Multifamily Market Remains Largely In Balance As Rents Rise While Vacancy Continues to Fall, Albeit at a Slower Rate
Apartment market fundamentals continued to be rock solid through the second quarter, becoming the first CRE property sector to make the full transition from recovery mode into expansion and see increasing rents, declining vacancy and a burst of new construction.
Of the four major property types, apartments possess the best recovery story with vacancy rates compressing by 190 basis points since the beginning of 2010. Rents have recovered in 30 of the 54 largest U.S. markets.
"Apartments continue to have very solid fundamentals. There’s no lack of demand, and we’re starting to see supply coming online," commented senior real estate economist Erica Champion this week during CoStar’s Mid-Year 2012 Multifamily Review and Outlook.
"Investors have to be very cognizant of the markets and submarkets they play in, but it’s a very strong story," added Champion, who presented the midyear update along with PPR director of multifamily research Luis Mejia.
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Multifamily market conditions held fast through the second quarter, despite tepid job growth and the ongoing questions about the health of the single-family housing market -- two important components of multifamily demand. The condition of the economy should become clearer after the November presidential election and the resolution of the "fiscal cliff" involving taxes and government spending policies that the U.S. faces before the end of the year, Mejia said.
The U.S. political situation, the Eurozone crisis and volatile energy prices have disrupted investor confidence this year (see related news report, "Déjà Vu All Over Again?"
). A slight cooling of investment in the top-tier properties and markets has helped ease investor concerns over potential bubble-like pricing conditions at the upper end of the apartment market, but has somewhat hampered the recovery of lower-quality properties, Champion said.
"Until we see employment growth coming back to those [manufacturing and construction] subsectors in a major way, we’re probably going to see muted demand for lower C-quality apartment assets," she said.
Vacancy Declines Slow as Developers Move Dirt
Apartments have now logged nine straight quarters of year-over-year occupancy gains and average U.S. vacancies have come down almost two full percentage points since the beginning of 2010. But the velocity of vacancy compression has slowed due to the unclear jobs and picture and a burst of new development in many markets.
"We’ve seen the beginning stage of the next supply wave come to shore. Construction crews are out there putting up shiny new apartments and turning dirt," Champion said. "Because pricing has gotten pretty rich and there’s been actual expansion in the market, this is the time that investors need to be a little bit savvier about how they’re playing the market and the differences between markets as well, because it’s getting competitive out there."
Sun Belt metros with high employment growth and low entry barriers for new supply have seen the greatest declines in vacancy to date. However, most of that compression had occurred by the middle of last year. Tech and energy rich markets like San Francisco, Silicon Valley, Salt Lake City, Oklahoma City and the Texas markets have continued to enjoy solid vacancy declines over the last four quarters.
For a look at the 2012 apartment market through the eyes of investors, see CoStar’s related story last week covering midyear surveys by the NMHC and KPMG.
In Washington D.C., Norfolk, VA, Baltimore, Raleigh-Durham, NC, and other Sun Belt markets where developers have been going gangbusters, a wave of new supply has caused vacancies to tick up as much as a full percentage point, however. For example, developers have so far delivered about half of the 6,500 units forecast for the D.C. market in 2012. With no slowdown in groundbreakings, an additional 6,000 units are expected to deliver in the District during 2013, just as demand softens due to federal spending cuts.
That said, many other markets are now seeing new supply from developers hungry to be first out of the gate, including projects in early recovering metros such as Dallas-Fort Worth, Seattle, San Antonio, Houston, New York, Austin, Denver, Raleigh-Durham, Charlotte and Chicago.
Rent growth has been red hot in some markets, including a 7% gain in San Francisco, and solid growth in Oklahoma City, Denver, San Jose and Chicago. Charlotte and Los Angeles are starting to see rent growth as vacancies edge down amid little new construction. A few other metros have yet to see landlords regain pricing power, especially housing bust markets like Phoenix, Las Vegas, Inland Empire, Northern New Jersey, Atlanta and Jacksonville.
The Supply Wave Breaks
Last year, about 36,000 units delivered in the 54 top U.S. metros. This year, that number will likely more than double to around 75,000, In 2013, deliveries are expected to exceed the 100,000 mark for the first time in four years, according to PPR projections.
Meanwhile, some investment capital is shifting from asset acquisition to development, particularly among multifamily REITs, which have about $7 billion in their supply pipelines.
Is this wave of new supply a major concern for the apartment market over the long term?
