After a multi-year period of strong performance, apartment rent growth is decelerating fast and occupancies are on the decline. Surging supply is one reason. But we also have evidence the recent rise in interest rates is responsible for at least some of the market-level differences.

According to RealPage, apartment asking rents were up 2.4% over the past 12 months as of 2Q23, a sharp deceleration from 13.6% as of 2Q22. U.S. apartment occupancy in 2Q23 fell to 94.7%, the lowest second quarter occupancy since 2013.

Development activity is a significant near-term headwind³. As shown in Exhibit 5, this is particularly true in many Sunbelt markets, such as Austin, Charlotte, Nashville, Raleigh-Durham and Phoenix, where near-term supply forecasts are far above recent trends.

But this only considers supply-side dynamics. On the demand side, a key risk moving forward is the potential impact to metro economies, and thus the incomes of apartment renters, from higher interest rates. Here we look to the body of academic literature on regional economics, where evidence indicates that the vulnerability of metro area economies to interest rate changes increases based on four key factors:

1. Level of household indebtedness (through higher debt service costs)
2. Proportion of GDP generated by the manufacturing sector (due to being capital intensive and from import/export exposure through the exchange rate)
3. Proportion of GDP generated by the construction sector (due to being heavily capital intensive)
4. Proportion of GDP generated by small and mid-sized businesses (due to reliance on short-term financing)

Using these factors, we create an index ranking major U.S. metros by their sensitivity to interest rates, as depicted in Exhibit 6⁴. Those that demonstrate lower interest rate sensitivity should prove more resilient on a relative basis in the face of higher interest rates. Given the Fed's current tightening cycle began in early 2022, we might expect to see some impact in the apartment rent growth data already. We look at a simple relationship between year-over-year rental growth versus our interest rate sensitivity index in Exhibit 7.

A noticeable negative relationship exists between rent growth over the past year and how sensitive a metro's economy is to changes in interest rates. Generally, we see that many economies in the Northeast and Midwest show less sensitivity to interest rates and have outperformed over the past year. Indeed, the 10 metros ranked as least sensitive to interest rates have recorded rental growth of 3.1% over the past year through July; conversely, the 10 metros ranked as most sensitive to interest rate increases have seen rents decline 0.9%.

The end of the tightening cycle appears in sight, yet we know impacts from monetary tightening flow through the economy with a lag. With that in mind, we expect to see these relative impacts continue to play out at least through 2024, and possibly longer should economic growth and inflation surprise to the upside, requiring even more restrictive monetary policy from the Fed. Were that to be the case, current 2025+ rent growth forecasts for the most interest rate sensitive metros are likely to be too rosy.

³See https://www.pgim.com/real-estate/commentary/united-states-part-1-shifting-apartment-winds-whats-outlook-relative-market-performance.

⁴Note: Factor #1 is proxied by using debt to income ratios in each metro. Given data limitations, we use small business employment as a percent of total employment as a proxy measure for factor #4.