Source: Zillow
Source: Zillow

Marshall Rosen doesn’t really want you to read this article.

That’s because the CEO of Summit, N.J.–based Solomon Organization, which owns 10,000 predominantly Class B apartments spread across New York, New Jersey, Pennsylvania, and Connecticut, doesn’t want you bidding against him on his next deal.

After all, he’s enjoyed relatively little competition from other operators going after Class B assets in his core markets: He closed on approximately $200 million in properties in a recent 12-month span—and he’d like it to stay that way.

Take, for instance, the Addison at English Village, a 600-unit, 40-something-year-old property in Horsham Township, Pa., just 11 miles from the Philadelphia city limits. Rosen was able to acquire the property quietly, in an approximately $75 million value-add deal that closed in January, and is now working to put in upgrades including granite counters, new appliances, and hardwood-style flooring.

A purveyor of what he refers to as “affordable luxury with a small ‘a’,” he plans to push rents by approximately $200 per unit. That means one-bedrooms will go from approximately $800 to $1,000 in rent per month, with two-bedrooms increasing from around $1,000 to $1,200.

At existing cash flow, the deal came in at a 5.4% cap rate, with an anticipated cash-on-cash return of 9% after improvements are made, and overall returns of 15% expected on a 10-year time horizon. That’s a huge premium compared with the sub-4% cap rates being written on deals for luxury apartments that rent for $4,000 a month or more in not-too-distant Manhattan. And the number of other bidders Rosen faced to win that outsized premium?


“It was ourselves, one of the better-known public REITs, and another Philadelphia-area private REIT,” Rosen says. “The other local player fell out pretty early, and then it was just us and the big public REIT going after it. Since we had closed on more than a hundred million dollars in properties in this asset class in the last year, that made the owner eventually feel most comfortable with us.”

The story of the Addison with its $1,200 rents and outsized returns, as well as the dearth of other bidders Rosen encountered buying it, illustrates both an untapped opportunity, as well as a burgeoning affordability crisis developing for multifamily today.

Namely, while Rosen and other operators focused on the mid-tier apartment market say demand for the sub-$1,200, workforce apartment is nearly unlimited across the country, major institutional money has shunned the sector, focusing instead on new, shiny, luxury apartment deals located in the urban core that bring in $2,500 a month in rent and above.

This institutional money, seeking to put a huge amount of cash to work, has helped push  a breathtaking ascent for rents across all apartment types, with new development focused almost exclusively on the high end, and a near vacuum -- or unlimited opportunity, depending on how you look at it -- for capitalizing deals in the lower, more affordable tiers of the market. “I hate to publicize it, but yes, that seems like a fair assessment of this market right now,” says Rosen. As affordability continues to dwindle within the multifamily market, those operators, like Rosen, who can operate affordable market-rate apartments outside the luxury realm, while making a solid a return, are faced with a tremendous opportunity.

Indentured Renters 

To understand the situation, its best to start with  the affordability gap first, and what’s causing it.

Source: Axiometrics

Consider these statistics, compiled by Zillow. Nationwide, renters making the median income of $53,602 can expect to spend about 30 percent of their income on rent, or 5.5 percentage points more than the historical average between 1985 and 2000.

That’s a notable increase, of course, but in what Zillow refers to as the Unaffordable Six—New York, San Francisco, Los Angeles, San Jose, San Diego and Miami—rents are now approaching nearly indentured levels. There, residents can expect to pay, on average, 39.4% of their income for rent. In San Diego, the number is 43.2%; in San Francisco it’s 44%; and in Los Angeles, it’s a whopping 48.2%, or nearly half the area’s median income.

“Renters are getting absolutely crushed,” says Zillow senior economist Skylar Olsen. “Rent is getting less and less affordable, and it’s a problem that’s getting worse at a faster pace than we’ve ever seen before.” Olsen’s colleague, senior economist Krishna Rao, sums it up thus: “Nationally, renters are spending more of their income on rent than they have at any point in the past 30 years.”

The picture becomes even more imbalanced if you consider just new apartment construction between 2011 and 2014—the core luxury sector that’s gotten so much attention from operators and investors during this cycle. For those units, nationally, residents can expect to pay 37% of the median income toward rent, according to Axiometrics. But that’s just the average. Want to rent a new apartment in New York? It will cost you 67% of the median income. San Francisco, by comparison, is still a bargain: you can get fresh digs there for just 53% of the median income. 

The numbers provide a stark—some might say appalling—contrast to how the apartment industry painted its own image less than a decade ago. At that time, when single-family home prices were soaring and many apartments stood vacant, the multifamily industry heralded itself as the first—and last—option of affordable housing for millions of Americans. But today’s numbers paint it instead as a bastion of over-the-top luxury apartments and ever-increasing rents pushing workforce renters to the brink. 

