As the commercial real estate world

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1 HANS NORDBY is the managing director of CoStar Portfolio Strategy in Boston, MA. MICHAEL TAYLOR is manager of U.S. Forecasting at CoStar Portfolio Strategy in Boston, MA. LEE EVERETT is a real estate economist at CoStar Portfolio Strategy in Boston, MA. leverett@costargroup.com Averages Tell You Little: The Effects of Multifamily Construction on Rents HANS NORDBY, MICHAEL TAYLOR, AND LEE EVERETT As the commercial real estate world moves through 2015, no single market factor shines brighter than the abundance of for-rent multifamily product coming to market. Growth rates for apartment stock in the coming year will easily surpass those of the technology boom; according to the CoStar Commercial Real Estate Multifamily Database, total 2015 new supply will equal roughly 2.5% of existing stock in the top 54 markets, a full 0.5% higher than its growth during the tech boom. As new deliveries flood the market, market average rents will begin to decline. Investors and property managers who can identify how their buildings fit into the market and react intelligently will be better able to cope with this developing market. This analysis will provide a unique window into how these new deliveries will affect existing properties within the marketplace by looking beyond a metropolitan average figure. Dipping one hand in a bucket of ice water and the other in a bucket of scalding water may in theory result in an average body temperature. But just as each hand doesn t register an average temperature, each building in a metropolitan area does not have an average response to an influx of newly built apartment buildings. The future of any existing project after a spate of apartment construction depends on several factors. In this article, we explore four important factors that affect how new apartment community construction affects existing apartment communities. First, we look at the distance from an existing high-quality community to the newly built project, because we would expect rent growth in the existing high-end apartment communities to be hurt by new, higher-quality, and more desirable apartments. Second, we demonstrate that average-quality apartments are positively not negatively affected by the construction of high-quality apartments in their neighborhood. Third, for the submarket containing the new and existing projects, we explore how the density level has differing effects on the health of existing projects in the face of new supply. Finally, we demonstrate that the impact of distance on existing project fundamentals declines with greater distance. It is important to note that this analysis focuses on effective rental rates. These rates remove building-specific concessions, or discounts, from their publicized asking rent. Although we feel this is the best indicator of overall market health, it is not the sole measure. Building occupancy can be sacrificed in order to keep rental rates higher, and the rate at which this happens varies by market. Also, the rate of economic and household growth within a market creates different rental rate fluctuation points. This analysis IT IS ILLEGAL TO REPRODUCE THIS ARTICLE IN ANY FORMAT 96 AVERAGES TELL YOU LITTLE: THE EFFECTS OF MULTIFAMILY CONSTRUCTION ON RENTS SPECIAL REAL ESTATE ISSUE 2015 Copyright 2015

2 focuses on two markets, Boston, an imperial, well-aged, traditional gateway market, and Austin, a newer, nonconstrained-growth market. Although they differ on the exterior, they do share similar strong economies and a clear central living and working core within the greater metropolitan area. These conditions allow us to produce actualized results without introducing new variables into the analysis. The analysis is also centered on a time period marked by a steadily rebounding economy nationally and exceptionally strong economies in these two metropolitan areas. Markets that have less job growth or more new apartments delivering, such as Houston in 2015, could face different results. CORE METHODOLOGY We use the CoStar commercial real estate multifamily database for our analysis. It provides propertylevel data, including latitude, longitude, number of units, effective rent, and year built; each property is also placed in a submarket and given a building rating. In all, the CoStar database contains information for more than 450,000 multifamily properties and over 14 million rental units. We construct the distance from new deliveries effective rent growth in several steps. First, for each property we calculate an annual rent from the quarterly rent data by averaging the four quarters of rent in each year for properties with rent data in all four quarters. We decided to use annual rents in this study for several reasons: 1) to