Amid serious concerns about a potentially teetering global economy and persistent domestic employment weakness, capital continues flowing into U.S. apartment properties at a near-frantic pace. Chalk it up to already recovering rental rates—and more rent growth expected ahead despite the generally hard times.
Key apartment lenders today are offering quite attractive rates and terms. For example, government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, along with certain life insurers, are quoting first-mortgage financing in the mid-3 to mid-4 percent range, often at loan-to-value (LTV) ratios of 75 and even 80 percent, observes veteran multifamily finance specialist Matthew Lawton, executive managing director with Dallas-based capital intermediary HFF L.P.
In leading markets, intense competition for favorably positioned properties is occasionally driving capitalization rates down to the mid- to high-3 percent vicinity, with low-4s more typical, reports Encino, California–based investment and mortgage brokerage firm Marcus & Millichap (M&M). Income-based valuations are a bit lower in less-favored markets across the country —but the 6 percent caps often seen in these cities for decently performing properties still indicate historically strong investor demand.
While global capital flows and property finance activities are generally pretty complex subjects, the fundamental demographic and supply factors underlying the boom in apartment investment are not hard to grasp.
The prevailing sluggish employment growth notwithstanding, apartment rents are already rebounding at a surprisingly heady pace—factoring to 4 to 5 percent annually in many markets—after an exceptionally slow construction period, M&M calculates. And they are expected to keep on moving north as more and more renter-oriented families form in the coming years.
Indeed, the research team at investment manager RREEF is projecting that the nationwide average effective apartment rental rate will likely hit an all-time high two to three years down the road. Of course, the extent to which the domestic employment picture recovers between now and then will help determine just how lofty that peak gets.
Meanwhile, it helps multifamily landlords’ cause that fewer families are able to afford homes (or at least qualify for home loans) these days—despite still-slumping single-family values and record-low mortgage rates. In fact, the U.S. Census Bureau reports that about 1 million more Americans were renters at midyear compared with mid-2010—marking the nation’s lowest homeownership rate in 13 years.
Ongoing economic uncertainties are no doubt attracting real estate investors to apartments over other property categories, as multifamily fundamentals appear to make it a less-risky sector at least for the coming few years.
The same is true for lenders. While the interest-rate-spread volatility seen in the commercial mortgage–backed securities (CMBS) arena in recent months does not exactly support commercial real estate liquidity, Fannie and Freddie continue demonstrating strong appetites for newly originated apartment loans. Also, life companies are often offering even better rates than the GSEs at their preferred LTV ratios.
| A development team, headed by Hines, is constructing the 16-story, 250-unit 1225 Old Town project in Chicago’s Old Town district. |
And it appears the deepest apartment construction slump in decades is a thing of the past. With recovery in construction lender confidence, the pace of development is picking up rapidly in quite a few markets around the country—although a sudden blip in August starts brings the strength of the seemingly rising wave into question.
The consensus appears to be that it will take a few years before construction could outpace demand—what with demographics and economics suggesting continued strong unit absorption by renter-minded population cohorts over the coming years.
Those who concur have plenty of evidence. From mid-2010 to mid-2011, ongoing moves from homes to apartments helped push the nationwide multifamily vacancy rate down by nearly 200 basis points to below 6 percent, New York research firm Reis Inc. reports. A key demographic factor here is the echo boom/generation Y cohort, which is entering its prime household-formation years and should continue producing plenty of renters for another half-decade.
Exceptional absorption of late has already pushed rents upward and, again, is expected to continue doing so in the coming years even as developers strive to meet the growing demand with new product. Effective rents increased during the second quarter of the year in 80 of the 82 U.S. markets that Reis tracks.
That kind of performance no doubt attracts the interest of investors, driving values upward apace—albeit with the most-favored markets and neighborhoods capturing disproportionate appreciation.
Indeed, apartments have recovered value far more dramatically of late than the other primary income-property categories—and should continue leading the pack going forward—according to New York–based valuation specialist Integra Realty Resources’ Commercial Property Index. Multifamily values are up an average of 7 percent nationwide over the past year—and are projected to appreciate at nearly that pace at least through the end of the year.
In contrast, office, retail, industrial, and lodging properties are all up in the vicinity of 1 percent—and are all likely to continue chalking up modest gains in the coming months.
Not surprisingly, apartments are trading at quite a brisk pace, with major nine-figure transactions closing regularly and smaller properties selling like hotcakes. To wit, M&M reports that 2011 multifamily sales activity hit the $25 billion mark by midyear—with the pace up a full two-thirds over the year-earlier period.
