13 Unlucky? Not for Apartments
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If anyone thought the red-hot multifamily sector was cooling going into 2013, the activity of the past few weeks would certainly prove them wrong. Take, for instance, Equity Residential and AvalonBay Communities’ $16-billion buy of Archstone Inc.’s assets. The deal, which hasn’t officially closed, not only quenched long-circulated rumors and speculation of a potential Archstone IPO, but it also marks the largest deal in the sector since 2007.
If that’s not enough, take a look at some of the latest data. CoreLogic, for one, recently reported that residential rental income grew 12% year-over-year in September. What’s more, the firm says the growth “shows no signs of slowing down.”
That’s pretty much on par with what most in the industry have been saying for months. At the RealShare Apartments 2012 conference in Los Angeles in late October, concerns over slow job growth and tepid economic recovery did little to dampen optimism of the 1,700-plus multifamily professionals that attended the event.
It was in fact the focal point of a keynote presentation given by research specialist Hessam Nadji of Marcus & Millichap Real Estate Investment Services Inc. The senior vice president and managing director asked, “Can Apartments Withstand the Economic Headwinds?” and the answer was a resounding yes, no matter how strong those headwinds may be. According to Nadji, the organic strength of the economy—both corporate and consumer spending—is being held back by political uncertainty. But, he added, the foundation of the economy is in better shape. The US added 1.8 million jobs between September 2011 and September 2012, though unfortunately the headlines were dominated by the debt and housing crises.
It’s been good news since then; the Bureau of Labor Statistics reported that the economy added 146,000 jobs and unemployment fell to 7.7% in November, the lowest since December 2008.
Demand is high and multifamily developers are ready to build, said Nadji, but equity for development is still very cautious and not readily available. “I don’t think overbuilding is going to be a problem through 2014,” he said. Home buying’s making a comeback, though he indicated it wouldn’t cause as much pressure on the rental market as it did in the last cycle. “There’s enough demand for all types of housing.”
In fact, all 44 markets tracked in Marcus & Millichap’s National Apartment Index are forecast to post continued employment growth and effective rent growth by the end of this year. Recovery has moved beyond the cyclical surge in demand to a more sustainable expansion, as remarkable shifts in demographic, economic and social patterns underpin demand for rental housing, according to the firm. That will lead US vacancies to hit 5% by year’s end, marking a 40-basis-point drop from 2011 and 4.8% effective rental growth. And with completions expected to total nearly 85,000 units for the year, there’s still plenty of room in the sector for developers to deliver new product; the firm says household formations are forecast to increase by 29% to an annual average of 1.4 million through 2015, aided by rising immigration and 2.1 million echo boomers entering the prime renter age group.
Nadji reported that year-to-date apartment investment clocked in at $63.7 billion through the third quarter, with the activity dominated by institutional money. The trends are shifting, however. More money is heading toward secondary markets, as well as properties that are going for between $10 million and $20 million. With capital continuing to flock to quality, he observed, “it creates a lot more opportunity for class B, value-add plays.”
That’s on par with Real Capital Analytics’ latest data, which has apartment sales volume at $4.6 billion in October, 2% more than the same period a year ago. And though the firm’s year-to-date total is more conservative than Nadji’s, at $62 billion, it’s “still well ahead of 2011 levels, up 43% inclusive of entity deals and 19% without them.” Further, RCA noted “the shift in investment activity to secondary and tertiary markets continues.” In fact, the major metro markets in the US saw volume actually go down 12% year-to-year in October, while sales in secondary markets increased 8% and tertiary markets recorded a robust 26% gain over the prior year.
“This has been the most interesting apartment cycle I’ve seen in decades, and jobs are playing only a moderate role in it,” remarked Michael Cohen, Property & Portfolio Research’s global strategist, at the RealShare Apartments event. “It’s not as much about jobs as it is secular and cyclical factors, including tepid confidence, tighter lending standards, record levels of student debt, etc.”