align rents with deliveries, where year built is more available in the data than quarter built; 2) to compensate for quarterly seasonality in the rent data; and 3) to control for a changing mix of units available for rent in each building throughout the year, such as more higher-floor units available in one quarter and more lower-f loor units available in another. Next, we take the natural log of the annual rents and difference them to get annual rent growth data for and for We use the natural log difference instead of the percentage change so that increases and decreases in rent growth are balanced. For each market, we also remove outliers by eliminating the 1st- and 99th-percentile rent growth observations. We separate the dataset into two groups based on year built those properties built before 2013 ( existing ) and those built in 2013 ( delivered, constructed, or new ). For each existing property, we check to see whether any delivered properties are within varying distance intervals of 0.05 miles, 0.10 miles, etc. For example, Exhibit 1 highlights existing properties in Austin that are within a half-mile of newly delivered properties. For each distance interval, we now have a set of existing properties that have deliveries nearby and a set that do not. And for each distance interval, we calculate the equal-weighted average rent growth of properties where a delivery occurred within that distance. As the distance grows, the average rent growth within it will approach the market average rent growth. CLASSIFYING PROPERTIES In order to examine the effects of new deliveries on different strata of the multifamily property universe, we use three different factors to classify each property into groups based on quality and market density. Organizing by quality allows us to compare the impact of new deliveries on the same kind of product regardless of location. Today s multifamily environment is characterized by a f light to quality, and developers and E XHIBIT 1 Existing Properties within 0.5 Miles of 2013 Deliveries in Austin SPECIAL REAL ESTATE ISSUE 2015 THE JOURNAL OF PORTFOLIO MANAGEMENT 97

3 investors focus primarily on building high-end products to achieve their characteristic high rental rates. Fully understanding the impact of new deliveries requires determining how these primarily high-rent deliveries will affect the rental rates of existing products of varying quality. To accomplish this, we use CoStar s building classification system, which looks at a number of variables, including building age, unit finish level, and available amenities to arrive at a Star rating from 1 5 for each building. A rating of 5 signifies the highestquality product and a rating of 1 the lowest. This system removes the subjectivity inherent in having a building s broker or manager define its class, instead utilizing an objective system to evaluate all buildings nationally. For the sake of universality, one can think of a 4 or 5 Star property as an A property. These properties are typified by multiple upgrades (granite countertops, stainless steel appliances, high ceilings, durable building materials, energy-efficient central air, multiple community amenities, etc.). A 3 Star property can be thought of as a B property. These are older, typically constructed with brick, stucco, or similar building materials, and have limited or no community amenities. In this article specifically, we limit our sample to buildings rated 3 Star and above buildings with a quality that ranges from average to best of the best. We group together 4 and 5 Star buildings, as they tend to behave similarly, whereas 3 Star, or average buildings, react to market changes differently. To organize properties into different geographic areas, we use CoStar s multifamily submarkets, which group properties together into similar neighborhoods and geographic areas. CoStar has created approximately 2,000 apartment submarkets nationally that segment similar geographies, based upon quantitative factors, such as localized demographics (income, population density, population age, etc.) and qualitative market expertise. There are approximately 30 submarkets in both Boston and Austin. Grouping properties by submarket allows us to investigate the depth of the apartment market as it affects observed properties. Understanding how a property fits within a market requires defining the depth of the localized apartment submarket. In today s urban-centric world, metros centered around a high-density living and working core are following an inside-out development pattern. To investigate what this means to the overall apartment market, we group properties into two buckets, either high or low density, by submarket. Exhibit 2 shows the properties in Boston by high and low density. We create the density measure by dividing