Secondary Spotlight

National Market Outlook

With occupancy on the rise, concessions shrinking and supply tightening, multifamily owners finally began to breathe a little easier in 2005. Even better news is that these improvements are expected to continue through 2006. While all markets will benefit from this slow recovery, some U.S. cities are particularly well-positioned to reap the rewards.

Capital Interest

The most powerful trend in the multifamily market today may be the spillover of capital from primary to secondary markets. Buyers in hot spots like Southern California, Washington, D.C., and Florida are selling at record-high values and record-low cap rates of 4 percent and below. They then reinvest their capital in secondary growth markets, where they can get more property for their dollar and earn higher yields with cap rates of 6 percent, 7 percent, and 8 percent. Some of the most attractive secondary markets in this category include Raleigh-Durham, N.C.; Memphis, Tenn.; Richmond, Va.; Norfolk, Va., Atlanta; Phoenix; Tucson, Ariz.; Austin, Texas; Denver; Indianapolis; Cincinnati; and St. Louis.

"This transfer of dollars to higher-cap markets is very significant," says Robert White, president of New York City-based Real Capital Analytics, a national research and consulting firm focusing exclusively on the commercial real estate investment market. "Investors moving out of low-cap, condo conversion-dominated areas are buying in markets that a few years ago they never thought they'd be in. The nation's hot new secondary markets are reaping the benefit of the spillover."

Boston ranks as one of New England's top multifamily markets. NEW DIGS: The 420-unit, 28-story Archstone Boston Common, below, is the city's first rental, residential high-rise to be built in 20 years. Archstone-Smith expects to deliver first units in mid-2006.

Credit: Andrew Gunners/Getty Images

Migration has doubled and even tripled transaction activity in some secondary markets, despite the fact that many still have a soft economy.

Raleigh-Durham and Memphis

Money from across the nation, and particularly Florida, Washington, D.C., and New York, is finding its way to Raleigh-Durham and Memphis. In the last 12 months, just less than $600 million in properties valued at more than $5 million have closed in Raleigh-Durham. The local price-per-unit has risen consistently from the upper $50,000s in mid-2003 to an average of between $70,000 and $90,000 per unit in 2005.

Buyers from as far away as California indicate that they're choosing this market over other competing areas in the Southeast because of its affordability, quality of life and education, and diversified economy that includes the stabilizing presence of job-generating engines such as Duke University, the University of North Carolina, North Carolina State University, and the state government. In short, buyers think the area has great long-term potential even after a couple of soft years.

Memphis had about half the multifamily transaction activity of Raleigh-Durham in 2005, at $303 million, and the local average price per unit is in the $50,000 range. Cap rates, however, are in the mid-7 percent range, and values are trending upward, which indicates this may be a good time to consider a foray into the area.

Rent growth in Memphis has been slow due to the relatively low cost of home ownership. Annual asking rent gains should remain below 2 percent through 2006 and beyond. Effective rate gains should just stay ahead, rising to 3 percent by 2007. In the Raleigh-Durham market, asking rent gains will also be slightly lower than effective rents over the next few years as landlords focus on reducing concessions. Effective rent gains are expected to reach 4 percent by 2009.

Richmond, Norfolk, and Atlanta Investment activity is increasing in central and Tidewater Virginia and Georgia, in part because of multifamily sellers coming out of Washington. Atlanta leads the pack with $600 million in multifamily property closings in mid-2005 alone.

Atlanta cap rates in the past year have fluctuated only slightly within the 7 percent range, and the average price-per-unit is steadily moving toward the $70,000 mark. REITs in particular have noticed Atlanta, operating largely under the condo conversion craze to make up 68 percent of the market's 2005 mid- to high-rise unit purchases.

Transaction volume this year in Richmond and Norfolk is lower, in the $100 million and mid-$200 million range respectively, but their price-per-unit average has improved rapidly from $40,000 a few years ago to between $60,000 and $80,000 today, with cap rates in the 7 percent range.

