The Phoenix apartment market has gotten so bad, it’s good.
Since the spring of 2007, when turmoil in the secondary markets for CMBS loans began mounting, the Phoenix apartment market has seen a steady decline in terms of operational and transactional volume. That spring, an ’80s vintage, higher-priced multifamily property could sell for a little more than $100,000 per unit. Since then, the market has been considered a “falling knife.”
Concessions began to increase significantly in the summer and fall of 2007, with rental rates falling steadily from the fall of 2007 until the summer of 2009. Transaction volume also came to a near halt with only nine 200-plus unit properties trading in 2008, approximately 95 percent off from the peak in 2006.
In the beginning of 2009, the Phoenix apartment market began to see transaction volume pick up, but buyers and sellers still had drastically differing pricing expectations, which prevented most properties from getting to the finish line. However, within the past three to five months of this year, there has been a noticeable difference. Apartment buyers returned in earnest despite the low number of quality properties for sale, which has resulted in a heightened number of offers on those properties that are on the market. On a recent sale offering of a 735-unit property, for instance, a whopping 34 offers were received. This is quite a sharp contrast from just a short time ago, when offers were scarce and investment equity had all but dried up.
The operational side of the market has also seen signs of life. Occupancies, rents, and concessions are leveling off after a steep slide over the past two years. Many owners are noting very slight firming in occupancy post-summer for Phoenix, which has led many to believe that although the market is a long way from a sustained recovery, “the worst is over” and it will at least hold steady in the near term.
Not Just Job Growth
Unfortunately, the city can’t rely on job growth alone as its driving force; 2009 is the third consecutive year of posted job losses in the Phoenix market. The biggest drivers right now are continued net population in-migration, which is still strong at approximately 45,000 residents a year, as well as the turmoil in the single-family housing market. There are now approximately 3,000 foreclosures in metro Phoenix every month, which benefits the apartment market.
Unfortunately, vacancies are still rising. The summer saw its usual softness in vacancies—when students and summer visitors leave town—together with a noticeably increased activity in the investment market. As of October, vacancies are hovering at more than 13 percent (a 20-year high), and most properties are offering two free months of rent in concessions, causing buyers to look at Phoenix today as an opportunity play.
Concessions will be the first indicator of an improving market. Currently, 16 percent annual rent discounts via concessions, combined with a physical vacancy of 13 percent, equates to an overall economic occupancy level of 70 percent. When capping income streams this weak, values come in so low when using “market” cap rates that the investment community is somewhat shifting to a “commodity pricing” model. In many cases, the cap rate would be higher for a stabilized property. However, the subsequent price per-unit and price per-square-foot become very compelling, even using lower cap rates than what would be considered “market.” With these capitalized values (in some cases equating to as low as 50 percent of replacement cost), many buyers are acquiring properties with the belief that the recovery in Phoenix is imminent.
What’s more, this fundamental shift to per-unit pricing has begun to thaw the deep freeze in transactions. Transactional volume has increased significantly as of the third quarter of ’09, and expectations are to see twice the amount of sales in the second half of ’09 as compared to the first half.
The performance of the Phoenix apartment market has always been closely tied to the housing market, and there have been positive shifts in both arenas. After a 27-month period of declining home values, housing prices are beginning to stabilize and even increase slightly. Unfortunately, many of these properties are being acquired by speculators, as the median price for a single-family home has fallen from a peak of $273,000 to $125,000, as of August 2009.
The good news is that as the affordability index improves in Phoenix, so does its attraction to large outside employers that value the city’s high quality of life as well as its affordable and diverse employee housing options. Positive movement is also occurring on the employment front: Unemployment claims in August declined for the first time in 22 months in the Phoenix metropolitan area.
Phoenix currently has 4,241 apartment units under construction today. This is in addition to a base of approximately 300,000 units. With the market fundamentals still weak, numbers like these are far too great. Therefore, until the market shows some signs of improvement, there is no need for the current pipeline.
As of 2010, there are virtually no new apartment permits for apartment properties of fewer than 1,000 units. Still, the city’s construction levels are down 45 percent from the 2005 to 2006 levels. The single-family, for-sale housing market is also contributing to this recovery. At year-end 2007, the MLS of for-sale housing inventory numbered 55,000 homes, of which 20,000 were vacant. Approximately 9,000 to 11,000 of the 20,000 vacant homes were also available for lease. Today, the total numbers of homes for sale on MLS is closer to 35,000, of which fewer than 5,000 are vacant or for lease. This is much closer to the natural norms for the Phoenix market.
Signs of Recovery
Over the past two years, Phoenix rents have tumbled nearly 20 percent. The current average effective rent is $0.79 per square foot effective and $0.93 per square foot gross. The decline in new construction, combined with the anticipated job growth and continued net population in-migration in 2010, will likely cause vacancy rates to peak in 2009 at 13 percent to 14 percent and will be close to that same figure at year’s end. In terms of vacancy and rent growth, no real recovery is expected in 2010, but 2011 will likely see some modest signs of concession decline and rent growth.
On the transactional side, cap rates in Phoenix have expanded disproportionately to the national average. Cap rates now are close to 8 percent for Class A properties, 8.5 percent to 9 percent for Class Bs, and 9 percent to 9.5 percent for Class C properties. With such high cap rates, buyers in Phoenix often discuss “commodity pricing.” Increasingly, buyers are looking at Class A properties that are less than 10 years old and being acquired in the $70,000 to $80,000 per-unit price range. Two years ago, these properties were trading at $100,000 per unit or higher, so the perception amongst buyers is that there’s real value in Phoenix on a per-unit, per-square-foot basis.
Through 2009, the Phoenix market will see slow, steady improvement on the operational side of the business, with a slight decrease in concessions and real rent growth happening in 2011 and 2012. The transactional side of the apartment market should also pick up through 2010, as the entire market will be able to establish a baseline of value from the recent increase in activity.
Population: 4.3 million
Median Age: 33.3
Median Income: $51,063
Average Rent: $0.93 per square foot
Notable: Greater Phoenix is home to more than 200 golf courses, which makes sense because the city averages more than 310 sunny days per year. Additionally, Phoenix is home to the largest municipal park in the world: South Mountain Park and Preserve covers more than 16,500 acres and has more than 50 miles of hiking, biking, and equestrian trails.
The Phoenix market has experienced a disproportionate share of the volatility of the national economic downturn. However, there has been a recent shift in the local mentality that some sense of stability is returning to the apartment market. Unemployment in Phoenix is also better than the national average at 8.4 percent versus the national average of 9.4 percent. Cap rates seem to have held steady, and opportunity is coming to the investment market.
Through the end of 2009, expect to see significantly more transactions in Phoenix, as well as continued stability in the operational market. The city is still one of the most affordable places to live in the country and offers a high quality of life relative to other major metro areas. And that means that what’s been so bad will likely soon be good again. [M]