Apartment Supply and the Beer Game Principles
In the 1960s, a group of MIT professors developed an innovative way to teach students the key principles of supply chain management. They called their creation Beer Game. The objective of the game is to meet customer demand while minimizing supplies on hand and total costs. But there is a lag effect from the time the upstream orders are placed to when the downstream supply is delivered. And just like in the game, bar owners try to accurately predict future demand. The same supply chain principles used in Beer Game also apply to the apartment market.
Apartment developers follow the same fundamentals as the Beer Game by forecasting demand in terms of future supply. However, the lag effect for multifamily development is much longer than the two-week time frame used in the game. Usual lead times for apartment construction to completion can run about 18 to 24 months. So in order to avoid excess inventory, investors need to be accurate when forecasting future demand.
MPF Research decided to observe the ratio of oncoming supply in terms of units under construction at the end of 2014 and permits issued in the year-ending November 2014 to the number of jobs added in the year-ending November. For the purposes of this article we will call this the “Jobs: Supply” ratio. Of course, job growth does not translate into apartment demand equally in every market, as several other factors influence absorption levels. However, this ratio gives visual clues for questions like:
- Which markets are starved for new supply? And which are potentially saturated with new supply?
- How well will new supply be absorbed in a given market?
- Where is job growth oversized/undersized relative to downstream supply?
For many of the 10 markets with high Jobs : Supply ratios, the ratio is relatively high at 4.5 or above, due largely to the limited number of oncoming units. Areas where the multiple is high – like Oakland, Riverside and Cleveland – are getting about seven to eight times as many jobs per apartment unit in the development and pre-development phases. On the other end of the spectrum, future supply levels are disproportionately high compared to job growth in Washington, DC and Philadelphia. For the U.S. as a whole, annual nonfarm employment growth has increased for four consecutive years, from nearly 2.1 million in 2011 to 3.2 million in 2014, according to the Bureau of Labor Statistics. The job growth level in 2014 was the largest since 1999, but growth in 2015 is expected to be even better. In fact, job growth looks so favorable in 2015 that much of the new supply concerns appear overblown. As employment growth remains above the long-term average, so do levels of future new supply. In fact, apartment construction levels in the MPF 100 have been meaningfully above their long-term average since mid-2012. While elevated from a historical perspective, permitting and construction activity have begun to come down from their recent peaks. Meanwhile, employment growth on an annual basis continues to surge, as seen in the chart below. That bodes well for lease-up of the oncoming supply in the top 100 metros.
Job growth in 2015 is expected to exceed the extremely strong levels in 2014, which should further suppress oversupply concerns in the investment community. And given those high-growth expectations, we wanted to take this study a step further by layering on the 2015 jobs forecast.
When the expected job gains for 2015 are layered on, ratios increase across the board. Multiples in cities with limited development activity relative to job growth – like West Palm Beach, Baltimore and Memphis – are expected to shoot up with huge job gains anticipated in 2015. But the robust pipeline activity in big job growth Texas markets – Dallas, Houston and Austin – will hardly move the needle on the overall ratio.
The same supply chain fundamentals of the Beer Game apply to the multifamily sector. If future demand is strong enough, it will absorb supply despite the lag effect. For the apartment market, revenue growth should strengthen this year in the wake of such strong employment growth. MPF Research believes that job growth in 2015 will continue to support long-term apartment supply expansion and revenue growth for the nation’s largest metros. These trends should further sustain multifamily development and provide a means to support vibrant rent growth, curtailing oversupply concerns.
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