Maintaing Value

The economy slows the multifamily sector’s progress, but strong properties hold firm.

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While stories of plummeting transaction volumes, staggering value declines, and scarce funding plague the commercial real estate industry, the multifamily sector has managed to keep a steady course throughout the economic turbulence. And there’s some good news in the forecast: Long-term sector fundamentals should remain solid into the foreseeable future.

Though not without its share of struggles — including sky-high vacancies and abandoned projects in many overbuilt markets — the multifamily sector has benefited from the strength of class B and C properties in job-steady markets. And, while financing is hard to come by in nearly every sector, CCIMs are taking a pragmatic approach to obtaining funds for multifamily deals across the country.

Commercial Investment Real Estate collaborated with a national multifamily expert as well as regional and local CCIMs to provide an in-depth look at where the multifamily sector is headed and strategies for securing deal financing in this unstable market.

The U.S. economy’s resiliency through the first half of 2008, particularly below-trend job losses, turned into a serious recession as the downturn escalated into a global financial crisis. Increased job reductions are likely to dominate headlines for several months with total losses considerably higher than during the dot-com bust and the Sept. 11 tragedy. Similar to other unsettled periods in history, concerns regarding additional risk — from falling consumption to the uncertain impact of the auto industry’s troubles — dominate the general economic psyche.

Clearly, there are reasons for concern; however, a number of factors could mitigate the recession’s depth, barring exceptional surprises. Domestic payrolls entered the downturn lean, having grown at the slowest rate of any expansion period since 1954. While choppy and uncertain in some respects, unprecedented U.S. government intervention likely will be expanded with another sizable stimulus package this year. Confidence is yet to be restored and the financial system is a long way from operating normally, but early signs point to a gradual improvement. Significant foreclosures and high for-sale inventories have driven down home prices by an average of 10 percent nationally and as much as 35 percent in some markets, sparking a modest rise in sales activity. A bottoming of the housing sector is expected by midyear in most metropolitan areas. That event, along with improving credit markets, should begin to stabilize the economy and set the stage for a recovery in 2010.

Solid Long-Term Fundamentals

The multifamily market fared well as the downturn intensified at the end of 2008. However, accelerating job losses will translate into higher apartment vacancies. The return of failed condominium-conversion projects to rental inventory, ground-up condo development, and an increase in for-rent homes remain sources of competition for multifamily owners, particularly in the class A segment.

The performance gap among metros is widening rapidly. The recession in overbuilt markets such as Las Vegas, Phoenix, Riverside-San Bernardino, Calif., and most of Florida will make 2009 a tough year. Healthier markets, such as San Francisco, Los Angeles, and New York City, also will see rising vacancies — due to job losses — but are better positioned to get through the recession. In most metros, class B and C properties will be the least affected by the economic downturn, as many households must continue to seek more-affordable housing options. Fundamentals in the pricier class A segment have been disproportionately impacted by eroding household-credit quality, making it difficult for many renters to qualify for high-end units.

Edgewater Luxury Apartments, a 193-unit multifamily community in San Francisco, recently sold for $115 million, or $595,855 per unit. Photo credit: Marcus & Millchap

Beyond 2009, economic and demographic trends support a positive long-term outlook for apartments. In stark contrast to just a few years ago, tight mortgage underwriting standards and scarce first-time home-buyer incentive programs are reducing attrition from the renter pool. Even higher-quality borrowers are facing tougher mortgage standards, with approximately 70 percent of banks tightening requirements for prime mortgages in recent quarters. At the same time, echo boomers — totaling roughly 70 million U.S. residents — are entering their prime renting years, a trend that will continue during the next five to 10 years.

On the supply side, construction starts are declining rapidly for all types of residential units, which should translate into a quick recovery for apartment vacancy and rents once economic expansion and job growth return. On average, new supply as a percentage of existing apartment inventory is forecast to reach just 0.7 percent annually through 2010, down considerably from the late 1990s and early 2000s.

Sales Activity Stalls

Last year’s drop of nearly 50 percent in apartment sales volume is indicative of more than constraints in financing and tighter underwriting. In this period of extreme financial market volatility and significant economic weakness, buyers are demanding higher yields. Apartment owners, the vast majority of whom have had the luxury of solid occupancies and several years of strong rent growth, have opted to hold and ride out the downturn.

Situations requiring a sale reflect price reductions necessary to clear the market. The degree of discounting varies sharply. During the past 12 months, class A properties in primary markets have traded with an average capitalization rate increase of 25 to 50 basis points and 75 basis points in secondary markets. Class B and C assets have sold with an average cap rate increase of 100 to 150 basis points. True distressed sales have been limited to failed conversions, highly leveraged new developments, and acquisitions made at the height of the market based on aggressive rent growth forecasts.

