After being overshadowed by Phoenix for decades, Tucson is emerging as one of the brightest multifamily markets in the nation. Strong job growth, an expanding population and an anti-development attitude have led the way to record absorption, low vacancy rates, and strong rental growth.

“There is really no weakness in the market,” said Mike McClain, senior director of the national multihousing group for Marcus & Millichap Real Estate Investment Brokerage Co. “From occupancy to rental rates to development, things look really good and everything points to an even better market next year.”

Today, about one million people live in Tucson, which is the home of the University of Arizona—one of the largest universities in the nation. Roughly 22,000 people move to the city each year, attracted by strong job growth and a high quality of life. Employment grew 3.3 percent in June 2007 for Tucson, on par with Phoenix, which is almost three times larger, figures from the Arizona Department of Employment show.

Despite its expanding population and job market, Tucson’s apartment market, which consists of about 60,000 units, isn’t growing. Only 368 units came online in 2006, according to Sperry Van Ness, and roughly 30 units are under construction today. “We have far less new development than we need—there’s just very little on the drawing board because it’s hard to find land in Tucson that is appropriate for multifamily,” said John Buette, an advisor with Sperry Van Ness’ Tucson office.

Land is not only hard to find, it’s expensive. Tucson isn’t known for being pro-development, either. “Land prices are quadruple what they were five years ago,” McClain said. “And there’s a lot of headache and cost related to the city. Our city council is not developer-friendly like it is in Phoenix.”

Industry experts don’t expect any substantial apartment development for the next 18 months, despite the fact that Tucson’s median home price jumped 21.4 percent from March 2006 to March 2007. “Homes are less affordable, so our renter base has grown,” said Melanie Morrison, co-owner for Morrison, Ekre & Bart Management Services Inc., a Tucson-based firm that has more than 5,600 apartment units under management locally. “In the tough years, we were losing renters hand over fist, and we’re not seeing as much of that now.”

Low rent, high expectations

The lack of new development translates into lower vacancies and higher rents for Tucson. During the first quarter of 2007, the city experienced the strongest absorption in seven years with 1,100 units absorbed and a vacancy rate that fell from 7 percent to 6.5 percent, according to Hendricks & Partners. Experts predict the vacancy rate will drop into the 5 percent range once college students and snow birds come back in the fall.

Morrison’s managed portfolio is 92 percent occupied and has been holding steady, allowing the firm to focus on maximizing rents. The firm’s stable properties are achieving effective rent growth of 4 percent to 5 percent, while recently rehabbed projects are seeing rate increases of 10 percent to 15 percent.

On a marketwide basis, Tucson achieved rent growth of 6.2 percent during the first quarter, a marked change from previous years. Historically, the city didn’t have strong rental rate increases. “Owners have been asleep for years when it comes to raising rents,” said Mike Sauter, CEO of S-J Management LLC, a Seattle-based apartment owner and manager that entered Tucson last fall with the $21.9 million acquisition of the 196-unit Springs at Continental Ranch Apartments. Since then, the company has invested another $250 million in Tucson, buying five more properties with a total of more than 2,000 units.

“Rental growth is one of the most important reasons I’m buying in Tucson,” Sauter said, adding that his plan is to acquire the majority of the Class A assets in north Tucson. Most recently, S-J Management acquired Summerlin Villas, a Class A complex with a vacancy rate of just 1.8 percent, an average rental rate of 95 cents per square foot and no concessions. He contends that the rents should be around $1.05 to $1.10 per square foot, an increase of $100 to $150 per unit, and within two to three years, he expects rents could easily be $1.15 per square foot.

During the first quarter, Tucson had the highest rent growth of the four southwest markets of Albuquerque, Las Vegas, Phoenix, and Tucson, according to Art Wadlund, a partner in Hendricks & Partners’ Tucson office. Still, rents in Tucson are some of the lowest in the nation—a whopping 27 percent less than Phoenix ($620 versus $789) even though the annual median income is only 15 percent higher in Phoenix than in Tucson ($60,100 versus $52,400).

“Even somebody who could not spell Tucson and did not know where it was located could figure out that rents in Tucson are low and have to go up,” Wadlund said. “And the Tucson market will get tighter in the future.”

Sperry Van Ness’ Buette agreed and predicted that rent growth will reach 5 percent or 6 percent in 2008. However, he’s keeping an eye on investor-owned single-family properties that are sitting empty (10 percent to 15 percent of homes sold in 2005 and 2006 were bought by investors).

“These investors aren’t able to sell the houses, so they’ll have to rent them, and we don’t know what that is going to do to the apartment market,” Buette said. “There’s going to be some fallout because I think these investors are going to get pretty aggressive on leasing rates, and that might affect higher-end apartment communities.”

Value-added plays

The lure of stable cash flow and rental upside is attracting investors from across the nation, particularly those from the West Coast, like S-J Management and San Franciscobased Prime Properties, which has invested $142 million in Tucson over the past several months. Most recently, the firm acquired Casa Dorinda Apartments and Mira Vista Apartments, two adjacent apartment communities with a total of 251 units, for $22.5 million.

Buette brokered the deal, which traded at a 5.4 percent cap rate. “For California investors, it’s just a quick plane ride over here to check out their properties,” he explained.

During the first half of 2007, roughly $350 million worth of apartment properties changed hands, according to Hendricks & Partners. Last year, investment volume eclipsed $780 million, and in 2005 it was $685 million. So far this year, pricing and cap rates have been pretty flat, with pricing ranging from $40,000 to $120,000 per unit and cap rates in the high 5 percent range.

Hendricks & Partners’ Wadlund said that most investors are focused on value-added opportunities. “Repositioning is a big thing right now,” he said, adding that buyers are looking for upside through rental growth.

La Jolla, Calif.-based Paragon Management Company, for example, prefers to acquire stabilized properties and create upside through improved operations and increased rents. The company made its first Tucson acquisition late last year, and has since expanded its portfolio to include six properties with about 1,000 units.

Paragon Management is achieving a 15 percent to 20 percent increase in net operating income once it rehabs its new properties and installs active management, according to Principal Ricardo Jinich. That’s why the firm is looking for more acquisition opportunities in Tucson.

“We find better returns and better values in Tucson compared to a lot of other markets, especially Phoenix,” Jinich said. He anticipates that the downturn in the housing market will last through 2008, which will bode well for Tucson’s apartment market. “People will be more inclined to rent versus buy, and that means that we’ll see continued high occupancy and solid rent growth,” he explains. “We think multifamily is the right play for Tucson.”