the total number of units by the area of each submarket to arrive at a density in units per square mile. We then use k-medians to cluster similar-density submarkets into the two separate groups high and low and arrive at a cutoff between the two groups of approximately 650 units per square mile. This allows us to investigate submarkets where development and existing product are colliding at the greatest magnitude, compared with submarkets where nodal density still allows breathing room for existing properties, alleviating downward pressure on rents. Using market depth to categorize buildings also allows this analysis to grow over time as development continues to move outward from the inner core of each metro and, ultimately, changes the makeup of entire submarkets. Lastly, Exhibit 3 summarizes the effective rent growth for all properties in the Austin and Boston samples. As we can see, overall rent growth in both markets is strong, but there are differences, depending on density E XHIBIT 2 Properties by High- and Low-Density Areas in Boston 98 AVERAGES TELL YOU LITTLE: THE EFFECTS OF MULTIFAMILY CONSTRUCTION ON RENTS SPECIAL REAL ESTATE ISSUE 2015

4 E XHIBIT 3 Summary of Effective Rent Growth and New Deliveries and building rating. The exhibit also includes the counts for 2013 deliveries. As expected, the vast majority of new deliveries are higher-class 4 and 5 Star properties. In high-density Boston, for example, 10 new 4 and 5 Star properties delivered in 2013 alone, compared with the 41 existing previously a one-year increase of 24%. The various effects of these 2013 deliveries on 2014 rent growth are what we ll explore in the following sections. RENT GROWTH AND DISTANCE FROM NEW CONSTRUCTION Now we consider the effective rent growth of existing properties and how distance from newly constructed properties affects that growth. Specifically, we look at effective rent growth from 2012 to 2013 (before the construction event) and compare it with rent growth from 2013 to 2014 (after the construction event). In both cases, we examine the effect of properties delivered in 2013 on the effective rent growth and how it varies by submarket density, building rating, and distance from new construction. We expect the relationship at the market level between rent and distance to be relatively neutral as distance to new construction increases. Alternatively, we expect there to be a differentiated relationship between 3 Star- and 4 and 5 Star-classified properties. In the year before the construction event, we expect the rent growth for 4 and 5 Star properties to be higher the closer that they are located to the 2013 delivery. This is because developers tend to build new properties in areas with previously strong rent growth for similar properties. Prior-year 3 Star rent growth won t be as important, however, and may not have a clear trend, because developers are not necessarily concerned with the rent growth of these less competitive properties. In the year after the construction event, we expect that the closer a 3 Star property is to new construction in 2013, the higher its rent growth should be. And the closer a 4 and 5 Star property is to such a new project, the lower its rent growth should be. This differentiation is for several reasons: First, newly constructed properties are more likely to be high quality and will more readily compete with the existing 4 and 5 Star properties, which puts negative pressure on their rents. Second, the newly constructed properties will often bring more and better amenities to an area new shops and restaurants to cater to the new tenants. These improve the overall neighborhood and attract tenants who are willing to pay relatively more, which allows 3 Star properties to charge higher rents. Exhibit 4 shows the relationship between effective rent growth and distance from new construction for high-density submarkets in Austin in both the year before and the year after new construction in The exhibit is further broken out by 3 Star and 4 and 5 Star properties. Rent growth from 2012 to 2013, in the year before new construction, is stronger the closer a property is to the new construction that delivers in This is the case for 3 Star and 4 and 5 Star properties, and it matches our expectations that developers choose to build in areas with above-average rent growth. Rent growth from 2013 to 2014, in the year after new construction, is slower than in the previous year. Due to the competition from newly delivered nearby properties, these buildings are not able to raise their rents as much as in the previous year. As distance from new construction increases, 4 and 5 Star properties do not see a change in their rent growth. These properties, which were outperforming other 4 and 5 Star properties the previous year, are now performing in line with them. The story with 3 Star properties, however, is different. For more than a half-mile in the proximity of new construction, 3 Star properties enjoy around 3% more rent growth than both the market and 4 and 5 Star properties. These 3 Star buildings outperform both the market average and other 3 Star buildings farther from SPECIAL REAL ESTATE ISSUE 2015 THE JOURNAL OF PORTFOLIO MANAGEMENT 99

