Investors are starting to swoon again in the City of Brotherly Love.

Multifamily properties are trading at healthy numbers, and fundamentals are steadily improving as the Philadelphia apartment sector ascends out of the recession. Vacancy rates, now at 5.5 percent, are down from a recession high of 6.9 percent at year-end 2009. And rent growth has slowly but surely gained momentum since 2009, hitting 3.2 percent this year and forecasted to average 3.25 percent through 2015, according to Boston-based market research firm PPR.

The Class A market has led the pace, with stabilized vacancy rates at an impressive 1.9 percent as of the second quarter and rent growth of 6.2 percent over the past year, according to Alexandria, Va.–based Delta Associates. Much of this rapid absorption and growth are concentrated in the heart of Philadelphia, where prospective renters will have a difficult time finding anything available. The Class A vacancy rate for Center City sits at an astounding 1.5 percent, and over the past year, rent growth for cream-of-the-crop downtown properties has registered at a whopping 10.1 percent, according to Delta Associates.

Driving this is Philadelphia's large increase in its rental population over the past decade. Between 2000 and 2010, the percentage of Philadelphians who rent, rather than own, a home rose from 40.7 percent to 45.9 percent, according to U.S. Census data, one of the largest increases in the nation's major metros.

These market factors of growing demand, dwindling supply, and a constrained pipeline for future deliveries have Philly poised to lead a strong recovery and drive investor demand for many years to come.

Development Yields

As is the case when fundamentals improve so dramatically, that most migratory of birds, the construction crane, has returned to the city.

Institutional joint-venture equity is again starting to look in Philadelphia as an alternative to the much pricier multifamily markets of New York City, Boston, and Washington, D.C. And developers are growing more optimistic about the region. Rochester, N.Y.–based REIT Home Properties recently gained control on two parcels of land in Conshohocken, where it's planning to break ground on 385 units in late 2012.

Last year, McLean, Va.–based Jefferson Apartment Group started construction on Jefferson at West Goshen, a 230-unit project on Route 202 in West Chester, armed with a construction loan from Wells Fargo and jointventure equity from AEW Capital Management. Return on cost using the then-current rents was forecasted to be 8.5 percent.

But as more equity investors enter the market, and cap rates continue to fall, development yields have fallen fast over the past year. Minimum return on cost today has dropped 100 basis points (bps) to 7.5 percent. Generally, equity investors want to see a minimum 150 bps spread between current cap rates and return on cost, which means equity investors are comfortable with a 6 percent cap rate, which is reasonable for new developments.

Today, development equity is seeking 20 percent or greater project-level leveraged internal rates of return. For existing product, value-add equity is seeking leveraged returns in the high teens.

Despite the right environment for development, however, the outlook for deliveries is still quite constrained for the near term, with only 317 units expected for delivery this year and 747 units expected to be completed next year.

Transaction Trends

Investors, too, are eyeing Philadelphia. A few transactions indicate where pricing is, as well as the disparity between Class A and B products in the metro.

Invesco Realty Advisors purchased the Class A, 309-unit Londonbury Apartments in Conshohocken from O'Neill Properties in June for around $80 million. The property was constructed in 2010 as part of O'Neill's Millennium development, a 60-acre mixed-use community.

Also in June, TIAA-CREF purchased the 185-unit Pepper Building in Center City for $50.8 million, underscoring institutional investor interest in the area. The seller was Philadelphia Management Group, which bought the complex in 2007, gutting and converting the former hospital and medical offices into rentals.

That same month, the 296-unit Willow Ridge, a Class B product developed in the early 1990s, sold for about $95,000 per unit to an undisclosed buyer. The deal, located in the affluent suburb of Marlton, N.J., about 15 miles from Philadelphia, received about 30 offers and exhibited a going-in cap rate of 6.25 percent when it closed. The new owners plan to do a rehab.

And in July, Home Properties purchased the Class B, 203-unit Waterview Apartments in East Goshen, a Philadelphia suburb, for $24.6 million, or $121,000 per unit, from Fairfield Residential. The REIT plans to pump in $2.3 million over the next three years to correct deferred maintenance and upgrade kitchens and baths.

Cheap Money

Generally, cap rates have ranged from 5.5 percent to 6.5 percent in and around Philadelphia, depending on the age and quality of the asset. Driving those aggressive cap rates is the plentiful low-cost debt available today.

Interest rates are in the 3.75 percent range for five-year money and the 4.75 percent range for 10-year loans, allowing buyers to bid aggressively for low cap-rate deals. Loan-tovalue (LTV) ratios max out at 80 percent for banks and the agencies, Fannie Mae, Freddie Mac, and the Federal Housing Administration. Life insurance companies will go up to 70 percent leverage, sometimes up to 75 percent, and for high-quality deals, their rates can be well inside of the agencies'.

CMBS lenders enjoyed a brief period of very aggressive bidding for deals in the second quarter but have pulled back with the August swoon in the capital markets. It's only a matter of time before their pricing falls in line with that of the rest of the debt market. Meanwhile, the conduits are still out there cautiously bidding and closing new deals.

This is all good news for apartment owners and investors in the area. Most important, the fundamentals are finally catching up with the sometimes overly optimistic investor underwriting models. In the case of Philadelphia, at least, that optimism seems well-founded.