actually increasing market rents.

For readability's sake, this graph only goes back to Q42007. Rental losses (an specifically concessions) peaked in many areas back in 2005 and 2006,often reaching levels from 12 percent to 15 percent. So we know that rental losses are down from mid-decade. In more recent years, however, rental losses have moved little. In fact, the graph suggests that in many areas, rental losses are slightly higher in 2010 than they were in 2008.

Rental losses rarely fall below five percent for a sustained period, but with many areas reporting rental losses up near ten percent, it does not appear that the stage has been set for immediate large increases in rents.

While it's not impossible for rents to begin sharp increases in the near term, it is more likely that rental losses will show at least one quarter of sharp declines before market rents begin to move quickly upward.

Summary: Examining year-over-year changes in market rents and rental losses, there are still indicators that widely-anticipated increases in rents will not be felt as sharp near-term increases, but as slow, sustained increases. Once annual changes in rents approach historical highs, and as rental losses are eliminated, rents will then begin to move upward more quickly.

Note: Rents did increase - in both nominal and inflation-adjusted terms - during 2010, but the increases, when adjusted for inflation, come after several years of declining rents in real terms.