The past several years have been a smooth ride for the apartment industry. Yet multifamily players now have mixed feelings about where the road ahead will lead.
Put a group of multifamily developers and investors in a room and it wouldn’t be difficult for them to reach consensus on the gangbusters success of the segment over the past few years. General economic factors and several demographic trends have worked strongly in their favor.
But ask the congenial group for a 2016 and beyond forecast and opinions splinter. Seeing the market’s results throughout the recovery, some multifamily buyers and builders are decidedly bullish. Others, fully aware of the axiom that what goes up must come down, see signs that the market may be headed in the wrong direction.
“Apartment fundamentals are better than ever,” declares Colin Gillis, Southeast VP of acquisitions at Passco Cos. “Year-over-year cap rate compression from 2014-2015 averaged around 10 basis points across all asset and location classes while the 10-year treasury rate came in 40 basis points over that same period, leaving around a 300-point spread between the two rates.”
He explains, “Once we see the gap between cap rates and the 10-year treasury dip below the historical average of around 150 basis points, that’s when the market begins to feel overheated. We would need a major swing in the market for that to happen.”
Adds R. Ramin Kamfar, founder, chairman and CEO of Bluerock Real Estate, a private equity real estate firm that sponsors Bluerock Residential Growth REIT, “We’re in the fifth or sixth inning and the game is a double header.
“The Millennial generation is coming into the prime rental age of 201 to 34 and that generation of 80 million is larger than the baby boomer populations,” he states. “Over the next 15 years, it will form another 30 million households. Further 70% of Millennials will rent for 10 years or longer, so we’re in a good demographic cycle.”
Kevin Finkel, EVP, Resource Real Estate, notes that we’re starting to see middle-class baby boomers “bubble back into rentals because they’re selling their homes. It used to be that, when you were 65, you just talked about the next 10 years, but now people are saying that may be around for a while. I see silver-haired people – in velour sweat suits – walking around our property all of the time now.”
Economic and industry research supports their claims. Marcus and Millichap’s national multifamily forecast for 2016, which ranks 46 markets, reports, “In 2016, GDP will grow from 1.5% to 2.5%. Job openings hovered near all-time highs in the second half of 2015, signaling that employers see additional expansion opportunities that will require more workers on the horizon.”
Further, MMI’s analysis reports that not only were new rentals absorbed in substantial numbers last year, but an expansion of US payrolls – along with the aforementioned demographic trends will also generate new households, supporting a 5% jump in the average effective rent this year, and continued new demand and solid asset operations.
However, the firm had some bitter news on apartment development. “Elevated completions will exceed demand and underpin a nominal increase in the US vacancy rate in 2016. Multifamily starts remained elevated nationwide, pointing to additional supply pressures over the near term. Several metros will record supply-induced vacancy increases this year.”
Marcus & Millichap is not alone in that sentiment. “The market may be overheating,” observes David Schwartz, co-founder and CEO, Waterton. “Valuations are very high and when you see them so much above their prior peak while cap rates are at historic lows, it raises your antenna.
“There’s good demand,” he admits, “but we might have overshot it so rents may taper or flatten. When you have tremendous supply deliveries you likely will see concessions, vacancies and rent drops.”
Cautions Capital One multifamily finance’s SVP, Kristen Croxton, “If apartments continue to perform well, we may see people step aside because cap rates will keep compressing and it will no longer make sense for some investors. I wouldn’t be surprised if we saw smaller portfolios of 10 to 15 properties change hands. If they feel they got in at the right time, the smaller investor will likely want to get out before things get too heated.”
Others see growth ahead but in less popular markets and product types. Arbor Commercial Mortgage chairman and CEO Ivan Kaufman, for instance, has only seen deliveries in the luxury segment due to the increased costs of land and labor.
“New supply is disproportionately downtown, partly because that’s where Millennials want to be,” he suggests. “So there’s huge opportunity in the affluent suburbs where existing apartments need significant renovation and the barriers to entry are blocking new projects. This is really the sweet spot. For lower income, there are government programs but if you’re a workforce person in the middle, no one is building for you.”
Schwartz agrees. “Everything being built is being designed for the highest level renter; it’s an arms raise for amenities. The market could get overbuilt within that niche.”
Even the bulls are eyeing slightly off-the-beaten-path markets.
“We evaluate opportunities on a deal-by-deal basis and try not to rule out certain locations due to stigmas,” concedes Gillis. “We will continue to evaluate all class A opportunities across both the primary and secondary markets of the Southeast.”
But while Gillis sees pockets of opportunity, he has concerns, too. “We are exercising an extreme amount of caution toward specific submarkets with high concentrations of development of homogenous product as opposed to blackballing an entire market.”
As examples, he cites midrise assets in the Buckhead area of Atlanta; the Downtown-West-End-Midtown section of Nashville; Charlotte CBD; garden assets along the International Drive corridor in Orlando; and garden assets in the Southside/Bay Meadows submarket of Jacksonville. Those are some submarkets, and product types, in which a lot of similar developments are chasing the same tenants, leveraging off of the same employment drivers and underwriting the same rents.
