Apartment Market Seeks a Comfortable Equilibrium

By Steve Bergsman
Additional Reporting by Kyle J. Ellis

Article courtesy of National Real Estate Investor.

Spurred by favorable tax laws and industry deregulation, the multifamily sector of the real estate industry took off like a racehorse in the mid-1980s. Record numbers of apartment units were built as financial institutions pumped development with a huge inflow of capital. The good times were relatively short-lived, as markets became glutted with vacant units and a deep real estate recession cast a gloom over the land. By 1990, the apartment market was in disarray. Fortunately, the bad times didn't last long, either.

With a lack of new development, vacancies became occupancies. An increased investment interest from the formerly disinterested Wall Street and the suddenly empowered real estate investment trust industry pushed multifamily back to the development and investment forefront of the real estate industry. That initial thrust, which really peaked about 1993-1994, is subsiding and the apartment industry once again is headed for a transition period.

"The apartment industry has been extremely active in the last five years and has changed dramatically in that time. It will continue to change through 1995," says Michael Mueller, vice president of CB Commercial Apartment Properties in Phoenix.

Hopefully, the changes won't be as dramatic as they were in the past. While the REIT industry, which fueled transactional business and new development over the past few years, has waned due to high interest rates impeding the ability of REITs to capitalize, other financial sources such as pension plans and traditional sources of capital like insurance companies and banks have come back to the market.

The current crop of investors like the continually improving benchmarks of the multifamily industry. The national vacancy rate, as reported by M/PF Research for the National Multi Housing Council, was as high as 12% during the late 1980s and has continually edged downward to about 9.4%.

"Out of the 54 markets we track, the majority of those are maintaining occupancy rates in the mid and upper 90%," says Ron Witten, president of Dallas-based M/PF Research. "Most markets nationally are in good shape."

The metropolitan areas of West Palm Beach, Fla., Las Vegas and San Francisco are at the top of Witten's list of best performers, all with an occupancy of 97%. Close behind with 96% occupancies are Detroit, Austin, Texas, Fort Lauderdale, Fla., Raleigh, N.C., Salt Lake City and Greenville, S.C. In fact, there were only two markets that reported below 90% occupancy: Miami and Cleveland.

As occupancies have improved, rental rates in selective markets have moved up as well. For example, last year in Phoenix, apartment owners enjoyed a 9.5% rate increase. In addition, general employment growth, which in turn creates the need for new residential formation, reached a six-year high of 3% last year.

"In most metro areas of the country, job growth has been good and housing demand somewhat stronger than anticipated," Witten says. "The acceleration is still reflective of the demand that is there."

In selected metropolitan areas, construction has come back strongly with a continued acceleration in volume. Rental starts posted the strongest consecutive quarters since 1990 in the second and third quarters of 1994. Annual starts are expected to total 175,000 for 1994.

No one in the real estate industry anticipates that the overbuilding of the 1980s will come back to haunt the apartment market in the 1990s. What is hoped for is an equilibrium between supply and demand.

Many of the markets, particularly those in the Sun Belt, were grossly overbuilt in the mid to late 1980s. It has taken some of these markets until 1992 and 1993 to trim the inventory. "That has all been absorbed," says Thomas Trimble, president of acquisitions at MIG Realty Advisors in West Palm Beach, Fla. "And it has been recent enough that there has been a little more caution in the market as it relates to creating new property."

This year, MIG hopes to do something on the order of $300 million in total investment. The vast majority of that investment would be in purchasing stabilized properties ž Class-A and -B quality garden and mid-rise apartments. The remainder would be for new development that is presold. "We are still geographically diverse," says Trimble. "We are very active in the Southeast, with some activity in the Midwest. MIG recently closed three deals in Texas and is looking more in the Southwest where we would like to do more business."

According to Alan Sweet, president of Chicago-based Amli Capital Inc., there were 500,000 to 600,000 apartment units developed in 1986. It is generally assumed the country needs between 250,000 and 300,000 units each year to satisfy obsolescence and new demand. This year, Sweet estimates the industry will create 250,000 new units.

"Some markets will be oversupplied. There will be certain markets that won't get enough new supply, but on a nationwide basis it won't be terrible," Sweet says.

Jonathan Kempner, president of the National Multi Housing Council in Washington, D.C., says his concern is that apartments "could be sexy one day and no one would want to deal with us the next day ž and the last two or three years apartments were the sexiest class by far." Kempner is not too worried, however. As he sees it, the apartment market has settled in that comfortable equilibrium that the industry would hope for. "People are interested in the asset class. Occupancy rates are generally up. Returns are pretty healthy. There is a general sense of well-being in the industry, not the euphoria of a year or two ago that was hard to sustain, but a realistic, solid performance," Kempner says.

