Investors Undaunted by Excess Supply

Apartments were a strategic investment target in 2004 and should remain so in 2005, even as occupancy and rental rates remain relatively flat in the shadow of a still-resilient single-family housing market.

But an uptick in vital signs at year-end juxtaposed with encouraging job-growth numbers may point to a more complete recovery in 2005.

After two years of negative rental-rate growth (-2.7% in 2002 and -0.4% in 2003), 2004 should end with a 1.1% increase, according to Dallas-based Axiometrics, an apartment-investment real estate research firm that covers 249 markets.

A record 1.4 million single-family and multifamily permits are expected to be issued by the end of 2004, “putting an overabundance of housing product on the market,” says Axiometrics President Ron Johnsey. While occupancy recovered from a four-year low of 92.8% in the first quarter of 2004 to 93.6% in the third quarter, that number could drop a point by mid-2005 due to excessive apartment inventory.

On the investment side, low interest rates enabled apartment investors to borrow at 6% and build projects with 7% to 8% yields, creating too much inventory. “Their thinking was even though we're not getting the good job growth now, we will soon,” says Johnsey. That growth was slow but picked up toward year-end 2004, he adds.

The apartment market has been more sensitive to interest rates than other sectors because investors are mostly leveraged buyers, says Robert White Jr., president of Real Capital Analytics. Multifamily cap rates average just under 7% nationally, but in high barrier-to-entry markets such as Southern California, they have dropped to as low as 4.5%. One interesting trend, according to Real Capital, is that cap rates have started to rise in tertiary markets but continue to fall in primary markets due to the concentration of buyers focused on the largest cities.

Although construction starts in the fourth quarter of 2003 exceeded multifamily starts in any quarter of 2001 and 2002, that still hasn't dampened investor demand, says Hugh Frater, executive vice president of PNC Multifamily Capital, a financial services firm focusing on the multifamily industry. In a 12-month period ending in September of this year, multifamily permit issuance was up 9.5% over the same period ending in September of 2003 and 3.8% higher than the same period in 2002, according to the U.S. Census Bureau.

“[Investors] are worried about the bond and stock markets, so real estate looks pretty good,” says Richard J. Campo, chairman and CEO of Camden Property Trust. “There are a lot of properties trading, and it's difficult to buy unless you're paying full price.”

But investors have been more than happy to pay high prices for apartments if they plan to convert them to condos, says Jeff Dishner, senior managing director for Starwood Capital, a real estate investment firm. “That strategy could backfire if there's a downturn.” In fact, the majority of apartment-complex purchases in late 2004 were for condo conversions, reports Real Capital.

Though job growth has averaged well below 200,000 monthly this year, October surprised financial experts with the creation of 337,000 jobs, according to the Bureau of Labor Statistics. If that trend continues, and single-family housing prices continue to rise, Johnsey says, the vacancies could begin filling in earnest in the near future.

Executive Insights

Name: Richard J. Campo

Title: Chairman, CEO

Company: Camden Property Trust

Headquarters: Houston

Biggest Surprise of 2004:

“The slowdown in job growth. We saw improvement in the first and second quarter and got excited by the creation of a couple hundred thousand jobs. But it slowed in the third quarter.”

Prediction for 2005:

“With the election behind us and the assumption there won't be major changes in economic policy, we look forward to a good 2005. If we rock along with sustained job growth, multifamily will be in much better shape.”

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