Thoughts from PCC’s CIO

By Darren Hulick

As of Q3 2024, we have reached an inflection point in our focus markets—Austin, San Antonio, Dallas, Denver, and Salt Lake City—where projected unit deliveries over the next 12 months are below units delivered over the trailing 12 months. Below is the information on unit deliveries over the previous 12 months vs. expected unit deliveries over the next 12 months, according to RealPage’s Q4 2024 Apartments Market Reports:

• Austin – 31,305 units delivered over the last 12 months vs. 18,883 units expected in the next 12 months
• San Antonio – 12,543 units delivered over the last 12 months vs. 6,247 units expected in the next 12 months
• Dallas – 44,218 units delivered over the last 12 months vs. 32,736 expected in the next 12 months
• Denver – 19,937 units delivered over the last 12 months vs. 11,100 expected in the next 12 months
• Salt Lake City – 6,730 units over the last 12 months vs. 5,907 expected in the next 12 months

The strong supply pipeline over the last 12-18 months has introduced several challenges for owners and operators, including lower occupancy, declining rents, increased concessions on stabilized properties, shifting tenant demographics and, as a result, rising bad debt.

The issue of shifting tenant demographics warrants further discussion. As the increase in supply has led to decreasing rents and increased concessions, this has allowed renters of class C assets to move up to class B assets, renters of class B assets to move up to class A, and renters of class A assets to move into brand new, state of the art class A+ assets. This migration has led to an increase in bad debt, particularly within workforce housing, as tenants who previously may not have qualified under higher rent-to-income ratios now qualify under lower rent levels. This shift has made tenant screening and creditworthiness more important than ever and a key focus for us.

Over the past 12 months, rent growth in our markets has ranged from -2.2% in Salt Lake City to -7.1% in Austin. Despite declining rents, occupancy has increased by a modest 0.3% to 0.8%, with current rates ranging between 92.0% and 94.3%, which is well below peak occupancy levels in mid-year 2022. There is a notable correlation between negative rent growth and the percentage of new inventory added—markets with higher inventory increases have experienced more pronounced rent declines. However, as mentioned earlier, the data is telling us we are past peak supply in these markets. Absorption is still very strong in these markets and barring any kind of black swan event, we believe we have likely seen peak negative rent growth and are looking for rent growth to move closer to zero or slightly positive in the next 12 months, depending on the market.

Given these trends, how are we adjusting our underwriting based on both short-term supply and demand projections as well as longer-term market outlooks? Generally, we are still marking rents to market based on comparable properties if we see an opportunity for a value-add business plan, though usually favoring a more moderate scope in order to keep our basis low, but we are underwriting zero rent growth (or slightly negative depending on the market) in year one with an expectation of getting back towards a long-term average of 3% rent growth in year two. Additionally, we are underwriting lower occupancy for the next 12-24 months, higher concessions, and higher bad debt, at varying levels depending on the market.  This is based on what we are actually seeing in our markets today as we expect the next 12 months to be similar to the previous 12 months based on the forward looking supply pipeline.  Looking further ahead, we anticipate rent growth will likely exceed 3% in 2026 and 2027, as construction starts peaked in late 2022 and early 2023, and permitting activity has since dropped significantly across all of our markets and nationwide.  Having said that, we are hyperfocused on untrended yield on cost to ensure that our analysis makes sense based on today’s rents and not due to expected future rent growth trends.  

Lastly, due to the elevated supply pipelines in our markets and the uncertainty it causes, we are generally underwriting low leverage with agency loans on stabilized properties and capping value-add business plans at 60% loan-to-cost (we will consider 65% loan-to-cost for relatively light value-add business plans). I once read somewhere that the use of leverage magnifies returns for equity in good times, but it also narrows the range of possible outcomes that a leveraged asset can withstand in bad times.  I think this statement is particularly valid in today’s market. Given the uncertainty caused by the robust supply pipelines in some markets, limiting leverage on future acquisitions will allow these properties to withstand a larger range of possible outcomes and maximize the probability of success.