The Atlanta-based Vinings Group, formerly M.F.I. Companies, recently changed its name to coincide with its new outlook. The Vinings Group now will focus on Class-B properties looking for moderate rehab that don't really compete with REITs, says Peter D. Anzo, president. Also, the company will focus on acquiring or merging with smaller apartment management companies and owners, he says. "We had been jumping around from Class-A to Class-D properties," he says.

"We have a fresh name to go along with our fresh outlook." "Vinings" comes from the name of the company's building, Vinings Point, which they purchased a couple of years ago. Anzo says that his company is expanding its office space with the addition of a new 6,800 sq. ft. building adjacent to the existing 6,800 sq. ft. headquarters.

In the mid-1990s, some people like the depth in the multifamily market. Initially, most investors and developers were only interested in Class-A properties and perhaps a high Class-B property. Now, there is a movement to Class-B, -C and even -D properties where investors will buy and then rehab to a higher level. Pension funds, which usually never stray below the Class-A property level, are now considering investing in lower grade properties. This has a lot to do with the cost factor as the renewed interest in apartments has pushed prices up too high to make the investment worthwhile in terms of expected yield.

Some people don't like the fact that the apartment market is a tougher place to build than ever before. There are some universals involved in new construction:

 Basic zoning requirements are much tougher now than they were in the 1980s.

 Substantial equity, 25% to 30%, is required on the part of the developer.

 The cost of building supplies, such as lumber and cement, is more expensive.

 Neighborhood groups have become more strident and active in opposing much new development.

 Land costs have increased.

The cost of land has risen dramatically, observes William Millichap, president of Marcus & Millichap in San Francisco. "If you look at the cost of land in 1992-1993, and since then, depending on the market, the same land could have jumped in value 30% to 100%. Prior to 1993, there was nothing going on. You would have to go back to the 1980s to see that kind of movement in prices."

The hottest market in terms of land zoned for apartments can be found in Phoenix, Tucson and Denver. "We have offices in Chicago, but it is slow," says Millichap. "Apartment land sales in Chicago have never had the enormous swings that the Sun Belt cities have had. In other cities such as Seattle, it's difficult to acquire land and sales have been relatively modest, while in places like Northern California rents aren't high enough to buy land for apartments."

The apartment market is widely divergent across the country. Some cities, mostly in the Sun Belt, have aggressive investment and development while other cities have been devoid of activity.

"What really fuels development is economic growth," says Michael Goldsmith, group president of Heller Real Estate Financial Services in Chicago. In some places like Dallas and Phoenix, tens of thousands of new jobs have been created over the past two years. On the other hand, some cities have experienced negative growth. "One job produces two-plus family formations. There is a lot of pent-up demand created through job growth, which is why you see a lot of development going on in Sun Belt locations."

While there has been a lot of activity in areas stretching from Florida and Atlanta through Texas to Denver and Phoenix, developers and investors generally have drawn a line at the Colorado River, which separates Arizona from California. However, California's moment in the sun might be returning. CB Commercial's Mueller, who deals with most of the Southwest markets, says: "From an investment standpoint, the biggest potential increase is probably in the Southern California marketplace. That's where all the investors say they want to be."

Earlier this year, when Ernst & Young Real Estate and Construction Services named the 10 most undervalued and underbuilt apartment markets, Los Angeles, Riverside/San Bernadino, San Jose and Oakland ranked in the top four places.

"All these markets are clearly speculative, but they possess attributes which would indicate that they will perform well in the next three to five years," explains Michael Evans, national director of Ernst & Young Real Estate and Construction Services in San Francisco. Other markets on the list include Phoenix, Boston and several Florida cities including Miami, Fort Lauderdale, Orlando, Tampa and St. Petersburg.

Manhattan didn't make the list, but could be a surprising candidate. Jack Heller, of Heller-Macauley Inc., says the rental market in Manhattan has seen huge growth. "It is the hottest market in New York."

There was a point in time from 1982 through 1986 that the for-sale market began to outpace rentals in New York, which has the second-largest rental market per capita in the country behind Newark, but Heller says: "This has always been and always will be a rental-base city. The rental market was strong in 1994 and will continue to be so in 1995. There are almost no vacancies."

The market has performed so well that a number of new apartment buildings comprising a couple of thousand units were started last year and will come on-line this year.

No matter which city, developers who tarry will be too late. Heller's Goldsmith says that already a lot of the easiest sites already have been developed. However, he adds optimistically, as communities expand, sites that weren't attractive five years ago become attractive.

There is enough demand to fill the supply of product being built, Goldsmith says. More importantly, from a financial point of view, there is enough institutional demand in the completed product that the project could be sold at attractive cap rates. "In other words, the developer can make money going forward."

Steve Bergsman is a Phoenix-based writer who contributes regularly to National Real Estate Investor.