For BlueRock’s part, says Kamfar, the REIT is in the top 40 markets below the leading coastal cities, such as New York City, San Francisco and Washington, DC. “In those gateway cities we find a lot of capital chasing deals, and valuations to be expensive, at cap rates of 3.5% to 4%,” he says. “Geographically, we’re not in the Midwest, because they lack strong job growth on a percentage basis.” In short, the firm looks for markets that will deliver high disposable-income jobs – such as in the fields of healthcare, education, technology, finance, trade, entertainment and high value manufacturing – for the foreseeable future.
The peril of larger markets is also clear to Matt Nix, principal of REVA Development Partners. “In Chicago, the Downtown class A rental market could be on the brink of overheating with approximately 8,000 units scheduled to deliver through 2017. That is one of the main reasons our focus is on the inner-ring suburbs.”
Nevertheless, urban communities are where most multifamily investors and developers are putting their efforts. “The number of apartment units inside CBDs jumped 19.5% from about 1.4 million units in 2005 to 1.6 million units in 2015,” according to MPF Research. “This increase marks a rate of more than double that of unit growth in the suburbs.”
During a panel discussion at the National Multi Housing Council’s 2016 Apartment Strategies Conference, Holland Partner Group chairman and CEO Clyde Holland said, “We only want to build in absolutely high-quality living environments in the urban core – and that’s it. As traffic gets worse and more expensive in terms of time and cost, there’s more demand for urban core product.”
High Street Residential, a subsidiary of Trammell Crow Co., sees the appeal of cities too, principal Josh Dix tells Real Estate Forum. “In Dallas/Ft. Worth, twice as many jobs are being created during the current economic cycle compared to last. With population growth exceeding 160,000 per year, the supply of new units is not meeting the demand.”
In Washington, DC, he continues, “The media declared that the area had a glut of apartments in 2013. However, concern of an overheated market at the time failed to take into account many of the fundamental changes that continue to benefit the multifamily industry. DC experienced record absorption in 2013, ’14 and ’15.”
Adds Kaufman, “The highest concentration of multifamily development over the next four years is projected to occur in New York, Nashville, Seattle, San Francisco, Washington, DC, and Charlotte. So far, apartment demand and household formation in these markets has kept pace with development, and demographics for continued strong absorption remain favorable.”
Much depends, though, on where rents are headed and what apartment dwellers can afford.
“Wage growth has not kept up with rent growth coming out of the recession,” Kaufman points out. “This affordability squeeze is unfortunately making it harder for aspiring homeowners to save up for a home loan down payment.”
Schwartz, too, sees an affordability problem. “Many renters in the country are spending half of their income on rent while wage growth isn’t occurring, so they’re spending more on rent and less on other things, such as cars or groceries. This will continue because we’re not seeing homeownership increase and when you look at what’s being built, it’s all luxury.”
The disparity between rising rental rates and stagnant wage growth – despite healthy job creation – is a significant challenge, concurs Dix. “Reasonable solutions include smaller units – and even micro-units in some markets – as well as a decent level of affordable housing integrated into market rate deals, as long as it’s predictable and fairly applied,” he relates. “Additionally, we continue to evaluate means and methods of construction to further reduce costs while not sacrificing the quality of the living experience.”
The imbalance between wage and rent growth will only continue, predicts Kaufman. “As new unit deliveries ramp up, rent growth will slow down while concessions are made to get these properties stabilized.”
At the same time, he notes, “Rents are increasing significantly. Looking back at 2015, we saw average asking rents increase nearly 5% nationally yet we have not seen any meaningful wage growth since the late 1990s.”
Gillis amplifies the point. “Many of the primary markets we track have experienced year-over-year rent growth as high as 12%, with many averaging over 6% annually for the last two years. This type of explosive growth does not feel sustainable through 2016.”
One factor helping developers and investors, though, is a generally positive lending environment for borrowers.
“There is an ample supply of debt and equity for best-in-class developments,” says Nix, adding that lending standards haven’t eased significantly, so the norm is conservative underwriting, relatively low leverage and personal guarantees.
“Attractive financing will continue to be available,” forecasts Kamfar, “because of the appeal of the assets we are buying – class A assets in high quality markets – and because we are only using moderate leverage.”
“We don’t see changes in the financing market for our product on the horizon,” he says. “The CMBS market may have some issues given new risk-retention rules that are going into effect at the end of this year.”
Croxton lends support to that theory. “Conditions are very volatile in the CMS market right now. “Pricing seems to be stabilizing some but we are hearing that many of the shops are reducing leverage and interest only. They’re still going to chase the good properties with strong borrowers but I don’t think we’re going to see the big numbers for total production that people were projecting a few months ago.”
This article was originally published in Real Estate Forum’s February/March 2016 issue.