CALABASAS, CA—Last year at this time, Marcus & Millichap researchers stated that although the economy was not at risk for a double dip, the US would see “a very volatile and choppy recovery.” Twelve months later, nothing much has changed, although the pace of the multifamily recovery is slowing a bit, said Hessam Nadji, the firm’s managing director of research and advisory services, in a webcast yesterday.
The US economy is facing significant headwinds, said Nadji, including a decline in confidence due to the US credit downgrade and the deadlock over the debt ceiling and other issues, as well as the geopolitical and economic crises in the Eurozone. There are also concerns over rising oil prices; high unemployment (8.2% today vs. 5% in 2007); a high unemployment rate at 14.5%; low consumer confidence; and decline in single-family home sales and prices.
“While these headwinds are long-term in nature, we cannot ignore some of the positive aspects that are evidence of a strengthening economy,” said Nadji. These include job growth in the private sector, rising worker productivity, growing corporate profits, a rise in exports, rising GDP, low Treasury rate (the 10-year is at 1.93%); and retail sales’ rising 10% above their pre-recession peak.
Employment growth—one of the key factors impacting apartment market performance—has been broad in the past several quarters. Between March 2011 and 2012, the private sector added 2.14 million jobs, with the largest gains seen in professional and business services; education and health services; and the leisure and hospitality markets. The public sector, however, saw a loss of 240,000 jobs, with the government cutting 200,000 positions and the rest in the information sector.
The good news, said Nadji, is that it seems there’s a reduced reliance on temporary staff, which means that companies may look to increase their pace of hiring. And although more young adults are living with their parents—over three million additional young adults are living at home since 2007—an increase in job growth will help release the pent-up demand. This, said Nadji, is an important indicator to monitor.
The audience was somewhat bullish on employment growth as well. When asked their forecast for job growth in the next 12 to 18 months, half of those polled said it would be the same, while 42% said it would be stronger.
According to Bill Hughes, senior VP and managing director of Marcus & Millichap Capital Corp., a lack of confidence among companies has had them wary of adding new workings, “but given the productivity growth of late, they’ll be forced to hire.” He added that the market would see a gradual organic recovery. “The natural pace of the organic recovery has been hampered by the uncertainty that’s pervading the market. The fear factor is keeping companies pretty cautious.”
The single-family housing and condo markets have yet to enter a sustainable recovery, said Nadji, “But we’re hearing from some of our larger clients, especially on the high-end properties, that they’re losing some renters to ownership.”
The US apartment market absorbed about 36,000 units in the first quarter, which is a decline from prior quarters, but still good considering the state of the economy. Meanwhile, Nadji believes new construction will not be a threat on a macro level in the foreseeable future. This is because it’s already at historically low levels, and even units in planning phases may not come to fruition in 2012 or 2013. It’s looking like “development will be a harder prospect,” he stated.
Not surprisingly, the top market in the country is New York City, which saw an 80-basis-point vacancy decline over the past year to land at 2% in the first quarter. It was followed by Portland, OR, 2.4% (150-bp decline); Minneapolis, 2.5% (-70 bp); San Jose, 2.6% (-80); and San Diego, 2.9% (-110). On the other side of the spectrum, the markets with the highest vacancy were Jacksonville, down 160 basis points to 8.6% in March, and Houston, down 220 basis points to 8.1%. Rounding out the top five are Atlanta, 7.4% (-180); Las Vegas, 7.1% (-150); and San Antonio, 6.7%(-130). Comparatively, the overall US average vacancy for the first quarter was 4.9%, down 130 basis points from the prior year.
In terms of rent growth, it’ll be moderate this year. For the poll question asking the audience what they expect rent growth to be like in the next 12 months, 12% foresee a stall in rent growth, 64% see 2% to 3% growth and 22% see growth of 4% to 6%.
In terms of the capital markets, Hughes indicated that the historically low cost of debt and equity continue to be drivers. Lenders’ attitude toward multifamily has been favorable due to the sector’s strong fundamentals, and capital is available for everything from trophy, core assets through C properties, and apartments in primary through tertiary markets.
Underwriting standards haven’t loosened either; lenders continue to look for quality properties with consistent income streams and stable occupancy with potential for rent growth, although new construction is becoming a point of conversation. Debt-service coverage is ranging from 1.25 to 1.15, and average LTV from 60% to 80%. And capital is available from a variety of sources.
The capital stack has been evolving in the past few years and now looks more like it did six years ago. In the 2006-2007 period, 80% of the average apartment deal was debt, 5% was pure equity and 15% was preferred equity/mezzanine capital. In 2009-2010, the average deal was 55% debt, 20% equity and 25% preferred equity/mezzanine. During that time, the standard rate on the debt was 5.5% to 6%, and the return on the preferred equity/mezzanine ranged from 12% to 15%. In 2012, however, the average apartment deal had 75% debt at a 3.75% to 4.5% rate; 10% pure equity; and 15% preferred equity/mezzanine, with a 10-12% return.
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The Evolving Capital Stack
There’s also been a shift in where financing is coming from. In 2008, CMBS dominated the market, with a 36% share, followed by government agencies, at 20%. The following year, CMBS fell to a 1% share of all deals, and agencies grew to 38%. National and regional/local banks almost doubled their share. CMBS remained at 1% in 2010 and 2011, while agencies grew to 80% before falling to 68%. Over the 12 months ending first-quarter 2012, CMBS deals grew to 2%, agencies to 65%, and national, international and regional/local banks to 19%. Insurance firms, meanwhile, went from being non-players in 2010 to accounting for 8% of all deals in 2012.
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Sources of Apartment Acquisition Financing by Dollar Volume
*Trailing 12 months through Q1
There’s $1.77 trillion in commercial/multifamily debt maturities coming due between 2011 and 2015, but Hughes stated it’s not a “big deal, particularly for apartments. Servicers have been able to manage their way through maturities and delinquencies. The major problems are in other product types.”
Last year saw $63.9B in multifamily sales, with $10 billion of that in the first quarter. Already in Q1 2012, there have been $16.8 billion in deals—if this pace continues, 2012 could surpass 2011. As of the first quarter, the average cap rate and price for deals is around 6.5% and $100 million.
Nadji said that the market has seen a significant recompression of cap rates from the peak of the downturn in 2009. But, he noted, because the dominant migration of capital has been in the institutional-quality, high-end properties—that is, deals of $20 million or higher in top-tier, preferred markets—the average cap rate figure is greatly skewed.
Although the cap-rate decline was steep in trophy assets in preferred markets, as opposed to traditional class A or B/C properties, over the past few quarters the cap rates in preferred markets have really started to flatten out. This, said Nadji, is partially due to economic upheaval around midyear 2011, and the gradual migration of capital to lower-quality properties and secondary/tertiary markets.
We could also see prices start to even out. In a poll, 69% of the audience said they believe pricing for class A apartment product is frothy. The balance felt that pricing was justified.
Looking at the rest of 2012, the outlook for investors looks promising. “Lenders are looking for new deals—it’s a pretty strong market for apartment financing,” said Hughes. Debt and equity markets are expected to remain stable and accommodating, and capital supply should remain healthy. Still, a choppy domestic economy, upcoming election and geopolitical uncertainty remain challenges. Investors will likely look for opportunities in overleveraged properties that are reaching maturity.