Asking rents in Richmond decreased slightly by mid-2005 to $712 per month. Rental gains are expected to remain below 2 percent through the beginning of 2006 and will increase to the 2 percent level thereafter. Asking rental rates in Norfolk, on the other hand, increased by 1.4 percent during the first half of 2005 to $752 a month and will continue to rise. Rental rates are increasing slowly by less than 1 percent in Atlanta, and small upticks in year-over-year gain will follow.

Phoenix, Tucson, Austin, and Denver The impact of Southern California 1031 exchange dollars can be felt across the United States, but the impact on nearby growth markets is astounding.

Phoenix may be the primary beneficiary, with transaction volume rising from $200 million per quarter in early 2004 to $400 million by mid-2004 and $800 million per quarter today. Phoenix values have some catching up to do, but they have steadily improved to an average $60,000 per unit over the past 12 months and should continue to rise in 2006 thanks to an improving economy and a population growth that is among the fastest in the nation.

However, falling cap rates in Phoenix–from 7 percent and 8 percent in 2004 to the 6 percents today–have also directed investor attention to Tucson. This much smaller market has grown from $50 million in sales per quarter last year to around $75 million to $100 million per quarter today. Tucson apartment values also are moving toward $60,000 per unit, and cap rates are among the better in the Southwest, at more than 7 percent.

Austin also has become a key Southwestern investment market, though it achieves less than half of the transaction volume of Dallas and Houston. In the past 12 months, Austin closed $750 million in multifamily sales, with 77 percent from private investor money. Cap rates have fallen to the middle 6 percents, but price per unit is one of the best in the region–and better than Dallas and Houston–at nearly $70,000 per door.

Occupancy has spiked 3.3 percent in the past 12 months and rents are rising, but experts on the ground warn that this is a "quick cycle" market with very little time between its commercial real estate recovery and expansion periods.

Denver's current $80,000-per-unit value tops prices in the West's secondary markets. Transaction volume, however, is still unsteady at anywhere between $100 million and $200 million per quarter with a cap rate of 6.5 percent. Considering Denver's lengthy economic downturn, these fluctuations may continue as the area finds its feet. On the plus side, Denver has not yet reached its value potential. Investors have seemed to pick up on this, and the market is attracting a solid mix of private, institutional, and REIT buyers as a result.

In Denver and Austin, rental rates are climbing steadily, as they are in Phoenix and Tucson. Rents in Phoenix are expected to rise by 1.9 percent by the beginning of 2006 to $712 per month. Tucson rents will make the most significant gains during this time frame, increasing by 2.4 percent to $583 per month.

Indianapolis, Cincinnati, and St. Louis Even relatively quiet, under-the-radar markets in the Midwest are feeling a perceivable rush from low cap rate dollars. Cap rates of around 8 percent have helped close $230 million in multifamily property in Indianapolis in the last 12 months, with buyer dollars split among private investors, REITs, and institutions.

St. Louis closed $300 million over the past year, $54.4 million of which was mid- or high-rise properties. The average price per unit for Indianapolis and St. Louis has also risen from the $40,000 and $50,000 marks in 2003 and 2004 to $60,000- and $70,000-per-unit–and higher–averages today.

Like much of the Midwest, Cincinnati is slowly pulling itself out of an economic downturn in the manufacturing sector. Fortunately, the local employment market is now growing by 7,000 new jobs per year, and its population is expected to increase steadily at 5 percent annually until 2008. With just 550 to 600 new apartment units coming online in 2005, Cincinnati is a good consideration for both investor and development dollars, with hopes that the improving balance of economy and demand may improve the area's mere 1 percent rent growth.

Rental rates in Cincinnati are also rising–but just barely–at $657 per month. In Indianapolis, asking rents are almost flat, with gains of less than 1 percent in 2005. Asking rents in St. Louis average $679 and are also expected to increase slightly through 2006.

International Appeal

Much as rising interest rates are encouraging institutional investors, an attractive exchange rate has refocused overseas dollars onto U.S. markets. On the international scene, capital is flowing from locales such as South America, Australia, Europe, and Asia. "This is an asset class that foreign investors typically don't participate in," Real Capital Analytics' White says, "so it's yet another good indicator of the strength of the multifamily sector."

