Last Cast Letter #21: The Case For More Class-A

The counterintuitive way new luxury apartments are bringing rents down.

September 30, 2024

Hi All - Happy Saturday. It’s the last day of the month, which means it’s time for the Last Cast Letter.

For the past two years, housing affordability has been at the top of everyone's mind — including Mr. Powell's — and it’s no mystery why: we are living through the least affordable housing market in recent memory. That’s all thanks to inflation, elevated interest rates, and low inventory.

Speaking to reporters after delivering a 50bps rate cut, Fed Chair Jerome Powell said, "The housing market is, in part, frozen because of lock-in, lower rates, people don’t want to sell their home because they have a very low mortgage and it would be quite expensive to refinance."

Powell also reiterated something we already know: "The real issue with housing is that we have had, and are on track to continue to have, not enough housing."

According to research published by Freddie Mac economists, the US housing market would need 1.5 million housing units built, and sitting empty, to bring housing vacancy rates back to historic norms.

That's on the buy side.

Unfortunately, there's not much respite regarding the rental side of the equation. According to the Bureau of Labor Statistics data, rents gained 0.4% in August from the previous month. This was down from July's 0.5% increase, but shelter costs overall ticked up and on an annual basis rose 5.2% in August, up from July’s year-over-year gain of 5.1%.

"The housing component of the inflation report was the only real standout surprise as it came in stronger than expected.”

Jack McIntyre, portfolio manager at Brandywine Global Investment Management, wrote in a note after the CPI's release.

So what's the solution?

In the same speech we mentioned above, Powell said, "... the supply question will have to be dealt with by the market, and also by the government."

When it comes to solutions from the government, President Biden suggested capping rent hikes to send a “clear message to corporate landlords.” We aren't going to go down that rabbit hole in this edition.

When it comes to market-based solutions, increasing inventory across the country is a logical next step. But, where on the spectrum should we start?

What if we told you that one way to lower rents for every class of building type was to actually develop Class-A, luxury, highly amenitized supply?

That's being done in some cities already and the results this high-end supply has on the rest of the market is worth noting.

The Great Filtering

Rather than re-write the tweet we came across explaining this waterfall effect, we're just going to include it below. But the concept is simple:

When cities see an oversupply of Class A units, what often happens is it's hard to rent them all. There are only so many wealthy tenants in the world. This is where you see incentives kick in. And when occupancy rates really start to worry the property owners, this is when you see rents come down.

Well, what do Class B tenants do when Class A rents come down, maybe to Class B levels? They say: “Why am I paying X to live in an apartment complex with no [insert amenity here: pool, new gym, dog spa, etc] when I could be paying the same price to live in a new development with [insert desired amenity] and more?” So the Class B folks level up to Class A buildings that have lowered their rents.

But what happens to the Class B properties? Well, now those owners might see their occupancy rates tick down. As a result, they might be forced to lower their rents. As in the example above, Class C tenants say to themselves: “Why am I paying X to live in an apartment with no [insert small upgrade here: individual laundry machine, dishwasher, etc] when I could be paying the same price to live in a Class B building with both of those (and maybe more) in my own apartment?” So the Class C folks level up to Class B buildings.

This puts pressure on the Class C landlords, forcing them to go through the same exercise. Maybe they start with incentives, or they just turn immediately to rental price cuts.

Remember, this all started at the top: an oversupply of Class A inventory that puts downward pressure on the entire ecosystem.

This isn't a new phenomenon. It's happened before and it even has a name: "Filtering". But it's always interesting when you see the data in motion. Rental housing economist, Jay Parsons, laid this out at the beginning of the year and recently updated his post. His explanation of what's happening at a city level is great, take a look:

When you build "luxury" new apartments in big numbers, the influx of supply puts downward pressure on rents at all price points -- even in the lowest-priced Class C rentals.

Here's evidence of that happening right now:

There are 21 U.S. markets where Class C rents are falling at least 4% YoY. What is the common denominator?

You guessed it: Supply.

Of those, all but one have supply expansion rates ABOVE the U.S. average.

There's no demand issue in any of these 12 markets. They're all among the absorption leaders nationally -- places like Austin, Phoenix, Salt Lake City, Raleigh/Durham, Atlanta, Tampa, Dallas, Charlotte, Orlando, etc.

But they all have a lot of new supply.

Simply put: Supply is doing what it's supposed to do when we build A LOT of apartments.

It's a process academics call "filtering."

New pricey apartments are pulling up higher-income renters out of moderately priced Class B units, which in turn cut rents to lure Class C renters, and on down the line it goes.

Less anyone still in doubt, here's another factoid: Where are Class C rents growing most?

You guessed it (I hope!) -- in markets with little new supply.

Class C rent growth topped 4% in 22 of the nation's 150 largest metro areas, and nearly all of them have limited new apartment supply.

Most new construction tends to be Class A "luxury" because that's what pencils out due to high cost of everything from land to labor to materials to impact fees to insurance to taxes, etc.

So critics will say: "We don't need more luxury apartments!" Yes, you do. Because when you build "luxury" apartments at scale, you will put downward pressure on rents at all price points.

Spread the word.

Jay Parsons

So when we think about how to bring that pesky shelter cost figure down, one way might be to encourage more luxury apartment development.

Any sort of friction that slows this process down: zoning, regulations, etc is where local governments would be wise to revise their playbooks.

As always, if you’re interested in investing alongside us, fill out the form below.

— Brooks