Philadelphia developers are torn between apartment demand, high construction costs

Center City is growing short of rental apartments, but in most cases the market's low local rental rates don't justify an investment in new construction.

Developers in Center City added some 12,000 residential units, mostly multifamily, between 2000 and 2010, expanding Philadelphia's housing supply by 2%. Most U.S. cities increased their residential supply by 10% in that decade, says economist Kevin Gillen, vice president of Econsult Inc. of Philadelphia.

The problem for investors and developers is that current rents are too low relative to the high cost of construction to make construction feasible, says developer Carl Dranoff.

Ten-year tax abatement plans for residential construction and renovation, adopted by the city council in the late 1990s, help lower expenses. State subsidies also help — Dranoff's 777 South Broad Street apartments received $4.5 million.

Dranoff estimates the Center City vacancy rate at 1.8%, with a typical one-bedroom unit renting for $1,342 a month. “Although occupancy is strong, we are recovering from a weak era, and have not seen rent spikes that could make unsubsidized construction feasible or prevalent,” says Dranoff.

That's good news for investors able to convert existing properties such as condominiums into rental apartments. Condo sales are down 18% from a year ago, and high-rise condo buildings completed after the housing bubble burst are especially hard hit.

Developers have resorted to auctions to test the market; the current average condo price is $295,000 per unit.

Investors able to repurpose buildings for lease as apartments can typically expect annual returns of about 4.5%, says developer and condo broker Allan Domb. “Real estate is paying three or four times what banks pay. The rental market is a bulletproof investment.”

The Pepper Building in the Graduate Hospital area of Center City is an example. Philadelphia Management Corp. paid $30 million two years ago for the former University of Pennsylvania medical facility, then converted the property into 185 apartments. In the second quarter this year, the building sold to a pension fund advisor for $50 million.

Investors are also converting many Class-B and C office buildings, including government assets, into rental apartments as demand grows. One is the Pennsylvania State Office Building at Broad and Spring Garden streets, which developer Bart Blatstein is converting to 204 rental apartments and retail space. Phase I of the project is $50 million.

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