New Apartment Boomtowns May Be the Next Bubble

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It was hard enough to build apartments in high-cost cities like San Francisco before the pandemic triggered an exodus from urban neighborhoods, and now the economics are even tougher. But that's giving smaller cities a chance to catch up to the rental boom that previously lifted other non-coastal metros like Austin and Denver. For builders, it's a riskier calculation.

The divergence in the rise and fall of rents between high-cost and low-cost metro areas means it makes better sense to build apartments in places like Spokane, Washington, than San Francisco — at least in the short-term.

To best understand this, look at rental prices in different metro areas now compared with the onset of the pandemic last spring. The June data from Apartment List shows that in the highest-cost metro area, San Francisco, rents are still down almost 15% from where they were in March 2020. On the other end of the spectrum, the metro areas with the fastest rent growth have been those that came into the pandemic with some of the lowest prices in the country, including Fresno, California, and Albuquerque, New Mexico.

Rising construction costs are another big factor for anyone looking to build anything right now. Rick Palacios Jr. of John Burns Real Estate Consulting showed earlier this month that the cost of building a home has risen by 22% year-over-year. And while apartment buildings aren't the same as single-family houses, both need plumbing and drywall and paint and construction workers, so a broad-based increase in the cost of construction is going to pinch multi-family developers as well.

So those builders in San Francisco are dealing with rents that are down 15% and construction costs that are up 20%.

Meanwhile, rent prices are booming in interior-West metro areas like Spokane, Washington and Boise, Idaho, rising more than 30% since March 2020. That makes those places more attractive to builders than they were 18 months ago, even with the higher construction costs. To the extent those cities missed out on last decade's Millennial stampede to downtown apartments in places like Denver, Nashville, and Austin, Texas, there's an additional incentive to build in places that need to catch up.

That raises some other questions, though. As economic conditions return to normal, we don't know how long these higher rents are sustainable in metro areas that benefited from changed priorities during the pandemic. We had a decade to acclimate to the idea of technology companies and young college-educated workers moving to the urban centers of large metro areas all over the country, and apartment developers built housing to meet that demand. Right now, the theme makes sense of homebuyers moving to Boise where they can afford a bigger house than they could on the West Coast. But are there really going to be growing numbers of people wanting to rent luxury apartments in metro areas of 250,000 to 500,000 people that aren't set to land the next technology-company campus? That's perhaps a riskier proposition for apartment developers.

Another, more sobering thought is what all this might suggest for rents down the road in San Francisco. If the increase in construction costs is permanent, to get back to pre-Covid economics for apartment developers we might need to see market rents that are far higher than they were in early 2020. Maybe it'll take one-bedroom apartments going for $4,000 a month to get the dirt moving on multi-family housing. And until that happens, fewer housing units will be delivered in the city over the next couple years than we otherwise would have expected. It's possible the current lower-rent period is just a passing reprieve for Bay Area renters, similar to how things were for a few years after the dot-com bubble burst in the early 2000's — before rents soared to previously unthinkable heights.

So we should expect the apartment construction pipeline in high-cost cities to slow down until rents rise enough — or costs drop enough — to give developers the economics they need again. But that doesn't mean apartment construction will dry up everywhere. It'll just shift to where the rents have risen enough to make it profitable.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Conor Sen is a Bloomberg Opinion columnist and the founder of Peachtree Creek Investments. He's been a contributor to the Atlantic and Business Insider and resides in Atlanta.

©2021 Bloomberg L.P.

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