Are Rent Renewal Costs Holding Off a Fed Rate Cut?

VettaFi contributor Dan Mika spoke with Danny Greenberger for more details. Greenberger is a portfolio manager on the Global Property Equities Team at Janus Henderson.They discussed how a quirk in the residential rental market may alter both the Fed’s path and the real estate sector.

Note: VettaFi has edited this conversation for clarity and brevity.

Dan Mika, VettaFi: Let’s start off with a technical question. Why was rent increasing for lease renewals in the past couple of months compared to 2021? Did landlords recoup that cost after COVID? Is it due to rate increases? What explains this?

Danny Greenberger, Janus Henderson: The typical historical rate of turnover for an apartment landlord — and we are talking about general institutional-grade, professionally managed assets — has been somewhere on the order of 50%. Historically, new leases — the leases that you charge on turnover rents where a prior tenant has moved out and you’re backfilling that tenant — those rates of change have tended to converge with the rates that you’re able to harvest on a renewal rent. That is someone who’s signed a lease, typically for 12 months. You’re sending along a renewal notice to them to re-up their lease for another period of time. So those rates have tended to converge.

Think about it like it’s a commodity business. There’s not a lot of differentiation in terms of unit types, amenity bases. When we’re talking about wide swaths of properties in certain locations, it’s a commoditized product. The new and the renewal lease rates tend to converge over time…

So why are renewals holding up (in price) at the moment relative to new lease rates? New leases tend to be a more accurate reflection about the pace of market rents — the actual change in market rents. Someone who has decided, “I’m vacating the unit, and I’m going to look for a new space.” This is a well-documented characteristic of the rental market. New leases tend to lag other measures of apartment rent changes by two to four quarters.

A variety of different academic studies bear this out, including those that have been done by various regional Feds. Chairman (Jay) Powell, at his most recent press conference… talks about the lag associated with the difference between the time when the new rents show up, which is the change in market rent, and when they actually flow through to the CPI data.

For instance, we have a new lease rental index from the Cleveland Fed. It was up 40 basis points in the first quarter. Renewals generally are running much higher than that, call it somewhere in the 4% range. Again, this is more institutional grade. I think what we’re going to see over time is a convergence between the two. The new leases have a two to four quarter (lag). They’re an indicator of what’s happening on the ground. The rest of the rental pricing indices will catch up to it over the next year or so.

And then the question, why have we seen a change relative to 2021 for instance? Large swaths of the economy were still closed in 2021. Therefore, new leases across a wide variety of markets in 2021 were actually down for at least the first part of the year. They didn’t really recover until the back half of 2021. You actually had both new and renewals down for a large part of the country in the first half of the year before recovering in the back half of 2021. I think that that’s attributable to the COVID reopening that was going on at various stages.

VettaFi: Does this have any ramifications for publicly traded REITs and the ETFs that are carrying them? If the Cleveland Fed is expecting the spread between the new asking rents and renewable rents to tighten in the next couple of quarters, does that suggest less revenue growth for REITs that have a lot of multifamily properties?

Greenberger: The short answer is yes. If you look at the last two quarters or so that are reported, we’ve seen that new leases, where the REITs have been down pretty much across the board for the apartment market, while renewal rents have been moderating as well. While the renewal rents are still positive, they are moderating. They’re moderating because of concessions and discounting that are being an ultimate rent reduction that are being offered as apartments reprice their units for new tenants.

That makes sense intuitively. For instance, one of the apartment REITs that has more of a Sun Belt orientation, their markets are getting hit by a lot more supply than other markets. Their new leases were down over 6% in the first quarter, and their renewals were up 5%. We think, how sustainable might that be? And we would actually say that that’s probably likely to be unsustainable.

If you think about the spread there in the first quarter, it’s an 11% spread between the discount you might find on a new lease relative to a renewal. You can either stay in your unit and take a 5% increase from this landlord, or you can decide to move. [You’ll] probably find something that’s comparable or even nicer in quality, because there’s so much new supply with all the latest amenities and features. [Then you] move at a discount to where you’re currently priced, and get about a free month or so as represented by the overall spread between the new (lease price) and renewal.

What does this mean? It means that people are going to respond to the concession discounts and lower rates offered by landlords across the country. They’re going to negotiate a lot harder on those renewal rents. That’s going to cause the renewal rent increases to decline, to moderate even further from here. You’re going to see more convergence between the trajectory of the new leases that we’re seeing getting signed and the rate of change on the renewal side.

