CREJ - Multifamily Properties Quarterly - October 2015
Coming out of the recession, the Denver multifamily market began an incredible run of rent gains – a streak so unprecedented that the only thing Denverites have to compare it with is the Colorado Rockies improbable push to the 2007 World Series. In January 2010, average effective rent for the Denver metropolitan statistical area was $828, according to Axiometrics. Today, that number is $1,364 – an increase of nearly 65 percent over five years. Median household income, however, has been on a different trajectory. In 2014, MHI for Denver was $66,870, according to U.S. Census. Compare this with a MHI of $58,732 in 2010, which presents an increase of just under 14 percent. The difference between 65 percent and 14 percent is monumental. The gap between rent growth and income growth resulted in a flight to affordability in metro Denver, with Class C apartments being the beneficiary. Annual effective rent growth for Class C properties is 13.1 percent, which is higher than Class B, 11.1 percent, and Class A, 7.6 percent. Occupancy tells a similar story, with Class C at 96.8 percent, which is higher than Class B at 96 percent and Class A at 95.3 percent. The difference in performance between urban and the less expensive suburban properties adds further evidence, with 11.7 percent annual rent gains for suburban properties, which is more than double the 5.4 percent for urban properties. It’s clear that the issue of affordability is having an impact on the rental market, which raises the question: How will today’s pricing affect tomorrow’s supply? It’s an important question for property owners and developers. Looking at historical unit mix trends, we can see that developers are responding by building smaller units. From the 1990s to the current decade, developers have increased the percentage of studios built six-fold. Over each of the last three decades, we’ve seen the percentage of two-bedroom units decline while studios and one-bedroom units increased. Digging a little deeper, we can pinpoint some notable examples of this shift. Denver’s central business district, the submarket with the highest average rent per unit, has responded accordingly – 73 percent of units delivered since 2013 have been studios and one-bedroom units, according to Apartment Insights. The Denver Tech Center followed suit; in 2014 and 2015, the DTC saw six projects deliver 60 percent studios and one-bedroom units. Of those six, two projects stood at 70 percent studios and one bedrooms, with another topping out at 80 percent. Perhaps the most notable example of this shift is Turntable Studios, which is a redevelopment of the old Hotel VQ and Denver’s first project with marketrate units smaller than 350 square feet. Micro units (typically ranging from 275 to 400 sf) first started popping up in high-density, expensive metro markets like San Francisco, Seattle, Boston, Washington, D.C., and New York, but today are found in less-likely metros, such as Des Moines, Iowa, Columbus, Ohio, and Omaha, Nebraska. These units typically rent on a dollars-per-month basis for 20 to 30 percent below conventional units, even though the rents per sf are much higher. From large to small markets, there is a demand for smaller units. It’s a price-point play for many renters, and it’s clear that the issue of affordability reaches well beyond Denver. While Turntable Studios is the first of its kind in Denver, it certainly won’t be the last. This is a new trend, so naturally there are skeptics questioning the exit for micro-unit investments 10 years down the road. However, even if rent-to-income ratios in Denver regress to 2010 levels, the migration is clear; the demand for affordable units will drive occupancy for micro units from a price-point perspective. According to the 2014 Urban Land Institute report, “The Macro View on Micro Units,” a survey of micro-unit renters showed 86 percent of respondents indicated price as a priority in the initial leasing decision. Additionally, 24 percent of respondents from a survey of conventional unit renters indicated they would be interested or very interested in renting a micro unit with 73 percent of respondents ranking price as the No. 1 or No. 2 reason they would choose a micro unit over conventional. It’s clear that many renters see an economic benefit to micro units, but also developers are economic beneficiaries. Because of the relatively fixed cost linked to kitchens and bathrooms, micro-unit projects cost 5 to 10 percent more per sf to develop than conventional projects; however, the 25 percent price per sf rent premium micro units typically achieve more than offsets the added cost. As the number of micro-unit projects grows, developers are creating a new market and value network – two key components of disruptive innovation – for lower-income renters. That’s not to suggest that one day new construction will consist of only micro units; rather, we should expect a greater diversity in housing options moving forward as projects with smaller units help combat market affordability concerns. “Affordability” is a relative term, however, and can be applied to high-income households as well. According to the U.S. Census 2014 American Community Survey, 30.8 percent of households in the metro Denver area have incomes of $100,000 or greater, ranking Denver 25th out of 381 MSAs for the highest percentage. Falling below Denver’s 25th spot are MSAs such as Los Angeles, Miami, Philadelphia and Chicago – markets where the portion of households earning $100,000 or more is smaller than in Denver, yet, according to Axiometrics, effective rents are anywhere from $115 to $795 per month higher than in Denver. Additionally, the 2014 ACS breaks down Denver’s renter households into segments based on household income, with the highest income segment being households earning $75,000 or more. Households in this segment outnumber lower-income segments, making up 22.5 percent of all renter households. Of the renter households earning $75,000 or more, only 3 percent are described as rent burdened (households contributing 30 percent or more of income toward rent), the lowest percentage of any household income segment. With all the talk over rents getting too high, there’s still a sizable portion of the rental market readily equipped to absorb higher rents. This, of course, is good news for developers and investors, as there’s a wide range of investment options, from the lower end of the market micro units to the upper end Class A core.