Like international buyers, institutional investors who have been frustrated for the past few years are making a return to the buyer scene. In 2003 (and much of 2004) institutions and REITs were haunted by the drastically leveraged private buyer who could consistently outbid them. In 2005, they were crowded out by condo converters operating on a similar low-rate footing.

ING Clarion is one example of how far some investors have gone to participate productively in the multifamily sector: In September, the company, in a joint venture with Lehman Brothers, bought an entire REIT–Gables Residential Trust–for approximately $2.8 billion because it was easier than buying properties individually.

Just a hint of rising rates, however, is now giving institutions and REITs the foothold they've needed to begin to reenter the commercial real estate investment game in a more assertive manner. Markets seeing the most activity include Florida, Seattle, San Francisco, Los Angeles and New York.

"As rates continue to rise in 2006, we'll see capital remain in great supply but grow more from the un-leveraged and low-leveraged buyers," says White. He adds that these sources have significant investment dollars and are eager to begin supplanting the leveraged investor and place more money with less competition.

In terms of both institutional and international capital, the first signs of change typically appear in coastal markets: Florida, Seattle, San Francisco, Los Angeles, and New York.

"Seattle has attracted a nice diversity of capital from players such as Equity Residential, Essex, and Archstone-Smith," says White. In July, Archstone-Smith entered the downtown San Francisco market, purchasing the mixed-use, 44-unit Fox Plaza high-rise for $147.5 million.

In October, New York-based REIT Stellar Management completed another major transaction in San Francisco: The company purchased a 3,221-unit complex near Lake Merced for more than $666 million with no indication of plans to convert to condominiums.

In Florida, major players are entrepreneurial private capital players, some in joint ventures with institutions. With their sights set on conversion, New York-based GE Commercial Finance Real Estate and Boca Raton-based Stoltz Cos. recently entered into a $123 million joint venture to acquire the 450-unit Coral Harbor Apartments in Boca Raton. And Sunvest Communities, U.S.A., has just launched a 1,020 unit portfolio of three Orlando complexes for conversion that may be sold out within 60 days.

Sunvest has recently closed on more than 1,600 units for more than $242 million in the state. Margolias Realty Group of Atlanta, MCZ Development/Centrum Properties, Colonial Properties Trust, and Orlando, Fla.-based Tarragon South all just closed deals in Florida as well.

While New York and its surrounding markets will always have a solid presence of institutional capital roaming the landscape, REITs such as Alexandria, Va.-based AvalonBay Communities are showing signs of stepping up their investment and construction activity. Of the company's 150 apartment communities in the United States, five are on Long Island, six are in the Westchester area, and two are in New York City. Avalon Chrystie Place, a 361-unit, newly built luxury rental property, opened in Manhattan earlier this year and is already at more than 80 percent occupancy. Full occupancy is expected soon.

In 2006 and beyond, international and institutional capital is expected to flow into markets further inland in a much more aggressive way as well. The result will be increased buyer competition and more financial support for new development.

Development Cycle

TOP OF THE TOWN: Demand has been high for the luxury condos at The Residences at the Ritz-Carlton.

According to Real Capital Analytics, condo conversions accounted for more than 33 percent of all 2005 multifamily deals through September, and conversions are likely to continue to lead the market through 2006. As a result, new multifamily construction has been kept in check, and the value of many Class B and C apartment projects has risen based on the demand for conversion units or because they are next in line to receive rental demand once Class A units are depleted by consumers.

Barriers to entry for new multifamily developments remain high as well. Dirt is expensive, vacancies are just now showing signs of improvement, and rents in all but the hottest markets are still only in the early stages of recovery. The continued rise in the cost of materials also is impacting the development market's bottom line.

"It's hard to pencil out a financially feasible apartment development with today's numbers," says White. "Some major players have been able to finance and construct traditional rental projects, with plans to hold until market conditions improve. But developers and investors that don't have the ability to hold a newly constructed apartment building are taking a risk. For most, value-added deals still make the most sense."