The apartment REITs are poised to illustrate flattish to modestly positive revenue growth this year. But where they’re signing signing rents today, and particularly thinking about new rents being down year-over-year in many markets, it portends a weaker 2025 in terms of same-store revenue growth versus 2024. As you work through all these leases, they’re going to be reset at lower rates, coupled with the softer renewal pricing that we think is likely to come to fruition.

VettaFi: So after a couple of years where rent prices were increasing quite a bit, in part due to the pandemic, we’re expecting to see a slower, more headwind-filled year for the multifamily sector?

Greenberger: We think that the overall market is likely to be more moderate in its growth. We’re not likely to see more material growth coming from the sector until 2026. I think the big driver of that is the supply, and what that means for market-level vacancy.

The market is generally considered to be balanced when there’s 95% occupancy levels, or inversely, 5% vacancy. But I was just having a look at some of the key large metros. These tend to be mostly Sun Belt-related. Denver, Charlotte, Raleigh, Houston and Austin are all at vacancy rates north of 7% (vacancy). Dallas, Nashville, Charlotte (are) at 8%… We consider those markets tenant markets because of the amount of concessions and discounting that are on offer right now, as these markets field a ton of new supply and new deliveries.

Our REITs are collections of portfolios, some of which have exposure to these markets. The strategy there, when you’re below 95% occupancy, is to push. Ultimately, you’re trying to hold your occupancy there. So what does that mean? It means you offer lower rents, whether it’s in the form of new concessions or lower renewals. In some cases, we’re seeing outright renewals that are negative in an effort for certain communities to keep their occupancy level stable in the face of all the supply. The bottom line is you’re beyond a stable level of occupancy in many of these Sun Belt markets. That’s what’s pressuring both.

VettaFi: So Danny, your colleagues were saying that as shelter inflation slows down within the larger CPI basket, that might be the signal for the Fed to start making more cuts. What would rate cuts mean for the multifamily industry, for the REITs, and also for the construction industry?

Greenberger: I think ultimately, rate cuts are probably good for REITs and real estate more broadly, so long as the fundamental economy stays intact… Why might that be good for commercial real estate landlords or apartment landlords in particular is because the borrowing costs will decline. It might actually alleviate some of the pressure that landlords have on offering concessions.

If you’re a developer right now faced with these very high current interest rates on your construction loan, you’re probably offering quite a bit of discounting in order to lease up property. You’re looking to stabilize your asset and ultimately sell the asset, at least for your cost, if not a profit. To the extent that interest rates decline, their cost of carrying that construction loan would decline as well. Therefore they might be less willing to offer such widespread use of concessions on a weak sub-asset.

I think ultimately, it’s probably healthy. You’ll probably see some price support for rent and get us going in the right way again on rents, even though we haven’t really seen that yet. Concessions are still meaningful in the Sun Belt, particularly on those with newly leased properties. And then ultimately you are seeing a very modest decline in construction activity. Although, we’re still at generationally high levels of multifamily construction.

According to the Bureau of Labor Statistics, we are, as of the end of May, at 900,000 multifamily units (under construction)… You have to go all the way back to 1973 to see that amount of multifamily construction for the country. So we’re at a multi decade-high level. I think there’s going to be several quarters where the deliveries are elevated because of the amount of supply that we currently have under construction. And a lot of developers are hitting pause right now on new starts activity, which has declined about 50% from the peak.

I think if you see a sustained decline in interest rates, we would likely see more supply begin to commence, perhaps not in 2024 and early 2025. But if you look at the next cycle, in 2026, you probably are likely to have more of a sustained pickup in construction activity.

But I think interest rates would probably have to fall quite a bit before you have more construction activity to pick up for multifamily. Lower interest rates in general would imply better asset pricing for REITs, which is ultimately going to be favorable. You’ve already started to see that in periods where rates have declined. It’s most notable in November and December of 2023, when the 10-year (Treasury) dropped dramatically, over 100 basis points. REITs had a very strong reaction to that.

I think if rates fall from here, whether the Fed is cutting, or the 10-year (is) declining in lockstep with the Federal Reserve’s intentions, that’s ultimately going to be supportive for REITs and multifamily asset classes.

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