Market Data

Cities Provide Incentives to Increase Urban Multifamily Development

Nationwide, multifamily real estate is mired in a cyclical downturn, as many markets struggle with rising vacancies and declining rents. Most developers have scaled back building plans, and development activity in early 2003 increased in only a handful of metropolitan markets compared with a year ago, according to M/PF Research, an apartment market research company. However, demographic, social, and economic changes are creating long-term opportunities for multifamily developers and investors to acquire, build, and redevelop properties in urban cores.

After years of decline, downtown populations are growing again. Demand for central business district rental space is driven by more professionals desiring to both live and work downtown. In addition, a growing number of empty nesters want to rent or buy CBD units. Whether their motivation is a shorter commute, closer proximity to restaurants and entertainment venues, or the preference for an urban lifestyle, tenants are showing increasing interest in downtown residential properties.

Cities Provide Incentives

To encourage developers to build new apartments downtown or convert existing buildings to rental units, many cities are providing a number of tax, economic, financial, and regulatory incentives.

The fate of multifamily projects often depends on such incentives because, although the number of investors and lenders for these developments is growing, it remains difficult to finance urban projects. They typically are more complicated and more expensive than suburban multifamily projects, and more often than not the land and buildings take longer to acquire and develop, creating a higher cost basis, which translates into higher rents in order to generate a yield that can be financed.

To counter this, many cities such as Dallas, Denver, St. Louis, and Los Angeles have created downtown historic districts, and developers are utilizing the tax credit to buy historic properties for multifamily adaptive reuse projects that preserve building façades but redesign and renovate the interiors. For example, a Dallas partnership of business and community leaders is spearheading an effort to transform the historic Main Street district into a residential and retail destination by using part of the property tax generated by downtown businesses to fund various improvements and to remove asbestos from empty structures.

While cities continue to focus on increasing affordable housing for low- and moderate-income households, they also are expanding their efforts to attract middle- and high-income tenants. Vancouver, Wash., recently adopted a 10-year property tax exemption program for multifamily residential improvements, which is not restricted to just low-income or rental housing.

Many cities also provide other incentives such as increased parking allowances, an important consideration for developers. The goal of many incentive programs is to jump-start construction or recycling of multifamily properties, which local governments hope will attract more developers and investors. As the multifamily market matures, cities usually scale back or curtail incentives.

Reuse or Rebuild?

Increasing demand for downtown rental housing creates a new market for hundreds of underutilized or functionally obsolete office buildings, hotels, and other properties. As most major downtowns' available vacant sites rapidly diminish, older buildings are becoming more competitive from a cost per unit standpoint.

Many considerations go into the economic analysis of whether to build from the ground up or recycle existing buildings. The cost to convert an existing building to multifamily, which varies from property to property even within the same submarket, translates into a certain rent necessary to achieve a yield that can be financed. Often the required rent cannot be obtained in the existing structure, and adaptive reuse is not feasible.

Even with financial incentives, some adaptive reuse projects don't get off the ground because developers cannot get the desired rents or the costs of meeting federal tax code requirements are too high. If recycling older buildings doesn't make economic sense, developers generally tear them down and build new apartments.

The Move Back Downtown

In Denver and an increasing number of other cities, municipal planners and the private sector are working toward highly flexible downtown models that combine a mix of new multifamily construction, adaptive reuse of historic buildings for apartments, and conversion of older commercial buildings to rentals. Also, apartments increasingly are integral components of mixed-use projects in many cities.

Urban residential markets generally have outperformed their suburban counterparts in most major cities since the mid-1990s. For example, Chicago's CBD added 8,000 residents between 1990 and 2000, and the median income of downtown households more than doubled to approximately $48,000, according to the U.S. Census.

In fact, urban residents have proven able and willing to pay a minimum 20 percent to 25 percent premium over market rent alternatives in suburban properties. This willingness and ability to pay higher rent is important to the formula because, whether it is new construction or adaptive reuse, urban high-rise residential development generally is more expensive and more time-consuming than suburban or garden-style properties.

At present, many multifamily developers and owners understandably are preoccupied with high vacancy rates, soft rents, and other problems. But as the economy recovers and job growth picks up, the apartment market should rebound. Developers and owners should look for future opportunities now, and some of the best can be found in the nation's re-energized downtowns. Particularly in redeveloped CBDs such as Los Angeles, developers still have the chance to acquire properties at competitive rates, but prices will rise and the opportunities will narrow as more developers move into the market.

Mark H. Cassidy and John R. Ausburn

Mark H. Cassidy is president and John R. Ausburn is managing director of Las Vegas-based Pacific Properties, which has developed and acquired more than 20,000 multifamily units since 1985. Contact them at 704. 734.4644 or mcassidy@pacificdev.net and 214.373.9006 or jasuburn@pacificdev.net.

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