Compare this trend to the economics of owning a home today, if you can come up with a down payment and qualify for a mortgage. Zillow says that homeowners in the U.S. today can expect to spend only about 15% of their income on their mortgage. That number is actually down from the historic norm of 21%. Which begs the question: Who in this market is still a renter by choice?

“After the housing bubble went bust, a lot of people lost the ability to own their own home,” says Olsen. “Now, because they were foreclosed on, or inventory is still so constrained in the for-sale market, they have to rent. They don’t have the down payment, they don’t have the credit, and they certainly don’t have the ability to compete with other home shoppers for the limited amount of inventory in the market.”

Source: Zillow
Source: Zillow

Obstacles of Affordability 

Of course, the hangover of a nearly non-existent development pipeline during the Great Recession is still contributing to demand outstripping available supply today, which accounts for a good portion of the overall surge in rents. But observers say there are many other reasons for the myopic focus on luxury that’s driving this affordability gap, and they don’t all have to do with developers chasing multi-thousand dollar rents.

“I think it's hard to blame developers for building what the market demands, whether they believe that demand makes sense or not,” says Dan Miller, co-founder and president of real estate investment crowd-funding site Fundrise. But Miller isn’t referring exclusively to demand for luxury apartments by residents, per se. Rather, he’s also talking about the demand in the capital markets to put money to work. With overseas capital flooding the deal pipeline, many large investors can’t even consider the lower end of the market because they simply can’t deploy enough cash there.

“Even if there’s more inherent, unmet demand for apartments in tertiary markets farther out, it’s much harder to put the financing together for those kinds of deals,” Miller says. “If I’m running a billion dollar fund, I can’t afford to do a $10 million deal. It’s just a lot easier to raise capital for the bigger deals in L.A., San Francisco, D.C. and New York.”

That lack of institutional interest at the middle and lower end of the market actually led Miller and his brother Benjamin to co-found Fundrise to pool together smaller real estate investors so those kinds of deals – like the ones Rosen sees little competition for – can get done. The sons of Washington, D.C. developer Herb Miller of Western Development Corp., the pair originally figured with their family’s network of connections, finding investors to help them finance smaller projects in less marquee neighborhoods would be a no-brainer.

“We went out and approached some big institutional investors that our family had worked with for years, people we knew personally,” Miller says. “And we thought, this makes perfect sense. They know us, and we’ll give them access to underserved neighborhoods. But the response we got was, ‘Well, we don’t really know the area you’re looking at.’ And even if they did, they couldn’t write a check for less than $10 million. Even our midsized transactions were too small for these guys.”

Building new affordable apartments isn’t any easier. The cost of land and the battles developers face for entitlements today push costs up to almost luxury levels before construction even starts. “When you layer on the costs, regulations, and review time in many cities, it’s extremely difficult to get something approved,” says Zillow’s Olsen. “If it’s that hard to get any one project approved, as a developer, you need to get the most bang for your buck. Which is why it’s not surprising we’re seeing so many luxury apartments.”

For Kevin Finkel, executive vice president at Philadelphia-based Resource Real Estate, which targets 1980s-era properties as value-add acquisitions and operates approximately 34,000 units, the imbalance between luxury and other apartment classes all comes down to market incentives. Namely, when it comes to building apartments that are affordable to rent, there are none.

“There is virtually no incentive to build new apartments in the Class B market,” Finkel says. “Developers need to get generally over $2,000 per unit in order for them to hit their rate of return hurdles. The only place they can do that is downtown, with high-end units.”

Jay Denton, senior vice president of research at Axiometrics, says that’s simply the nature of new multifamily product – now and always. “That is true this cycle, and it was true in previous cycles,” says Denton, whose firm tracked 474,436 new units coming online from 2012 to 2014. “It really doesn't matter which market, we see this trend all over the country. It's simply how the market works.”

Which is why any modicum of market-rate affordability can only be achieved in value-add deals today. Indeed, Rosen is candid about the numbers, and the rents, that are in place at his “affordable luxury” apartments at the Addison. “There’s no way we could have done this for replacement cost,” Rosen says. “If we were building new in that location today, we’d have to charge between $2,200 and $2,500 a month instead of $1,000 to $1,200.”

Easy Money at the Low End

Now, consider the opportunity this affordability crisis has created. As investors chase Class A, competition drops lower down the quality scale. And, for operators who focus on the low end, success seems almost assured.

John Lauder, senior acquisitions analyst for Chicago-based 29th Street Capital, which runs a portfolio of 5,500 Class B & C apartments, sums up the competitive landscape thus: “Class A is big, and it’s a very competitive bidding process. But most of our deals range from just $8 to $20 million. There’s a lot less competition where we are, with virtually no institutional investors. We see a lot of off-market deals that result in better pricing for buyers such as ourselves.”

