• Surging apartment supply will probably restrain rent increases
  • To propel inflation, other prices will need to take up slack

Welcome news for America’s renters could be unhelpful for the Federal Reserve.

A 42-year high in the number of apartment buildings under construction points to an impending surge in supply that portends a moderation in the cost of shelter, which in June capped the biggest 12-month jump in almost a decade. Any cooling in the most pronounced driver of inflation means the Fed will have to wait even longer to reach their 2 percent price target -- a prerequisite for some policy makers to raising interest rates.

“To expect rents to stay this strong would be a bit of an overreach,” said Richard Moody, chief economist at Regions Financial Corp. “Will the market be able to absorb all that supply that’s coming on? I have my doubts. We’ll see rent growth decelerating.”

Costs for shelter accounted for 63.9 percent of the run-up in the consumer price index excluding food and fuel in the 12 months ended June, the most since 2007 and almost four times the contribution of medical care, the next-biggest source of upward pressure, according to the Labor Department. That boost will be difficult to repeat.

Shelter inflation is “reaching a plateau,” Goldman Sachs economists wrote in a June research note, and while it may remain elevated into next year, they don’t project any additional pickup. Counterparts at Morgan Stanley went one step further, forecasting a deceleration over the next couple of years.

Growing Supply

“Additional supply in the multifamily market caps the upside in rental-price growth as vacancy rates are now rising and supply is catching up with demand,” Morgan Stanley economists wrote in a July 17 note. That’s among reasons they project inflation, which has failed to reach the Fed’s goal since 2012, will again fall short in 2017.

Rents and owners’ equivalent rent, or OER, together make up more than 40 percent of the core consumer price index and about 17 percent of the Fed’s preferred price measure that is tied to consumer spending, excluding the volatile food and fuel components.

Shelter prices -- including rents, OER and lodging away from home -- jumped 3.5 percent in June from a year earlier, the most since 2007.

A look back to the housing crash helps explain what unfolded. Demand for rentals surged as millions of homeowners became tenants when their properties were foreclosed. As the economy emerged from the recession in 2009, it still took several years for residential construction to pick up.

By mid-2015, about 43 million households lived in rental housing, an increase of almost 9 million from 2005 and the largest gain in any 10-year period on record, according to Harvard University’s Joint Center for Housing Studies.

The jump in demand and lack of supply caused rents to soar, eventually sparking a surge in construction of multifamily units. That market became so hot that builders which focused on single-family homes also jumped in.

All those projects are now coming on line: The number of buildings under construction with five or more units climbed in June to the highest since 1974 and the most were completed since 1989, Commerce Department data show.

“Everybody got enthusiastic about building, and what we’re seeing now is an excess supply,” said Ryan Severino, a senior economist at Reis Inc., which tracks apartment trends. “I don’t think apartment demand will collapse, but it’s struggling to keep pace with the huge volume of construction.”

Discounts, Incentives

Building exceeded net gains in occupancy in the second quarter for a fifth straight period, according to Reis figures. Effective rents, which take into account discounts and incentives, slowed in the first half of 2016 after growing 5 percent at the end of 2015. Reis projects gains of 3.7 percent this year and 3.4 percent in 2017.

Growing supply will push up vacancy rates this year and next, Reis forecasts. Newer properties are having difficulty attracting first-time tenants or renters from competing buildings, Severino said.

Ben Weixlmann, who recently relocated to Washington, saw seven apartments over two months before moving with his girlfriend into a new development in Arlington. For a few hundred dollars more, they snagged a two-bedroom place instead of having to settle for a one-bedroom.

“We found somewhere we’re both quite pleased with,” said the 28-year-old, who works for an aerospace company. What helped cinch the deal: a 14-month lease for 12 months of rent.

Of course, what ultimately shapes inflation also depends on how other costs behave as rents cool. A sustained pickup in wages may prompt companies to raise prices, while a stronger dollar will lessen pressures. Health-care costs, which have a greater influence on the Fed’s preferred price gauge than on the consumer price index, have been cooling.

Nonetheless, until supply realigns with demand, the pipeline of new properties may “prove hard for the market to digest,” Severino said.

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