Renting an apartment in Greater Phoenix has become an increasingly costly endeavor since the onset of the pandemic. Zillow reports that as of July, the typical monthly rent in Phoenix is $1,949, up from $1,408 in March 2020 — a nearly 39% increase. At the same time, University of Arizona’s Economic and Business Research Center notes that building permits issued for all types of housing in the Valley are down almost 30% year-over-year as mortgage rates have increased and inflation remains persistent-yet-slowing.
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This mismatch of supply and demand has caused a trickle-down effect in the Phoenix multifamily sector, where those who would otherwise purchase a home are instead renting Class A apartments, which pushes folks already in that product class to Class B apartments.
“I’ve been in this business for 40 years, and I have never seen pressure on rents like we’ve seen in the last three years,” says Reid Butler, owner of Butler Housing Company. “To buy a house these days, your credit better be in good shape, and you probably need a 20% down payment. Interest rates are still over 7% when just two years ago they were around 4% for a mortgage. Is the unattractiveness of the housing market part of why there’s so much demand for apartments? I agree with that.”
At the same time, there’s a narrative being spun from national economists, says Zach Haptonstall, CEO and co-founder of Rise48, that Phoenix is actually overbuilt since organic rent growth is trending down. Yet, many of the new units are being built in the far Southwest and Southeast Valley, with build-to-rent, single-family housing being a newer product appealing to those who can’t quite reach homeownership or otherwise don’t want to.
Rise48, which focuses on infill multifamily housing in Metro Phoenix often built in the ‘80s, doesn’t invest in those outlying areas because there aren’t many apartments that match the renter demographics the company targets.
“Our residents will likely never buy a house, and they can’t afford luxury Class A apartments,” Haptonstall says. “Since the cost to build has been so expensive, you have to build luxury Class A and command premium rents to make those deals pencil economically. And all these people can’t afford that.”
Even if the market is potentially overbuilt today, he continues, many projects have been put on hold because of interest rate increases, so the pipeline of new units will not keep up with demand.
Ryan Abbott, executive vice president at Clayco, adds that tighter lending practices, along with elevated labor and material costs, is impacting development even though lease rates are flattening.
“Where all of these [economic factors] converge is deal complexity — read ‘delay’ — in closing a modern deal,” he says. “The greatest impact on development and construction is how to predict an undeterminable, moving point in the future. This complexity requires smart, agile, hardworking, courageous participants.”
Phoenix multifamily affordability
The U.S. government operates the Federal Low-Income Housing Tax Credit (LIHTC) program, which incentivizes the construction or rehabilitation of housing units for those making less than 60% of an area’s average median income. For developers and investors to qualify for the tax credits, the project must adhere to specific guidelines and rent restrictions laid out by the federal government.
One developer operating in Arizona that specializes in affordable and workforce housing, along with public housing redevelopment and urban renewal projects, is Gorman & Company. It has about 2,000 units in Arizona, with around 1,000 under construction and about 1,000 additional units in the pipeline.
Even though Gorman & Company is very active in the market, the current conditions are burdensome, says Brian Swanton, president and CEO of Gorman & Company. Rising interest rates, supply chain problems and construction cost issues are especially tricky due to criteria that must be met to access LIHTC and other funds.
“We have government-restricted rents, so it’s not like we can just increase the rents on people to make up for losses,” Swanton continues. “We’re locked into an affordable rent structure for typically 30 years or longer. That means we’re having to go back to other funding sources and get creative with reducing project costs to keep deals alive. I know a lot of developers have lost projects because of changing market conditions.”
On the other hand, demand for affordable housing is so high Swanton says the company doesn’t worry about filling apartment buildings — about 17,000 people are on waitlists for properties owned by Gorman & Company. There’s also a heightened awareness from legislators regarding the need for affordable housing.
“[Gorman & Company uses] fairly complicated capital structures, tax credits and other government financed vehicles to get projects done,” Swanton explains. “When stimulus funds and other state, local and federal resources come down the pike, they’re often targeted to our business. The Inflation Reduction Act, the tax credit passed in Arizona, the $150 million investment in the state’s Housing Trust Fund, and the American Rescue Plan has funneled funds into affordable housing.”
Thanks to these measures, Gorman & Company hasn’t had to delay closing or construction on its projects.
“We’ve left a lot of profit on the table,” Swanton notes, “and we’ve had to fund gaps at the corporate level and write checks we didn’t think we’d have to in order to stay alive. But for the most part, the federal, state and local governments have rallied behind the industry to keep everyone’s pipelines as active as possible because of the nature of the crisis.”
The missing middle
No program akin to the LIHTC exists to encourage developers to build units that cater to renters who make too much money to live in an apartment built with LIHTC funds but can’t afford a luxury apartment. This segment is often referred to as attainable or workforce housing and is the toughest part of the market to serve, according to Butler.
“You’ve got a market where there’s a fair amount of supply at the top end, unlimited but critical supply at the lower end constrained by financing, and then virtually no new supply for the middle market. [This demographic] ends up living in older housing, which is not always acceptable, and the location may not be ideal. The middle part of the market is also the hardest to finance, which is why you don’t see it,” he says. “If you’re building new housing for the middle of the market, it’s pretty much the same cost as building for the top end of the market.”
When land, labor and material costs are essentially equal between workforce and luxury apartments, it’s easy for developers to pour a little more capital into the project and charge higher rents, Abbott notes. This, he says, ultimately de-risks the investment by maximizing the lease rate. This may be a canny business decision, but it contributes to the issue of the “missing middle.”
Butler says he often hears people talking about the new apartment buildings that have gone vertical around the Valley as proof that the problem is being addressed, but it’s still simply not enough supply. There are projects in the pipeline, but they are taking longer to deliver — up to two years instead of one — and are concentrated in a few submarkets such as Downtown Phoenix and the Central Corridor since some subregions in the Valley don’t want higher density housing.
“It’s hard to comprehend, but when you add 100,000 people to Metro Phoenix, that’s about the size of Metro Flagstaff, and that’s happening every year,” he notes.
As for solutions to the supply problem, Butler says the Arizona Multihousing Association has worked for the last few years to create more supply and density.
“Incremental density would make a big difference in my view,” he continues. “I would find ways to add density and then address the other, real issues, whether that’s parking, traffic, privacy or [preserving] historic buildings. Even giving bonus density to urban infill, because it takes advantage of existing infrastructure.”
Greater Phoenix, he continues, has a history of building horizontally rather than vertically, which makes trying to build up rather than out more difficult, but the added density helps address the overall supply issue.
“More supply takes away the pressure on rents,” Butler concludes. “That’s what we need — more supply, more options and finding a way to build into that missing middle, maybe with some new product designs where apartments can be a little smaller and higher density. Does every two-bedroom apartment need two bathrooms? We have to find ways to create these incremental solutions to make housing a little less costly and therefore a little more affordable.”
