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Primed for a soft landing

The current economic expansion, just a few months shy of its 10th birthday, is the longest on record. This kind of longevity tends to create two separate camps of thought: There are those who expect the good times to go on indefinitely, and there are those who worry with each passing month that it will come to a crashing end.

In reality, both history and economics tell us that we will suffer an economic downturn. Unfortunately, they do not tell us when it will occur or how deep it will be.

Despite the hopeful wishes of the first group, it is sound business practice to look ahead and consider how the apartment industry will fare when the good times end. The National Multi Housing Council's (NMHC) research finds that while a recession would certainly end the remarkably good run the sector has experienced recently, there is reason to believe that the industry may be less sensitive to an economic downturn now than it has been in the past.

Real estate and the economy It is well known that the real estate industry is more cyclical than most. While the inflation-adjusted growth rate of the Gross Domestic Product (GDP) has ranged from a low of negative 1.9% to a high of 7.3% over the last 20 years, the swing in multifamily investment has been much greater, growing as much as 30% and declining by more than 17%. This is due, in part, to what is known as the "accelerator effect," which essentially says that industries show greater volatility when they depend on the change in the level of economic activity instead of the overall level of activity.

More importantly, the time lag between the decision to build a new apartment property and its actual completion can contribute to cycles of over- and underbuilding. That is, when demand for apartments increases, new apartment construction begins, and it continues as apartment demand continues to rise. When demand slows, however, new supply continues to rise as previously started apartments are completed.

The end result is that supply overshoots demand, sometimes by a considerable amount in markets already overbuilt. While all commercial real estate is subject to this kind of cycle, the apartment industry is somewhat better off than other real estate sectors because the lag between groundbreaking and completion tends to be longer for office, industrial and retail space than it is for residential buildings.

Two other factors also make the apartment industry vulnerable to economic cycles. First, household formation, which determines the number of potential new renters, is strongly influenced by economic conditions. Second, the industry relies heavily on external finance, the cost and availability of which can vary considerably over the economic cycle.

Theory aside, it should be noted that real estate cycles are not always correlated with upswings and downturns in the overall economy. In the late 1980s, for example, major changes in the federal tax code sent real estate into a tailspin while the rest of the economy continued to expand. Still, demand for real estate is likely to be stronger in a good economy than a faltering one.

Apartments and recession To get some perspective on how the apartment industry will fare in the next recession, it is tempting to look at past recessions. This turns out to be less helpful than might be supposed, however, for the simple reason that structural differences make comparisons difficult.

For example, although the 1990-91 recession was relatively mild, multifamily construction fell by more than 20%. This was less the result of recession, however, than the Tax Reform Act of 1986 and the overbuilding of the 1980s, to which the industry was still adjusting. Hence, that experience sheds little light on how today's industry would be affected by an economic downturn.

Similarly, the recession of 1981-82 is also not a very useful guide since today's apartment industry looks quite different. Compared with the early 1980s, there are more large, well-capitalized owners and managers. Apartment finance is now better able to tap the capital markets through mortgage securitization and REITs. And perhaps most importantly, better information is available to everyone, including lenders, which should mitigate the level of overbuilding that can occur.

Even though the direct experience of previous downturns offers little help, we can get some insight by looking at the industry's performance in the current economic expansion. And current performance suggests that the sector is indeed less volatile now than in the past and more able to withstand a downturn.

One helpful metric is multifamily investment as a share of GDP (see chart). For industries that tend to fluctuate more than the overall economy, as apartments do, this ratio will vary considerably, rising during an expansion and falling during a contraction. But looking at 1993 to the present, we find that the sector has been relatively stable.

That is, multifamily investment has gradually increased to the current plateau, with very little variation around the general trend. This is in direct contrast to the 1975-1982 period - prior to the impact of the 1980s tax changes and the 1990s recovery - when multifamily investment was significantly more volatile.

Statistical analysis confirms this casual observation. If we identify a trend line for each of the two periods and measure how close the actual multifamily investment/GDP ratio is to those lines, we find that the trend lines explain less than 25% of the variation in the multifamily share of GDP in the 1975-82 period, but almost 85% of the variation from 1993 to the present.

There are other reasons the apartment industry could be better shielded against the next economic downturn. First, demographic and lifestyle changes, especially the desirability of intown locations, should remain favorable for apartments in the near term. Two of the groups most likely to select apartment living over the next 10 years are people in their mid-20s and empty nesters in their 50s., which all happen to be two of the fastest growing age groups.

Second, NMHC's recent "Capital Upgrading to Apartments" report projects an increase in apartment upgrading. This should help to take up some of the slack from any decline in new construction that would take place during a recession.

Finally, we are starting off from a better position this time around because of the simple fact that today's rental markets are tight instead of already overbuilt, which should mitigate the decline in demand associated with a downturn in the national economy.

A few words of caution Some caveats are in order, however. First, the recent evidence only covers the expansion, so this conclusion is as yet untested. Second, even if the multifamily share of GDP holds steady, a decline in GDP means a decline in multifamily investment.

A downturn is still a downturn, and fewer new units will be built. But all in all, the multifamily sector is well-positioned to weather the inevitable slowdown of this unprecedented economic growth.

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