Multifamily

Magnetic Attraction

Investors remain drawn to multifamily assets.

By Beth Mattson-Teig |

Rising interest rates may prompt apartment buyers to modify expectations and strategies, but these factors haven’t diminished their desire for multifamily properties — at least not yet. The voracious demand that has fueled transaction activity and capitalization rate compression across the multifamily sector in recent years appears steadfast in many markets. “We are seeing sales volume that is equal to or slightly greater than the same time last year,” says John W. Stone, CCIM, principal, managing director of Multifamily Services/Foreign Investments at Colliers Arnold in Clearwater, Fla. “There is no shortage of bidders. There is no shortage of cash. There is no shortage of want.”

National apartment sales activity surged during the first half of the year with $49.4 billion in properties trading hands — a 55 percent increase compared to the same period a year ago, according to Real Capital Analytics. However, sales volume spiked during the first quarter due to a large Archstone portfolio sale. Extract that sale from the mix, and apartment sales rose a more modest 9 percent, according to RCA.

Multifamily has been commercial real estate’s strongest magnet, drawing a wide range of investors during the past several years. The sector was the first to recover from the recession and the combination of solid occupancies, strong rent growth, and available financing have attracted investors seeking properties that deliver steady cash flow. Yet industry experts are beginning to question whether that demand is sustainable in light of rising interest rates and lower expectations for rent growth. Some institutional buyers have already pulled back due to the cap rate compression that is occurring among core properties in top markets.

“I think 2014 will be a slower year because those higher interest rates are going to impose themselves on the deal structure sooner or later,” Stone says. “You can’t keep lowering your yield requirements and think somehow you are going to survive.”

Yet, for now, the demand to buy apartment properties remains robust. Competition for deals has some buyers willing to adjust return expectations and price higher capital costs into a purchase in order to close deals. “Nine out of 10 buyers who come to the Tampa Bay market looking to buy apartments go home without anything,” Stone says. So, buyers are willing to absorb higher capital costs in order to clinch acquisitions in a still competitive market, he adds.

Solid Fundamentals Spur Demand

Demand remains strong across the board from the relative safe haven of stabilized class A properties in major metros to value-add and opportunistic buys among class B and class C properties where investors see more upside to boost rents and realize higher yields. That continued appetite for apartments is not surprising to some industry veterans. “There is almost an instatiable drive for yield since alternative yields are so low, and the dynamics of the apartment market are still strong,” says George Tikijian III, CCIM, president of Tikijian Associates, a multihousing investment advisory firm in Indianapolis.

That demand is supported by very accessible financing and strong underlying fundamentals. “I think investors like the stability of multifamily in comparison to the other asset types,” agrees Thomas McConnell, CCIM, director of Marcus & Millichap’s National Multi Housing Group in Elmwood Park, N.J. National multifamily occupancy at midyear remained steady at 4.3 percent. The accelerated pace of rent growth that the industry has enjoyed in recent years has moderated, but not enough to scare off buyers. Asking rents rose to $1,110 per unit in second quarter — a 2.3 percent year-over-year gain, according to Reis.

While multifamily development is on the rise, it remains relatively controlled and focused mainly in areas where there is high demand and high growth. In addition, recovery in the single-family housing market is not expected to create a drag on performance in the apartment market going forward. Historically, when the single-family market has been healthy, the multifamily market has been healthy for the same reasons. Job growth generally sparks new household creation — for both home ownership and demand for rentals.

The apartment market in San Diego is “as good as it gets,” says Terry Moore, CCIM, director and principal at ACI Commercial in San Diego. San Diego’s stable rental market is attractive due to its diverse economy and barriers to entry for new development, including restrictive zoning and high fees. “Slow growth forces and NIMBY-ism have combined so that in 28 of the last 30 years our county has not built enough new apartments to satisfy demand,” Moore says. Apartment vacancies in San Diego are below 5 percent, which is standard for the area, and rental increases are higher than the inflation rate.

Despite those attractive qualities, San Diego is a tough market to enter for outside investors. Ninety percent of the apartment stock is valued less than $2 million with properties that typically range between 5 and 15 units, most of which are bought by local investors. “The bulk of the fortunes made in San Diego apartments are in renovating 1970s assets and raising rents more than 10 percent,” Moore says. That has been a common theme for a generation and is still prevalent in today’s market, he adds.

For example, Moore sold a nine-unit property last spring that had not been renovated in more than 20 years. The property received multiple offers and ended up selling above list price with a signed purchase agreement within two weeks. The new owners completed renovations and raised rents by more than 20 percent within six months. “It is still a seller’s market. There are still more than 20 buyers for every seller,” Moore says.

Price Correction Ahead?

Despite its continued performance, the apartment sector is not immune to the effects of rising interest rates and higher capital costs for buyers and owners. Since mid-May the 10-year Treasury rate has increased about 100 basis points from 1.9 percent to nearly 3 percent as of mid-September. Higher interest rates naturally raise questions about the subsequent impact on operating income and cap rates. Interest rates going up normally means that cap rates are going up. “We know that’s coming. It just hasn’t happened yet,” Stone says.

During second quarter, garden apartment properties sold for an average price per unit of $85,046 and an average cap rate of 6.5 percent, while mid- and high-rise apartments sold for an average price per unit of $201,515 and an average cap rate of 5.2 percent, according to RCA.

One theory is that a rising interest rate environment means that the economy is improving, which will allow buyers to justify paying premium prices. Buyers could argue that they will now be able to underwrite more aggressively with expectations that they will be able to push rents higher more quickly. The problem is that apartments are already coming off a streak of rent increases, and most industry experts are projecting fewer rent increases in 2014. Rents in class A properties in particular have increased considerably during the past few years and are now bumping up against the ceiling in many markets.