He was part of a discussion on the factors impacting multifamily—aptly named, “Anticipating the Curve Ball,” that also included moderator Scott Farb, managing principal of CohnReznick; Tom Bannon, CEO of the California Apartment Association; John Burns, CEO of the John Burns Real Estate Co.; Steve Carlson, president of Steve Carlson & Associates; and Brannan Johnston, VP and managing director of Experian Rent Bureau.
Echo boomers aside, one of the biggest factors impacting the market is growing demand by non-traditional households. While the attention is going to young adults, Cohen pointed out that one in two renter households these days is middle aged. And if you look at census data, he noted, one of the biggest cohorts for renter households was single mothers. “Developers are so focused on the echo boom that they’re missing the forest for the trees,” he said.
The affordability of rental units is one big problem of this cycle, added Cohen. “In some markets, it’s cheaper to buy than to rent. The demand side is going to play a big role in next stage of the cycle, or ‘Chapter 2.’ ”
Cohen expects a modest increase in interest rates, 130 basis points, over the next five years. But, he warns investors, “The gains we’ve seen in the past few years aren’t going to persist because supply is coming on line and the for-sale market is coming back,” he related.
Burns, meanwhile, believes the country as a whole is not in danger of being overbuilt, though some coastal areas will see a glut. And for those looking to complete a sales deal at this point in the cycle, “prices are rising so much that the buying opportunity is probably gone by now, or will be.”
Those concerns are doing little to dissuade those looking to place capital into multifamily, though. Some of the industry’s major investors spoke candidly during a panel moderated by Cushman & Wakefield’s vice chairman, Mark Renard, which looked into investor appetite and trends in the market.
With a huge pent-up demand of 500,000 to 700,000 units, “we’re on the cusp of a good long period of time in multifamily,” stated Dean Henry, CEO of Legacy Partners Residential. “As long as rates are low, we’re going to be buying as much as we can for as long as we can,” he added.
The environment for apartment REITs also remains positive, with the ability to tap the public markets for equity a clear benefit, noted John Bezzant, an executive vice president with Aimco. In today’s investment market, he points out, determining whether to obtain equity to buy properties is a tough question, since it depends whether it’s accretive to the REIT’s portfolio.
For pension funds, said Heitman EVP Blaise Keane, real estate, and especially apartments, has become a legitimate asset class. “We’ve always been a big apartment investor and are certainly advocating an overweight to them for variety of reasons.”
TIAA-CREF senior director Chris Burk concurred. He added that while current prices, cap rates and IRRs aren’t a bargain, they’re acceptable to the firm’s investors.
To achieve high returns, Rockwood Capital focuses on markets that aren’t inundated by investors, and where there might be some asset risk, says Bob Gray, a partner with the firm. “We want to be where the puck will be, not where it is.” As such, the firm is going to what Gray dubbed “out-of-favor markets—those are markets where it’s good to have purchased something over the past 12 months.”
Outside of apartments, he says Rockwood is finding opportunities to tee up development sites and sell them early. “There’s no incremental return for development and a lot of risk, so we’re able to sell those development opportunities to others,” he relates. “Plus, it’s difficult to borrow for development; all the public firms have balance sheet advantage.”
This new era has also brought in a new trend—or, at least, a different way for investors to do a pre-sale: entering into joint-venture development opportunities with the option to buy out the partner at a later date.
Like many of the investors on the panel, and a growing number of investors in general, Keane said, “as a general matter, we steer clear of markets that have gotten so heated that you’re buying above replacement cost.” Replacement cost is a significant factor, he stressed, since it tends to drive your rents.
Yet Henry doesn’t give as much weight to replacement cost, since construction costs could increase, and that’s something no one can forecast. And on development, he points out there’s a big difference between today’s development deals and those done in 2007: leverage. “Having 30% to 40% equity in deals is the only way you can do it today,” he stated.
Looking ahead, rent growth and location still play major roles in investors’ decision-making process, with particular interest in markets with high-demand-generating industries like technology and energy, as well as service and retail. The experts also believed there will be “overwhelmingly more” transaction volume next year as opposed to 2012, with the San Francisco, Seattle Bay and Boston markets as the top targeted locales.