5 E XHIBIT 4 Austin Rent Growth in High-Density Submarkets E XHIBIT 5 Austin Rent Growth in Low-Density Submarkets new construction. The difference of means between the 3 Star and 4 and 5 Star properties, however, is only statistically significant at the 15% level at a distance of around three-quarters of a mile. We believe this is due to a relatively low sample of 3 Star buildings with nearby deliveries in high-density submarkets of Austin. Exhibit 5 shows the same relationship as the previous exhibit for low-density submarkets in Austin. Here, the rent growth reveals a similar picture as for high-density submarkets 4 and 5 Star rent growth is stronger the closer a property is to upcoming new construction. The 3 Star properties do not show a clear rent growth response, likely because these properties are not as competitive with new stock and do not factor as much into developers decisions. Next year, after the 2013 deliveries, overall rent growth again slows relative to the previous year s rent growth due to the increase in deliveries. However, where last year 4 and 5 Star properties in proximity to upcoming construction outperformed both 3 Star and other 4 and 5 Star properties farther away, in we see the opposite. Near new construction, 4 and 5 Star properties have much lower rent growth lower than that in both 3 Star and other 4 and 5 Star properties farther away. The 2013 deliveries compete with existing 4 and 5 Star properties and hold their landlords to below-average rent raises. In contrast, 3 Star properties see higher rent growth the closer the property is to new deliveries over 3% more rent growth than for 4 and 5 Star properties within up to 0.4 miles. And although the advantage for them continues to diminish farther out, the difference of means is statistically significant at the 10% level until around one mile. 100 AVERAGES TELL YOU LITTLE: THE EFFECTS OF MULTIFAMILY CONSTRUCTION ON RENTS SPECIAL REAL ESTATE ISSUE 2015

6 E XHIBIT 6 Boston Rent Growth in High-Density Submarkets E XHIBIT 7 Boston Rent Growth in Low-Density Submarkets Exhibit 6 shows a similar comparison as the previous two exhibits for high-density submarkets in Boston. Similar to the case in Austin, rent growth is stronger for 4 and 5 Star properties the closer they are to upcoming new construction. And rent growth for 3 Star properties near upcoming deliveries is slightly below other farther-away properties in the same class. After new deliveries in 2013, the rent growth by building rating switches compared with the previous year. Now, 4 and 5 Star buildings near new construction underperform relative to 3 Star and 4 and 5 Star buildings farther from any new construction. The 3 Star properties receive a 2% boost to rent growth over the market average within 0.2 miles of new deliveries. They see an even greater boost of 4% over 4 and 5 Star property rents until around a half-mile from new deliveries. In fact, the difference of means between 3 Star and 4 and 5 Star properties rent growth is statistically significant at the 5% level for the entire two-mile distance. Exhibit 7 shows the effective rent growth relative to distance for low-density submarkets in Boston after new deliveries in We only look at the rent growth because there are not enough rent observations for existing 4 and 5 Star buildings during the time period. In low-density areas of Boston, 3 Star properties have higher rent growth within around 0.5 miles of new construction than other farther-away 3 Star properties. The 4 and 5 Star properties, however, see an increase as well. Although our expectation was for lower 4 and 5 Star rent growth in proximity to new construction, we can offer several possible explanations. First, while there is a good sample of both low-density 4 and 5 Star existing properties (147) and low-density deliveries (20) not very many of the deliveries are near the existing 4 and 5 Star properties. This gives us a relatively low sample of 4 and 5 Star rents with nearby new construction. Second, we believe that Boston is unique in that its low-density submarkets contain high-density nodes with recently increasing numbers of high-paying employers. These create micro areas where 4 and 5 Star properties can do well despite nearby construction, due to the relative lack of competing properties. ADJUSTED RENT GROWTH AND DISTANCE FROM NEW CONSTRUCTION We now take a look at adjusting the rent growth in order to isolate the effect of new construction only. In the following section, we investigate whether 3 Star properties with nearby new buildings also outperform other 3 Star properties in the same submarket, as well as whether 4 and 5 Star properties near new properties also underperform in their submarkets. In order to learn how a property with nearby deliveries performs compared with SPECIAL REAL ESTATE ISSUE 2015 THE JOURNAL OF PORTFOLIO MANAGEMENT 101