*Estimate Sources: Marcus & Millichap Research Services, Real Capital Analytics, CoStar Group

Properties priced below $20 million have generated the most transaction activity due to the influence of private buyers and more obtainable financing. Additional upward pressure on cap rates is expected this year, with the spread widening further by quality of product and market. More distressed properties will emerge, dominated by high leverage, weak operations in the lower-tier markets and submarkets, and maturing loans. A number of major owners, particularly some real estate investment trusts, may have to sell assets to increase liquidity, creating attractive buying opportunities.

*3Q07 to 3Q08 change
Sources: Marcus & Millichap Research Services, Real Capital Analytics, CoStar Group

However, buyers should not expect an overall distressed condition in the greater apartment market. Owners with balanced leverage and relatively healthy operations still comprise the majority of the marketplace. These investors will continue to ride out the downturn and will be rewarded by several key factors that point to long-term value. The significant decline in new construction now taking hold and renter demographics similar in scope to the baby-boom wave will be the main drivers of value creation.

Student Housing Opportunities

The student housing niche continues to grow despite the struggling economy. College enrollment remains on an upward trajectory and is expected to increase 8 percent during the next four years. Stimulating the demand for more housing is the fact that more than 15 million degreed workers will be needed nationwide through 2012. Despite the current recession, as the employment situation rebounds late this year, these additions will be needed not only to cover anticipated job growth, but to replace retiring baby boomers.

Another driving force for student housing demand is the continued expansion of the college-aged population, which is expected to grow 4.2 percent through 2012. The only downside could come from tightening lending regulations, as many private-sector loans are curtailed. The good news, however, is that these loans account for only about 10 percent of all education financing.

Due to high construction costs, universities in general have been unable to keep up with mounting housing demand. Moreover, off-campus housing trends have become more upscale, as students look for extra amenities: Those typically associated with an apartment lifestyle usually do not exist in most dormitory environments. Developers have responded accordingly, with the delivery of more than 21,000 units since 2000, while an additional 8,500 units are forecast to come on line by the end of next year.

Located in Gainesville, Fla., the $73.7 million Cabana Beach student housing community offers desirable amenities, including a fitness center, lagoon-style pool, in-unit washer/dryer, high-speed Ethernet connection, and utility allowance. Photo credit: Marcus & Millchap

New ventures also are forming to answer increasing demand. Charlotte, N.C.- based Campus Crest Communities and Chicago-based private equity firm Harrison Street Real Estate Capital recently created a $220 million joint venture to develop 10 student-living communities near university campuses throughout the U.S. Additionally, builders are tackling projects that are more of a spin on traditional apartment mixed-use assets. A prime example is the University Village in Ann Arbor, Mich., where 524 apartments (1,758 beds) will be combined with more than 16,000 square feet of retail space.

Despite heightened levels of construction, robust demand has kept vacancy from increasing significantly, maintaining upward pressure on rents. Nonetheless, vacancies are up in many markets. Reported vacancy rates have risen approximately 200 basis points during the past year from the 4 percent to 5 percent range to the current range of 6 percent to 7 percent. Interestingly, properties that traded hands in 2007 had an average occupancy of nearly 95 percent, while this year the average occupancy at closing has been closer to 91 percent.

Rental rates, however, continue to climb and currently are up approximately 3 percent from fall 2007. Depending on the number of beds in the unit, monthly rates range from under $300 per bed for more modest quarters in tertiary markets to in excess of $1,500 per bed for newer, well-appointed accommodations in primary markets.

Investor demand for student housing assets has grown significantly during the past several years, as climbing revenues lure buyers to this increasingly popular niche. Despite a down cycle, rents are rising at a faster pace than those of traditional multifamily assets, while cap rates are often 50 to 100 basis points higher. Freddie Mac has responded to skyrocketing — and primarily institutional — demand with a new loan program targeted at acquisitions due to the segment’s reputation as a solid performer, even in soft housing markets. In November 2008, Freddie Mac used the student housing program to purchase a $38.7 million mortgage to provide financing for a 612-unit property in Lincoln, Neb.

Despite a major drop in sales activity, apartment properties are trading and being financed nationwide, thanks largely to agency lenders and still-active local and regional commercial banks. The current apartment transaction climate, defined by various degrees of price declines, should be distinguished from the sector’s long-term intrinsic value. Properties that must be sold in today’s environment obviously require discounting to clear the market. On the other hand, owners without a compelling need for an immediate sale are positioned to hang on through the downturn. More than ever, a fresh look at each property’s hold, refinance, or sell strategy is warranted, given the recent market volatility. There will be increased buying opportunities and distressed assets, more than any time in recent history, but investors should not generalize the overall condition of the apartment market as distressed.

Linwood C. Thompson

Linwood C. Thompson is senior vice president and managing director of Marcus & Millichap’s National Multi Housing Group. Contact him at (678) 808-2700 or


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