Ask any economist what American city is dying a slow, painful death, and chances are they will say Detroit. The once-great auto manufacturing capital of the world has suffered catastrophic job losses, the demise of several industries, and years of population decline. Yet, while Detroit’s economy will continue to struggle through the downturn, apartment fundamentals are, surprisingly, expected to remain fairly steady this year due to ongoing weakness in the area’s housing market and minimal construction activity.

Foreclosures and falling home prices will persist, increasing the renter pool while keeping many potential homebuyers on the sidelines. In addition, residents concerned about downsizing at their companies are unlikely to commit to homeownership until—and if—the local manufacturing sector stabilizes.

As consumer spending wanes nationwide, auto sales will continue to be a major factor for the metro’s short- and long-term outlooks. Additionally, a merger or bankruptcy in the auto industry could lead to drastic job cuts in 2009. On the supply side, few apartment developments can command rents to justify construction costs, limiting the potential competitive threat from new units. Overall, investor sentiment will remain mixed for Detroit’s apartment properties in 2009, with yield-seeking buyers staying the most active. Cap rates, which are approaching 9 percent, are among the highest in the country, attracting buyers but also illustrating the long-term uncertainty in the market.

Tight Times

There’s no doubt that things are not great in Motor City. For one, limited reinvestment opportunities for current owners have kept the number of listings restricted in recent quarters. As such, competition among buyers will hold prices fairly steady, though the heightened cost of capital could force some sellers to modify their expectations. Properties will remain in high demand in nearby Ann Arbor, where the University of Michigan provides a consistent renter base. Additionally, in the greater Wayne County, residents have few housing alternatives, so stabilized properties should produce predictable cash flows for buyers upon purchase.

Employers eliminated 112,500 jobs in 2008, a decrease of 5.8 percent. The loss of positions represents the largest 12-month decline in the workforce since the third quarter of 1980, when payrolls were reduced by 144,000 jobs. As the auto industry continues to struggle, manufacturing reductions will persist well into 2009. Over the past five years, one out of every four manufacturing jobs in the metro has been eliminated.

The one bright segment for the market is the educational and health services sector, which added more than 5,000 positions last year. The city’s aging population will support further gains in that sector. Overall, however, the metro is expected to lose 80,000 jobs in 2009, an additional 4.4 percent decrease. A major portion of the decline is projected to be in the manufacturing and professional and business services segments.

Development activity in Detroit remains limited, with just 244 new units completed during 2008, a modest 0.1 percent expansion of stock. Several recently completed projects were additional phases of existing complexes due to the lower construction costs associated with current landownership. Still, few new projects can achieve the rents necessary to justify construction costs. What’s more, Class A space has also been competing with unsold condos and single-family homes employed as rentals. Overall, 300 units are under construction in the market, and the planning pipeline has thinned to 2,200 units, though most of these projects are unlikely to come to fruition.

Only some of the projects presently on the books are anticipated to break ground due to the weakness and long-term uncertainty in the local economy. Going forward, builders will likely be very selective about future development, focusing on highly affluent areas of the metro where the gap between mortgage payments and rents remains significant. During 2009, only 300 units are forecast to come online, a 0.1 percent increase to inventory.

Weak but Steady

Vacancy levels finished in 2008 at 6.7 percent, up 30 basis points from the previous year. While the faltering national economy resulted in several very large vacancy increases across the country last year, occupancy levels in Detroit remained relatively stable. Many potential homebuyers stayed on the sidelines due to falling home prices and tighter lending standards—a trend that will likely persist in the coming year. In addition, job seekers that were quick to move to other metros during the economic boom are unable to find employment elsewhere, as nearly every market across the country is now shedding jobs, helping to support local apartment occupancies.

In the market’s top tier, vacancy levels increased 60 basis points in 2008 to 6.4 percent. Class B and C vacancies, meanwhile, pushed up 10 basis points to 6.8 percent, as residents in this sector have few living alternatives. While poor economic conditions have maintained demand for apartments in Detroit over the past several years, vacancy rates are forecast to rise in 2009 as renters begin doubling up to save on expenses. By the year’s end, Detroit’s vacancy rate is projected to reach 7.2 percent, a 50 basis point increase over 2008.

Rent gains in the metro have been limited by the relatively affordable housing market in recent years. During 2008, asking rents climbed 0.1 percent to $835 per month, while effective rents decreased 0.4 percent to $768 per month. Concessions finished the year at one month of free rent. In the Class A segment, asking rents have advanced 0.3 percent year-over-year to $1,041 per month. When the local housing market stabilizes, owners may have to decrease rents to stay in line with mortgage payments.

Meanwhile, Class B and C rents have decreased 0.1 percent during the past year to $721 per month. Interestingly, the disparity between Class A and Class B/C rents is one of the highest in the country. The average property-level revenue fell 0.5 percent during the past 12 months due to the rise in vacancy. This year, asking rents are projected to retreat 0.6 percent to $834 per month, while effective rents fall 0.9 percent to $761 per month. As such, average revenue is expected to decrease 1.4 percent during 2009.

Moderate Outlook

The weak economy kept many investors on the sidelines in the most recent 12-month period, as velocity decreased by 44 percent. In addition, Detroit property owners with stabilized complexes have been reluctant to list their assets due to the dearth of reinvestment opportunities. Properties that changed hands in that time had a median sales price of $34,700 per unit, down 1.4 percent from the previous year.

Some of the stability in prices can be attributed to fewer marginal properties trading. Average cap rates in the metro are approaching 9 percent, with some deals transpiring above 10 percent. Perceived risk in the market will likely result in further pressure on first-year yields, making Detroit’s apartments some of the highest returning investments in the country.

And that’s good news for a city grappling with bad headlines. [M]

Steven Chaben is the first vice president and regional manager of the Detroit office of Marcus & Millichap Real Estate Investment Services.