A variety of investor types is targeting apartment acquisitions and developments, including institutionally backed advisers large and small; public and nonlisted real estate investment trusts; various local and regional entrepreneurial types; other private players; and even some offshore capital. And they are investing in all kinds of multifamily assets: market rate and affordable; garden and high rise; student and seniors.
It has also become quite clear that amid a distinct flight to low-risk real estate, well-located properties in leading markets such as New York City and San Francisco are trading at capitalization rates that are about as thin as they have ever been—4 percent and even a bit lower in some cases, notes Max Swango, managing director with investment manager Invesco Real Estate in Dallas.
Swango also calculates a significant cap rate differential—amounting to some 200 basis points—between those property profiles and even strong assets in secondary markets. “Similar to what we’re seeing in the office sector, properties in ‘A’ locations of secondary markets are more likely to trade at about a 6 cap.”
For its part, the RREEF team is particularly bullish on prospects for effective rent growth—and, in turn, value appreciation—in Boston, New York City, and the Baltimore-Washington corridor, and in prime south Florida territory as well. It expects the San Francisco Bay area to lead West Coast performance—along with strong showings in Seattle and Portland.
Southern California’s big coastal markets will likely lag in the near term before generating better gains a couple years on. In the nation’s interior, RREEF also likes the quality-of-life magnetism of Austin and Denver.
But the team is also wary of prospects in several large metropolitan areas currently facing high vacancies, lingering single-family distress, and/or minimal constraints on new supply. These places include Atlanta, Dallas, Houston, Jacksonville, Minneapolis, St. Louis, Philadelphia, Phoenix, and California’s inland population centers.
With the GSEs leading the way, the CMBS volatility affecting other property categories has not proved much of a factor in multifamily finance. Wall Street, in fact, has demonstrated relative comfort with Freddie Mac’s regular apartment-backed loan securitizations.
Freddie projects it will acquire some $16 billion in apartment-secured mortgages this year, up from $14.8 billion last year. And Fannie Mae invested some $10.5 billion into multifamily transactions during the first half of the year, putting it on pace to far exceed 2010’s total of $16.9 billion.
The Washington, D.C.–based Mortgage Bankers Association, in fact, calculates that the GSEs boosted their collective apartment-backed debt holdings by some $4.4 billion during the second quarter alone—accounting for pretty much the quarter’s entire increase in overall outstanding commercial property debt nationwide.
And reflecting today’s historically low treasury yields to which most fixed-rate commercial mortgages are indexed, rates today are exceptionally affordable for qualifying borrowers. HFF’s Lawton notes that the GSEs in mid-September were quoting five-year loans in the vicinity of 3.5 percent, seven-year transactions at roughly 4.1 percent, and ten-year loans at about 4.4 percent.
As for leverage, Fannie and Freddie are typically willing to go up to 75 and even 80 percent LTV, Lawton continues. But with some of the high-priced institutional-class properties acquired at sub-5 cap rates, the GSEs frequently look to limit leverage to the vicinity of 65 percent, he adds.
Life companies, which tend to focus on stronger properties and sponsorships, usually aim to keep LTVs in the 60s but will go up to 75 percent if they are comfortable with the situation, Lawton explains. And in many cases they quote tighter spreads than the GSEs, often to the tune of 30 to 40 basis points, he says.
Meanwhile, commercial banks have become more comfortable financing apartment construction—as today’s more developer-friendly terms suggest. As Lawton notes, banks are often willing to fund 65 percent of projected project costs with no personal recourse to the borrower—compared with more like a 50 percent loan-to-cost ratio a year ago with “a slice of recourse.”
And more and more developers are jumping into the fray after the long drought. Reis reports that deliveries of new apartments during 2011’s first six months came to all of 15,600 units—combining the two slowest quarters the firm has encountered since it started tracking activity back in 1999.
So even with the uptick of late in ground breakings and announced development plans, activity remains well off the 30-year national delivery average of 150,000 units.
Dallas-based multifamily consultant Witten Advisors is now projecting that developers will end up breaking ground on projects totaling roughly 150,000 apartments over the course of 2011—up sharply from the 120,000 units the firm was forecasting as the year got underway.
The more liberal financing terms, along with the low cap rates resulting from strong investor demand, are key factors driving the rapidly rebounding construction activity, says Ron Witten, president of Witten Advisors. “It’s easier to find new deals that are viable” as aggressive investors continue to bid up values of stabilized new developments, he notes.
Witten’s firm is now projecting that projects totaling about 210,000 units will get underway around the nation in 2012.
But August’s anemic national employment growth figures, along with a 13 percent decline in starts compared with July, leave some experts wondering whether lenders are now thinking about constricting the freer-flowing construction financing spigot.
Invesco’s Swango for one says he won’t be surprised if some would-be developers end up losing their tentative financing commitments from equity investors and construction lenders.
