Sunny outlook for apartment owners

Favorable economic factors, strong demand for rental housing and sluggish construction of new apartment units are among the positive factors apartment owners and investors can bet on this year.

The outlook “is certainly encouraging [in terms of] meaningful revenue growth over the coming year,” said Greg Willett, vice president of research and analysis at M/PF YieldStar in Carrollton, Texas.

Apartment buyers remain optimistic about longer term yields on these investments, while operators should see fewer concessions, higher occupancy rates and rising rents in most markets, said Linwood Thompson, managing director of the multifamily housing group at Marcus & Millichap, a national commercial property brokerage company.

Dynamics remain favorable

Interest rates will rise sooner or later, Thompson warned, yet he doesn’t believe that trend will push up cap rates on multifamily properties. That’s because other factors such as the strong demand for apartment buildings and rental units, the trend toward using long-term valuation models for investment decisions, and the hotly competitive loan market, which constrains lenders’ ability to widen their spreads, aren’t likely to change and should offset the interest-rate impact.

Higher interest rates coupled with the tremendous run-up in home prices has made homebuying less affordable to the average household, noted Ron Witten, president of Witten Advisors in Dallas.

“More people who are in the housing market will choose to rent, many by necessity and some perhaps believing that prices have peaked and aren’t going to go up as rapidly, and it might be a better time, investment-wise, to be a renter,” he said.

Apartment owners have “quite a bit of upside” to raise rents because this expenditure today consumes a smaller share of household incomes than it has in the past, he added.

“There is room for rents to go up not only relative to homeownership costs, but also in terms of [renters] being able to afford to pay higher rents,” he said.

Job creation, another key driver of housing demand, also is expected to strengthen this year. Marcus & Millichap predicts national employment growth of 2% in 2006, a better pace than the 1.6% achieved in 2005. Austin and San Antonio, Texas, and Orlando, Fort Lauderdale and Tampa, Fla., are expected to be the top five markets for job growth with Phoenix, West Palm Beach and Jacksonville, Fla., Riverside/San Bernardino, Calif., and Denver, Colo., rounding out the top 10. The professional, business, education and health services sectors are expected to account for nearly half of the nation’s new jobs.

New construction, condo conversion slow

Construction of new apartment units around the country remains sluggish. Marcus & Millichap expects the number of units delivered nationally in 2006 to be lower than the 95,000 units delivered in 2005. Washington, D.C., Phoenix, Los Angeles, New York City/Manhattan and Atlanta head the company’s list of markets where the most completions are expected. Market researcher Reis projected that 94,700 units will come on line in 2006 and an additional 96,500 units will be completed in 2007.

A run-up in construction costs due in part to international competition for such raw materials as steel and cement and higher land prices due in part to the demand for new-built condominiums have hurt apartment projects’ ability to attract new investment capital, Witten noted. A moderate pace of new construction combined with strong demand for rental housing should produce a “healthy overall [apartment] market from a supply and demand point of view,” he said.

Overbuilding wasn’t cited as a concern, yet new supply naturally will impact vacancy rates. Reis expects increases in supply to stall the national vacancy rate at 5.7%, the current level, according to the research outfit’s January 2006 report on the apartment sector. Witten expects the national vacancy rate to improve from 5.5% to 5%. Marcus & Millichap expects a 30 basis-point drop in the vacancy rate to 5.5% nationally with the lowest vacancy rates in three California markets (Orange County, Los Angeles and San Diego), and Las Vegas and Fort Lauderdale, and the highest vacancy rates in Houston, Dallas/Fort Worth, Indianapolis, Charlotte and Milwaukee. Those rankings exclude short-term occupancy gains in Houston and Dallas/Fort Worth in the aftermath of Hurricane Katrina.

Condominium conversion activity likely reached its cyclical peak in 2005 and is expected to slow as interest rates creep higher and make deals more difficult to pencil out, particularly in such hot condo markets as South Florida, Las Vegas, San Diego and perhaps Phoenix. Yet Thompson said a slowdown in conversions doesn’t necessarily spell trouble; rather, condominium markets are “correctly pacing” themselves.

“As the market gets saturated, development has to pull back,” he said.

Witten expects new condominium construction to pull back 10-15% this year relative to last year, yet strong fundamentals on the demand side will keep the market active. People who can’t afford to buy a detached house may prefer a condominium as a more affordable option, and the condo lifestyle appeals to both Baby Boomers whose children have moved out and Echo Boomers who haven’t yet had children, he said.

Taken together, these factors are expected to enable apartment operators to raise rents on a national basis, although not all individual markets or properties will share in that collective benefit. Witten has predicted a 4.5% increase in effective rents on a national basis this year, while Reis has forecast a 3% rise in effective rents in 2006 and a further 3.3% increase in 2007. Marcus & Millichap’s forecast anticipates effective rent growth of 5.2%. Investors should be wary of variable performance among markets in different cities and quarterly fluctuations in absorption of new housing supply, both of which can affect vacancy rates and rents.

California, Florida dominate top 10 list

Marcus & Millichap has scored 42 U.S. apartment markets on a series of 12-month forward-looking supply and demand indicators that suggest which markets are most and least likely to outperform the national average in 2006. The top 10 markets, half of which are in California, are Orange County, Fort Lauderdale, Las Vegas, San Diego, New York City-Manhattan, Oakland, West Palm Beach, Riverside-San Bernardino, Los Angeles and Washington, D.C. Factors that pushed these markets to the top of the list included low vacancy rates, high median prices for single-family houses, reduced apartment supply due to condominium conversions and strong job creation.

The bottom 10 markets on the list are Indianapolis, Charlotte, Kansas City, Houston, Milwaukee, Cleveland, New Haven, Cincinnati, Columbus and Detroit, most of which are in the Midwest. Two of these markets improved their position since last year’s rankings: Indianapolis moved up nine places and Cincinnati gained one place.

Weak labor markets in Midwest cities are often blamed for a poorer than average outlook.

“The change [in employment] is positive, but it is barely positive in most of the Midwest markets, and most of them have a long way to go in terms of getting employment back to where it was before it started falling in 2001,” Willett noted.

Marcus & Millichap’s rankings and M/PF YieldStar’s market grades, included in the accompanying story, suggest the nation has become divided into two apartment markets, one along the East Coast, West Coast and as far inland as Las Vegas, and the other in the Midwest. M/PF YieldStar awarded straight A’s to 10 markets in the South, eight A’s and eight B’s to markets in the West, and one A, five B’s and two C’s to markets in the Northeast/Mid-Atlantic. The Midwest markets earned five B’s and five C’s.

These rankings represent market trends, not individual investments. A well-chosen investment in a poor market could outperform a poorly picked investment in a strong market.

Good hunting

Given the hypothetical opportunity to shop for apartment properties anywhere in the country, Willett eyes Phoenix and Southern California due to strong demand for rental units and, in the latter locale, high obstacles to new construction. Thompson also likes Phoenix as well as Tucson in the short term, and Florida, Washington, D.C., and Los Angeles over an eight-to-10-year horizon.

Willett and Thompson both suggested that apartment investors also might do well to consider some often-overlooked smaller markets. Willett mentioned Memphis, Tenn., Birmingham, Ala., Raleigh, N.C., and Denver as places that could harbor attractive opportunities, while Thompson suggested the Carolinas as a possibility.