Minimizing Credit Risks

While Pangea illustrates how affordable apartments can be offered to the lower end of the market profitably, operators accustomed to Class A residents’ credit profiles may flinch at the underwriting risk inherent in B and C apartments. To address this, Pangea uses a proprietary algorithm in its underwriting process that doesn’t look at credit scores alone.

“We’ve found, below a certain threshold, credit scores are no longer a great predictor of whether a resident will pay,” says Martay. Instead, the company considers other factors, such as the time a prospect has been at her current job and address, as well. “The biggest challenge in most of the properties we acquire is physical and economic occupancy, and our underwriting has helped us address that.” 

Other companies who are capitalizing on higher returns at the lower-end of the market while providing more affordable apartments say operational poise is crucial for success. 

“The appeal to this market is the price: You can obtain cap rates in the 8% to 10% range, whereas luxury will be much lower,” says James Wise, principal of Parma, Ohio based Holton-Wise Property Group, which focuses on Class B and C apartments. “Investors are starting to come to us from New York and California, where they’re stuck with multifamily properties trading for 2% to 3% cap rates. They can more than double that out here with Class B alone.”

But the biggest challenge is dealing with a resident demographic among whom an economic hiccup is much harder felt than among millennials in the urban core. “A lot of our residents might not have enough savings to withstand a job loss or if someone gets sick,” Wise says. “Operating in this space means having a specific process in place and sticking with it. You can’t let things slide.” 

Finkel points to the colossal size of this underserved market. 

“In the middle tier, you can charge around $1,300 a month, which just happens to be 30% of the average median household income in America,” Finkel says. “What’s incredible is that represents over half the population of this country. That’s a huge number of Americans who aren’t being supplied with apartments.”

And, in many cases, this demand persists through economic ebbs and flows. “There is, and will always be, a strong demand for a more affordable, no-frills type of apartment, no matter what the economy is doing,” says Chad Dewald, vice president of multifamily management at Tampa, Fla.–based Franklin Street Real Estate, which runs 2,500 Class B and C units. “If you’re able to keep expenses reasonable while still providing a clean, safe place for hardworking people to rest their heads, there’s almost no limit on the demand side.”

The same can’t be said of all those luxury units dotting the skylines of America’s premier cities today, whose owners will still have to pay debt service when this cycle inevitably turns.

But for the rest of the apartment market, if you can do what people like Rosen, Finkel, and Dewald are doing—providing that clean, safe, no-frills apartment at a livable price point—profits are yours for the taking. Plus, you’ll be providing an affordable place to live for an underserved market that multifamily’s obsessive focus on luxury has all but left behind.

Depends Where You Look

The sub-$1,200 lease isn’t a thing of the past everywhere. Michael Taus, vice president of marketing at Abodo, the map-based apartment search app founded in Madison, Wisc., says there is an abundance of affordable apartments for rent today, if you know where to look.

“Yes, rents are high. Yes, it’s becoming increasingly unaffordable. But then there’s this huge swath of the country – where most of America still lives – that doesn’t suffer from the same problem,” Taus says. “Renters do have a lot of choice, but up until now it’s been difficult to access because the data is very fragmented.”

For example, Taus points to Minneapolis, where a recent screen on Abodo culled 812 active listings below $1,200. He then filtered for apartments that had amenities, such as free Internet and utilities included in the rent, and found hundreds within that selection. From his perspective, that’s representative of owners who are providing value to renters, just not in the coastal cities. “Minneapolis is a thriving, downtown, urban environment,” Taus says. “It's a pretty good example of what middle metropolitan America looks like. And in that environment, if you can screen for value, and the exact amenities you’re looking for, you’ve still got plenty of inventory to choose from.”           

To be sure, there are already operators targeting this niche, where opportunities abound not only to make outsized returns, but to help improve outdated housing stock as well.

Take Chicago-based Pangea, which was founded on the principle of acquiring distressed buildings in sometimes blighted areas and catering to higher credit risk individuals. Launched six years ago by investors with a background in the short-term consumer credit industry, the company has amassed a portfolio of 10,000 units in underserved portions of Chicago, Indianapolis, and Baltimore, and charges an average of about $700 for apartments with new kitchens, updated bathrooms and hardwood-style floors.

“Many of the buildings we’ve been able to acquire were in a less-than-desirable condition,” says Pete Martay, the firm’s chief investment officer. “In some cases, we’ve been able to change entire neighborhoods, upgrading a dozen vacant buildings to livable apartments and turning those areas around.” The financial results for Pangea, according to Martay, have been “double-digit, unlevered returns.”