A piece of good news on the development front is that multifamily inventory has remained steady, and as condo conversions take more rental units out of the market, a further reduction in supply will continue to improve the fundamentals of the apartment sector. This is particularly true in super-hot condo conversion markets such as San Diego, Washington, D.C., Las Vegas, Manhattan, and Florida's Miami, Orlando, and Tampa metro areas.

Based on new development announcements and murmurs among multifamily owners, the turning point toward a healthy rental market may already be on the horizon. Some opportunity for new multifamily units is riding in on the coattails of the mixed-use and lifestyle center development craze.

In most major cities, there is also now a waiting list of people trying to rent condominiums, signaling either an oversupply of condos or a dwindling supply of apartment units. The main concern among speculators is what will happen if rates rise rapidly and the homeownership trend goes away.

"What will investors in conversion-crazy markets do if the condo market disappears?" asks White. "Will there be a mass of sellers trying to unload properties at prices drastically lower than they ever expected to?" He adds that condo conversion is a cyclical event and that the opportunistic buyer who can purchase in a major market for a good price and then hold for the long term could earn a windfall from the next and eventual positive market swing.

Good Times

Steve Witten is senior director of Marcus & Millichap's national multi housing group in New Haven, Conn.

Regardless of the application, 2006 is going to be a strong year for multifamily. Higher interest and cap rates may usher in the beginning of change–slight adjustments in price, improvements in occupancy, and the emergence of new types of capital–but they won't stop things in their tracks on any front. There is enough capital out there to keep projects progressing and deals rolling for the year to come, and probably well beyond.

Lone Star Living

Texas apartments fill with hurricane survivors.

One quarter out from Hurricane Katrina's devastation, Texas apartment owners and operators are seeing their vacancy rates reconfigured by a stream of displaced residents.

Apartment demand following the storm was particularly robust in Dallas and Houston, says Joe Clements, managing editor at M/PF YieldStar.

HIGH LIFE: The Mandarin Oriental Boston will be a mixed-use development with a luxury hotel, apartments, and condos, in addition to high-end retail. Slated to open in 2007, the project is expected to revitalize Boston's upper Boylston St. neighborhood.

A closer examination of Dallas/Fort Worth shows that Katrina's impact on plummeting vacancy rates was felt most keenly in neighborhoods with many older units. According to M/PF YieldStar, stronger-than-usual demand was felt in Dallas/Fort Worth submarkets such as the Highlands and Mesquite, among others.

Not surprisingly, vacancy rates for Dallas/Fort Worth dipped 2.1 percentage points year-over-year for the third quarter of 2005, down to 7.8 percent. (Vacancy rates for Houston registered 6.2 percent in the third quarter of this year, versus 11 percent for the same period in 2004.)

Clements observed that owners in Houston, Dallas, and other markets took concrete steps to help those so abruptly displaced. "Though these two [metropolitan areas had already] received a notable bump in demand between June and September, causing occupancy rates to climb meaningfully, apartment operators chose to lower rents," he explains. "They didn't want to appear as if they were price-gouging evacuees."

–Amy Rogers Nazarov

Slow Or Steady?

Experts offer their starts predictions for 2006.

2006 may be the year rising interest rates begin to slow multifamily construction. Or maybe not. Although housing industry economists all predict 2006 housing starts that stay close to the volume seen each of the last five years, there are some modest differences. Economists at Fannie Mae and Freddie Mac forecast a slight decline thanks to rising interest rates and high vacancies–but the National Association of Home Builders and the National Multi Housing Council do not.

"My guess is we will see starts that are not that different from the last few years," says Mark Obrinsky, NMHC chief economist. "There's no reason to think anything different."

In fact, the NAHB forecast calls for multifamily housing starts to remain at 349,000 through 2007.

Freddie Mac, on the other hand, predicts interest rate increases will slow starts to 340,000. Fannie Mae economists say high vacancy rates will bring a drop in starts to about 324,000 next year.

What housing economists don't expect is a big impact from energy prices. "I don't think we're going to see a further run-up in oil prices above where we've seen them," says Frank Nothaft, Freddie Mac chief economist.

"I think they will hover in the $55- to $65-a-barrel range for the next few months, then come down."

–Nichola Zaklan