"We don’t believe it is because we’re in the middle of the Echo Boom, which is entering the prime renting cohort, and we expect around 7 million new households to be formed over the next four years - the strongest young household growth since the Baby Boom years -- producing the biggest demand boost in 40 years. There’s enough demand to meet that supply wave," Champion said.
"To some extent, demographics mitigate the risk that an improving home ownership market will hurt the apartment market," added Mejia. "Any eventual losses of apartment occupancy to home buyers will be supplemented by additional demand and households formed by the Echo Boomers."
The recent housing crisis redefined the American Dream, Mejia noted. To be sure, the nation’s homeownership rate, which has fallen from almost 70% in 2004 to 65.5% in the second quarter of 2012, is a wild card in projections of future apartment demand. Before the ownership rate can stabilize, stubbornly high delinquency and foreclosure rates will have to come down closer to historical averages, Mejia said.
Until consumer confidence, employment and household debt levels and mortgage availability improve help stabilize the homeowners rate, the apartment market will continue to benefit from the shrinking pool of homebuyers. Consumer confidence, which is at historical lows, compared to any other recovery period, is especially important. The transition from renting to homeownership is not going accelerate until consumer confidence improves, Mejia added
Pricing Bubble Concerns Easing
With demographics and the homeownership rate so favorable to landlords, investors won’t be falling out of love with apartments any time soon, Champion noted. While the honeymoon is far from over, the second quarter appears to be the first three-month period since late 2009 that failed to achieve year-over-year growth in apartment sales volume, according to preliminary CoStar data.
However, all CRE sectors saw sales volume declines, and the dip in apartment sales is very slight slightly and could even amount to a rounding error once all transactions are accounted for, Champion said.
In fact, multifamily actually increased its share of capital placed by investors from an average 25% of all CRE capital to 30% in the second quarter.
"We see positive momentum in the investment market," she said. "The average price per unit has almost recovered to the five-year average and pricing and liquidity have improved, unlike other property types.
Sales have rippled beyond the "best of the best" markets into select secondary and tertiary markets. With fewer of the best assets available on the market as investors opt to hold onto their properties and reap rent and income growth, investors are moving on to non-primary markets, helping compressing capitalization rates on the broader apartment market.
Among 4- and 5-Star properties in primary markets, cap rates have started to expand from their sub-5% low last year, easing concerns about an apartment pricing bubble. Cap rates are still falling in 4- and 5-Star properties in non-primary markets, and 3-Star properties in all markets, showing that prices are strengthening more broadly as investors fan out across the market.
That said, investors still want to play in the top markets, focusing especially on supply constrained urban core properties. CBD-located properties rose to over 30% of total sales volume in the first two quarters. About half of the capital placed in PPR’s so-called "sexy six" markets - Boston, Chicago, Los Angeles, New York, San Francisco, and Washington, D.C. -- is for projects in urban locations.
Investor appetite is resulting in premiums paid for urban assets of more than 200% compared with suburban assets -- down a bit from the first quarter’s 250%, but still a gaping spread. Champion, who forecast that suburban apartment pricing would begin to improve outpace urban property prices in 2012, noted that average prices for suburban properties are 8.5% higher over the past year, while up only 2% for urban core assets.
"The exuberance is over and investors are sharpening their pencils to make sure these deals write out," Champion said. "Pricing improved the most for the ‘best of the best ‘assets first, and now it’s starting to level off."
Mejia added to despite changes in asset performance, overall, the apartment sector has performed well and will continue to perform well in a "half-full, half-empty" economy. The reason is that in a weak economy, consumers take a defensive position that favors renting over buying.
Distress Fades as Recovery Broadens
In another key development recently, the share of distressed transactions as a percentage of total sales is finally dropping in markets that suffered the brunt of the housing collapse. In 2009, one in three U.S. apartment trades involved a toxic asset. The ratio has fallen sharply in 2012 to one in eight trades today.
Despite the abating distress, some of the largest transactions in the second quarter were distressed deals. In the largest transaction of the quarter, PJ Finance sold 33 properties in Arizona, Florida, Georgia, Tennessee and Texas in a bankruptcy fire sale to Gaia Real Estate & Starwood Capital for $500 million, or $52,632 per unit.
In an REO deal, US Bank NA and CW Capital sold 16 apartment buildings formerly part of the Lembi holdings in San Francisco to a joint venture of Angelo Gordon & Co. and The Prado Group for $103 million or $156,000 per unit, a steal for San Francisco, Champion noted.
In a non-distressed transaction, UDR sold 15 properties in Arizona, Florida, Texas and Virginia to DRA Advisors for $477 million, or $96,735 per unit.