How deep is the demand for high-end apartments?

Kim Duty
Senior vice president, public affairs, National Multifamily Housing Council, Denver

One of the hallmarks of the current development boom has been the degree to which it has been focused almost exclusively on high-end apartments. Proponents say it represents a change in our housing preferences, with more and more higher-income households choosing to rent amenity-rich apartments. Critics point out that the nation is facing a near crisis-level shortage of affordable housing, yet the only properties being built are pricey Class A+ or luxury ones.

The apartment boom also has gotten more media attention this cycle than in the past. The homeownership count continues to edge downward, millennials are flooding into cities looking for the hip urban lifestyle, and baby boomers are downsizing and choosing to rent. Given the media headlines, it can be tempting to make this trend toward higher-cost, higher-rent infill construction seem like a new phenomenon. But it’s not. Conventional wisdom has long been that the only new developments that pencil in most areas are either high-end or low-income housing tax credit properties.

But old trend or new, a common worry is whether the industry is in danger of overbuilding the high end of the market. At the National Multifamily Housing Council, we heard this same refrain a year ago, two years ago, even three years ago in some markets. Yet, in most cases, demand has held up better than many expected, resulting in good absorption of the new supply of higher-end units.

Consider that in Denver, we have added nearly 30,000 new units over the past four years and are expected to add another nearly 12,000 in 2017. It’s fair to ask whether this can continue. After all, how many people can afford to rent these units? Mark Obrinsky, NMHC chief economist, recently looked at large, public microdata sets to see if we can get some valuable insight into who’s renting these high-end residences.

While a definitive conclusion is impossible, our analysis suggests that there are still many households – even many apartment renters – with sufficient income to rent new Class A apartments. Potential pullback in demand for these higher-end units in the future is more likely to reflect changes in resident preferences than affordability, with some residents perhaps choosing to spend less on their housing or opting for different types of housing altogether.

Many upscale renters downsize from single-family homes. Identifying “luxury” apartments using public micro datasets turns out to be challenging because they lack class ratings (A, B, C, etc.) since there is no uniform agreement on how to define these class ratings. We could theoretically use the apartment characteristics that these data sources provide to try to create our own ranking system. But the data sets are missing one critical piece of information – namely, exact location.

Instead, we looked at apartments where the rent is at or above the 90th percentile of all apartment rents in the same metro area, which we’ll call upscale apartments. While an imperfect measure – what qualifies as luxurious or upscale differs across diverse metro areas – it is, nonetheless, a useful proxy in gaining perspective on the high end of the market.

One of the first things the analysis showed is that there are some noticeable differences in who moves into upscale apartments. Data from the American Housing Survey on recent movers (those who moved within the past two years) showed that a slim majority – 51 percent – comes from other apartments. However, another 30 percent of upscale renters come from single-family, owner-occupied homes and 15 percent from single-family rentals.

In other words, 45 percent of those who moved into upscale apartments in the last year came from single-family houses. This is only a little higher than the 41 percent share in 1999-2001, suggesting this trend is not a temporary bump caused by the bursting of the housing bubble.

Clearly, existing apartment renters are not the sole source of demand for upscale apartments. The fact that just under a third of upscale apartment renters had previously been single-family owners/occupiers is noteworthy, particularly considering that single-family owners tend to move far less often than renters.

Recent movers to upscale apartments also are considerably less likely to live by themselves – just 31 percent of movers to upscale apartments are single-person households versus 43 percent of movers to other apartments. They are much more likely to have roommates (15 percent) than other recent movers (9 percent), and are a little more likely to be married.

These differences make sense. Roommates and married couples tend to have more income than single-person households, making such households more likely to be able to afford upscale apartment rents. In contrast, single parents are likely to have higher expenses relative to income than other households, so they may be less able to afford upscale apartments.

Many renters can afford expensive apartments. Among apartment renters, the pool of potential upscale renters is substantially larger than the number currently living in upscale apartments, at least using the standard affordability metric that says housing costs should be no more than 30 percent of income.

In fact, in the top 45 metros, there are 1.5 million apartment households that could afford to pay the 90th percentile rent but instead pay rent rates between the median and the 90th percentile. This is especially true in New York and Los Angeles, where there are the most apartment households that could afford the 90th percentile rent but currently pay less.

Locally, in the Denver-Aurora-Lakewood metropolitan statistical area, there are 31,021 apartment renters who can afford rents at the 90th percentile but are renting between the 50th and 89th percentile, according to NMHC tabulations of 2014 five-year American Community Survey microdata. The rent used to represent the 90^th percentile in Denver was $1,464.

The top 10 metro areas with renters who could afford to pay at the 90th percentile or more is noted on the table. Denver is No. 15 on the list of the 45 MSAs analyzed.

Most of the metro areas on the top 10 list also have seen considerable apartment development in recent years. This suggests that resident incomes might not be as large a governor on potential new development as some have suggested.

That said, the high cost of new development in many of these metros means that rents on new apartments may exceed, perhaps by a lot, the 90th percentile rents on the existing stock. In addition, many residents may be happy paying a good deal less than 30 percent of their incomes for rent, even if it means fewer amenities or inferior location.

The more educated, the more likely to live in upscale apartments. We also analyzed the key economic, social and demographic variables available from the American Community Survey to identify any additional distinguishing characteristics of upscale renters. Only one stood out: education.

Among those who can afford 90th percentile rents, both nationally and locally, there is a strong relationship between the number of years of education and the rent they pay; the more schooling, the more likely they are to pay upscale apartment rents.

For example, among those who can afford 90th percentile rents in Denver and are living in upscale apartments, 45 percent have four years of college under their belts; another 26 percent have five or more years of college. By contrast, among those living in apartments with rents in the 50th to 74th percentile range, 33 percent have four years of college education, while 16 percent have five or more years.

It is unclear why greater education leads to a greater likelihood of living in an upscale apartment, even after taking into account income. There are likely other characteristics of an individual or household that play a factor. But it does suggest one additional element to look for when trying to estimate the size of potential upscale apartment demand.

Coming back to the question of whether the industry is in danger of overbuilding the high end of the market, our analysis suggests that, from a macro-market perspective, there is still a substantial reservoir of households who could afford upscale apartments.

The data shows that many high-end renters are essentially lifestyle renters or renters by choice. Many are highly educated and are married or living with roommates, making them more willing and able to pay higher rents for upscale apartments. Moreover, a good portion of them have had a single-family living experience, either as an owner or renter, prior to living in an upscale apartment. For whatever reason, an upscale apartment now makes more sense for their current needs.

But arguably more important is the fact that there appears to be more depth to this market, as there are many apartment residents who could afford to pay upscale apartment rents but spend less. So the question is less about whether they can afford it and more about whether they see enough value in upscale apartment living to pay the higher rents.

Featured in CREJ’s May Multifamily Properties Quarterly.