“While we still expect some rental rate increases, they are not going to be the 5, 6, and 7 percent increases that we saw two years ago,” Stone says. Now owners are just hoping to get annual increases of 2 to 3 percent, he adds.

Although competition will keep pressure on pricing, a shift is inevitable, especially if rates continue to rise. The rising interest rates have yet to impact cap rates in markets such as northern New Jersey. Thus far, cap rates remain near historical lows in every county, generally averaging in the mid-6 percent range and dipping below 5 percent for top properties in the best locations, McConnell notes. However, that shift will eventually occur as both sellers and buyers adapt to the higher rates and adjust expectations. “Some of the properties I sold in the low interest rate environment in first quarter wouldn’t sell at the same price today,” he adds.

Quest for Yield Continues

The competition for properties coupled with higher interest rates is prompting buyers to adjust both return expectations and investment strategies. Buyers are continuing to venture into secondary markets in hopes of finding more favorable pricing. Although major markets such as Los Angeles, Washington, D.C., and New York City are still posting the highest sales volumes, there is a notable increase in sales in secondary markets such as Charlotte, N.C., Jacksonville, Fla., and Raleigh/Durham, N.C.

If buyers can’t find what they want at a price they are willing to pay in Tampa or Orlando, Fla., they are going to Jacksonville, which historically has been overlooked by investors, according to Stone. As a result, Jacksonville has claimed some of the highest per unit sale prices in the state during the past 18 months, with 26 properties sold during the first half of the year for a total price of $446.7 million, according to RCA.

Buyers are also shopping for properties that offer more opportunities to boost net operating income. “Right now, class A assets are pretty stable, but they don’t have a whole lot of upside left,” Stone says. Class B properties have more potential to improve occupancies and raise rates. In addition, class B and class C properties are likely to gain favor among investors because there is more opportunity for rent growth. “There are value enhancements that you can make to improve your rental structure and stabilize your occupancy,” Stone says.

Investment sales among class C properties are heating up in markets such as Phoenix. In 2012, Phoenix-based Gerchick Real Estate closed $45 million in multifamily sales and the firm expects to double that this year. “This market is incredibly active,” says Linda Gerchick, CCIM, designated broker and team leader at Gerchick Real Estate in Phoenix. Some investors have been tired of waiting on the sidelines and are ready to make a move, which is driving demand. The desire to buy investment property with good cash flow is another attractive incentive, she adds.

Phoenix is experiencing a flurry of rehab and retrofitting activity among older properties. The improvements make the rents “go over the roof” and properties have been selling “like crazy,” Gerchick says. That demand is driving prices higher. In the past year, prices for class C properties have doubled from $17,000 per door to $36,000 to $38,000 per door. Gerchick is currently negotiating with a California buyer who is interested in purchasing a 72-unit property in Phoenix that has been rehabbed and will likely sell between $38,000 and $40,000 per unit, she says.

Clearly, investors still have abundant capital to place and apartments remain an attractive choice. “Activity has not trailed off. There is still a great deal of demand from buyers, really across all segments,” says Tikijian. Tikijian sold 14 apartment properties in 2012 and expects to close on a comparable volume in 2013. “I see nothing on the horizon that will reduce the demand to invest in apartments,” he says. “If interest rates continue to increase, it could have a negative impact on pricing, but it won’t necessarily curb investment sales.”

Beth Mattson-Teig is a freelance writer based in Minneapolis.

Demand Drives Development

The economy’s continued recovery has launched a new wave of development in the multifamily market.

Construction activity is ramping up across the country in markets ranging from New York to Oregon. More than 100,000 new units are expected to be completed this year, and that resurgence is just the start of a new era of building over the next few years, according to Reis.

The development drought appears to be over in markets such as Las Vegas where the future is looking brighter for both apartment owners and developers. “Developers are bullish for the next several years with some 10,000 units either planned or in the pipeline,” says Garry Cuff, CCIM, vice president at Colliers International in Las Vegas. The improving economy, including the addition of approximately 20,000 new jobs over the past year, has helped to fill existing apartments in the Las Vegas metro area, which spans a total inventory of about 160,000 units. Occupancies for class A properties currently stand at 94 percent, while class B and class C properties are only slightly lower at 93 percent.

“Barring some unforeseen downturn in the national economy or negative geopolitical event in the world, multifamily properties should perform very well compared to the past several years and I see Las Vegas climbing out of the basement compared with other parts of the country,” Cuff adds.

Although there are some concerns that the added inventory may have a negative impact on occupancies, most metros are likely to see those new units absorbed relatively quickly. Many of the properties are coming online at occupancies of 85 percent or more, indicating that demand for apartments remains strong, according to Reis.

For some investors, urban redevelopment projects are presenting an opportunity to tap into growing demand from renters to move into revitalized downtown neighborhoods. In Indianapolis, for example, recent redevelopments include transforming historic Bush Stadium into the new Stadium Lofts. The first 138-unit building opened earlier this summer. Such conversions are ideally suited to the growing demand for urban living. “Our downtown market has been the strongest market by far for years,” says George Tikijian III, CCIM, president of Tikijian Associates, a multihousing investment advisory firm based in Indianapolis.

Currently, there are about 5,000 apartment units located in downtown Indianapolis with an estimated 2,000 new units that will be added over the next 12 months. Although that activity will likely create some oversupply in the short-term, Tikijian expects renters to absorb those units by 2015. “All of the factors that have caused high demand for apartments over the last few years are still in place,” he adds.