7 its peers without nearby deliveries, we first calculate the average rent growth for each set of properties by submarket and by building rating. This gives us a baseline average rent growth for each submarket and building rating; we then adjust the rent growth of each property by subtracting this baseline average growth. Using the adjusted rent growth, our expectation is that 3 Star buildings near new deliveries will outperform other 3 Star buildings in the same submarket. As new construction brings more amenities to an immediate area, these will allow 3 Star landlords to charge relatively more rent than landlords farther from the new construction. We also expect existing 4 and 5 Star properties to underperform their peers in the same submarket as the shiny new building next door steals their tenants, they must lower rents to compete. Exhibit 8 shows the relationship between submarket- and building rating-adjusted rent growth from 2013 to 2014 compared with distance from new 2013 deliveries in Austin. It is broken out by high and low density and by 3 Star and 4 and 5 Star. Similar to the unadjusted rent above, adjusted rent growth for existing 3 E XHIBIT 8 Austin Adjusted Rent Growth ( ) Star buildings is noticeably higher than for existing 4 and 5 Star buildings in both high- and low-density areas. In high-density areas, 3 Star rent growth outperforms its peer rent growth by 1.5% when properties are within around a half-mile of newly delivered buildings. By contrast, 4 and 5 Star rent growth is neutral relative to its peers growth and underperforms compared with 3 Star buildings in terms of the advantage offered by nearby deliveries. In low-density areas, 3 Star properties outperform their peers by 0.5% rent growth out to 0.35 miles from new buildings, whereas 4 and 5 Star properties underperform their peers by 1% or more for almost a mile. We also see that 3 Star properties within 0.15 miles of new construction enjoy, on average, 2.5% more rent growth than 4 and 5 Star properties a difference of means statistically significant at the 10% level. And while the 3 Star advantage decreases farther out, around a 1% rent difference remains until 0.6 miles. Exhibit 9 shows the same relationship as the previous exhibit for Boston. In the high-density areas of Boston, 3 Star properties earn around 1.5% higher rent E XHIBIT 9 Boston Adjusted Rent Growth ( ) 102 AVERAGES TELL YOU LITTLE: THE EFFECTS OF MULTIFAMILY CONSTRUCTION ON RENTS SPECIAL REAL ESTATE ISSUE 2015

8 growth than their peers at a distance of 0.35 miles from new deliveries and this is statistically different from zero at the 10% significance level. That contrasts sharply with 4 and 5 Star properties, which actually see 2% lower rent growth than that of their peers when within 0.2 miles of a newly delivered building. And 3 Star properties enjoy a 2% or greater rent growth advantage over 4 and 5 Star properties for around a half-mile. In the low-density submarkets, 3 Star buildings have a 2% rent growth advantage over their peers within 0.4 miles of a new delivery statistically different from zero at the 10% significance level. In this case, existing 4 and 5 Star properties also show a rent growth advantage over their peers. Although this is counter to our initial expectations, as detailed earlier when discussing unadjusted rent for low-density Boston, we believe there are explanations for this behavior. E XHIBIT 10 Benefits of 3 Star over 4 and 5 Star Properties ( ) A CLOSER LOOK AT THE EFFECT OF NEARBY DELIVERIES Exhibit 10 presents a selection of the previous findings in a slightly different format, highlighting some of the trends we found. Specifically, it shows the distance from new deliveries at which 3 Star properties enjoy a positive rent growth differential over 4 and 5 Star properties. For example, for rent growth in highdensity areas of Austin, 3 Star properties have, on average, 2% more rent growth than 4 and 5 Star properties when within one mile of a newly delivered property. Looking at rent growth across both markets, we find that the average distance over which 3 Star properties have a rent premium of 4% over 4 and 5 Star properties is 0.2 miles from new deliveries. For a rent premium of 3%, the average distance increases to 0.55 miles. And for a 2% rent premium, the average distance is 0.9 miles. By investing in an existing 3 Star property within one mile of a new delivery, owners earned on average 2% 4% more rent growth than did owners of similarly located 4 and 5 Star assets. For adjusted rent growth, the advantages are lower but still positive. For a rent growth premium of 2%, the average distance from new construction is 0.25 miles. And for a rent growth premium of 1%, the average distance extends to 0.55 miles. After stripping out all the other factors that affect rent growth, closeness to new construction still confers a greater advantage to 3 Star E XHIBIT 11 Benefits of 3 Star Properties Relative to 3 Star Peers ( ) SPECIAL REAL ESTATE ISSUE 2015 THE JOURNAL OF PORTFOLIO MANAGEMENT 103