Lenders are just as bullish on the sector. Grace Huebscher, president and CEO of Beech Street Capital, believes multifamily is going to be “peachy” in 2013. “I don’t think the market’s overheated,” she maintained during an Industry Leaders session. There are two camps of borrowers these days, she explained. “One set of borrowers is sitting on the sidelines because they think we’ve reached the peak. The other set thinks there’s still room for growth and is out there, aggressively buying.”
Al Brooks, president of commercial lending for Chase, indicated that the firm has been dramatically ramping up its multifamily lending program. “The economy is doing spectacular, but our business is doing great,” he commented. Though, he added, “imagine what would happen in a growth economy and every 20-something would move out, including mine?”
Still, there were words of warning from the experts. Jerome Fink, a principal with the Bascom Group, stated that his “biggest concern is the rent-to-income ratio outstripping the historical average. Whereas that ratio has been 20% historically, in some markets it looks like it’s going up to 25%.
“There’s a lot of concern that you’re outstripping the buying power of the consumer,” he continued. “If so, something will have to give, be it reduced demand for units, a move into single-family or rent control going into effect.”
Brooks, meanwhile, advised investors not to stray too far from their comfort zones. “There’s one lesson to be learned from the downturn. Where we saw the really big losses, from our point of view, is when people chased cap rates and left the markets that they know,” he shared.
The good news is that interest rates are expected to remain low for at least the near future. Next year, said Huebscher, “is going to be a great year for borrowers because of the competition to provide financing, especially longer term funds.”
Added Fink, “When I’m on the phone with lenders, I feel like they’re more motivated to make the loan than I am buying the property.”
Deal terms haven’t changed that much, despite the rise in prices and lender competition. What has changed, though, is capital sources’—and investors’—attitude toward development. “Historically, developing wasn’t always the safe bet, whereas now some prefer it over buying in some markets,” said Fink. “In some markets like Orange County, you’re paying the same for a class C asset that you would on a site and project. In the past few years, those who did development deals will make a fortune. It was a once-in-a-lifetime environment.”
It still may be. According to CBRE’s Capital Markets Lender Forum, construction lending activity has topped $1 billion for the year to date through September, and has been fairly evenly spread over each of the past three quarters. Construction loans represented nearly 14% of all non-agency lending activity through Q3, and multifamily development accounted for 75% of all construction loans.
Average loan-to-values have also risen slightly for permanent, fixed-rate debt on commercial projects—to 64.6% during the third quarter, up from just below 62% during the second quarter. What’s more, CBRE found, multifamily-related LTVs held above an average of 69% for the third consecutive quarter. That ratio has remained consistent over the course of 2012, maintaining their highest levels since 2008, according to the firm. “The growth in multifamily acquisition activity appears to have been boosting average LTVs throughout the course of 2012.”
Of course, the sources of capital have grown: CMBS, life companies, regional and national banks (particularly for bridge lending) have opened up their coffers for apartments. And, of course, there are the GSEs, which have been a huge boon to the sector.
As poorly as their single-family arms may have been doing, both Fannie Mae and Freddie Mac continued to lend to multifamily—in a big way. Fannie Mae vice president Phyllis Klein and Freddie Mac’s regional managing director, Paul Angle, shared their views during a panel focusing on the mortgage giants and their new leadership. Their stories, told to NorthMarq Capital president Jeff Weidell, were similar.
The multifamily components of both companies are the profitable arms of the overall businesses. Both are seeing growth in originations, loan requests and their number of staff.
Fannie and Freddie have also been more active on the securitizations front, according to CBRE. The firm points out a shift taking place in the structure of agency financing for multifamily. “As the country emerged from the financial crisis and recession, agency-backed securitizations restored liquidity to multifamily markets. Put under pressure by regulators to reduce the size of their on-book portfolios, agencies have increasingly turned to securitization structures to provide greater liquidity,” CBRE reports.