9 properties compared with their peers than it does for 4 and 5 Star properties compared with their peers. In Exhibit 11, we now take a look solely at 3 Star properties with nearby new deliveries compared with all 3 Star properties located in the same submarket. The exhibit shows the distance from new construction at which a positive rent growth premium of 1.5%, 1%, and 0.5% occurs in 3 Star properties relative to their submarket and building rating as a whole. In high-density areas of Boston, for example, a 3 Star property has 1% more rent growth when it s within 0.4 miles of a delivery than its submarket and building rating average rent growth that is, it outperforms its peers by 1%. The average distance from new deliveries up to which 3 Star properties outperform their peers by 1.5% rent growth is 0.35 miles. For a 1% rent growth premium, the average distance from new construction is 0.45 miles; for a 0.5% rent growth premium, the average distance is 0.6 miles. Regardless of market density, owning 3 Star properties is more advantageous when other buildings have been recently delivered nearby. CONCLUSION As alluded to at the beginning of our article, the effect of a newly constructed high-quality apartment building on an adjacent property s rent depends partially on whether the existing building is a high-end project, and the type of node high or low density in which the property is located. An average-quality building will earn increased rents as the surrounding neighborhood gentrifies, or at least improves in tandem with the new supply. The effects are seen most strongly in neighborhoods such as Alewife or the Seaport in Boston, where the gentrification impact is driven by apartment and retail/office development. Buildings as simple as a Whole Foods (Alewife) or as major as the luxury mixed-use Fan Pier (Seaport) can greatly intensify the neighborhoodlifting impacts of new multifamily supply. Our research shows that in high-growth, economically strong markets, such as Boston and Austin, new apartment construction has exactly these rent growth effects. On the one hand, new deliveries compete with existing high-quality properties, which forces them to lower their rents. On the other hand, new construction helps the existing average properties, by competing for a different tenant base while also making the area more attractive for new shops, restaurants, and other development that will improve the quality of living in the area. Renters are attracted to these new amenities and those who can t afford the shiny new buildings but still want to live in the area fork over a little bit more to live in an average building nearby. Over the next few years, this distinction will be important for investors. As possibly the largest supply wave of apartment construction in decades bears down on American cities, investors will need to do everything they can to gain an edge, or in some cases to mitigate their losses. Our study is certainly not the end of what we ll be able to learn from this historic construction wave in the coming years. While we were able to show significant rent growth differentiation by building quality in high-growth markets, markets with different drivers and in different parts of their growth cycle can also be researched. Other factors beyond distance from new construction could be studied as well such as occupancy rates, macroeconomic drivers, and household growth. Although increasing supply at the market level results in aggregate pressure on occupancies and rents, certain properties can transcend these pressures and can even benefit. Buildings that strike the right balance between location and rent stand to gain the most. And our study shows that in order to find these advantageous buildings, investors need to use building-level analysis, adding an important piece to the puzzle of determining how buildings will perform in the face of new construction. To order reprints of this article, please contact Dewey Palmieri at dpalmieri@iijournals.com or AVERAGES TELL YOU LITTLE: THE EFFECTS OF MULTIFAMILY CONSTRUCTION ON RENTS SPECIAL REAL ESTATE ISSUE 2015