The residential market

After a banner year in sales, price increases and new construction, single-family home professionals are grumbling loudly. Ignoring a chorus of detractors, the Fed raised short-term rates from 3.3% in March to 4.7% as of October 1994. Banks boosted the prime rate to 7.5%, the highest level since November 1991. The scramble to secure mortgages at lower rates prompted robust sales activity between March and June 1994, but by July the effects of the higher cost of money had surfaced. Year-over-year new home sales dipped for the first time this year and permit activity showed signs of stalling. Still, seasonally adjusted annual figures estimate that 4.7 million new and existing homes will have changed hands in 1994, the largest annual total since 1978.

Mixed signals continue to emerge from the multi-family market as well. Recent surveys indicate investor interest remmains high. Competition for apartments is so keen that cap rates have dipped below 8%, representing the strongest income-to-price ratio among the five major property types. But as we cautioned in last year's Forecast, selecting the right market has become a thornier task. Too much capital chasing too few projects has already initiated another building cycle.

Rent corrections are under way in many areas. This suggests strong returns, predicated on rising incomes, are likely to flatten out. Meanwhile, new product is coming on line. While some analysts suggest that construction levels are still well below historic trends, they forget that the bloated annual figures from the mid-'80s were triggered by the artificial incentive of tax breaks and therefore should not be viewed as meaningful benchmarks.

Wall Street, always quick to capitalize on a good story, has made a best seller of apartment REITs. Backed by real properties but highly liquid, REITs combine the attractiveness of an actual asset with the flexibility of paper. While it is true that REITs poured much-needed capital back into the real estate markets, especially when traditional investment was scarce, the same questions that began to rise in the mid-'80s regarding the long-term wisdom of LBOs are surfacing in REIT discussions. The test for both LBOs and REITs is whether the architecture of these financial instruments is good for the businesses that ultimately must support them. For REITs, the issue is whether capital improvement funds, essential to the long-term viability of the assets, will remain available if dividends begin to sag. The potential for abuse, combined with the increasingly crowded playing field, has some industry observers cautious.

As of October 1994 there were 35 apartment REITS, up from 11 in 1992. During 1993, apartments accounted for $4 billion of the $15 billion of REIT capital raised, according to statistics published by NAREIT. With fewer and fewer quality properties available for purchase, some apartment REITs are actively pursuing development deals, a comparatively risky growth strategy. While some markets are clearly undersupplied, and others are expected to post relatively robust economic gains over the next several years, few markets possess both characteristics. Beware of banking on robust demand in the years ahead. Furthermore, the product itself should be carefully considered. In some gateway cities of Texas, California and New York population gains are likely to be fueled by immigration. Recent arrivals seldom rent luxury product -- the most tempting type of construction for developers.

These cautions noted, the overall quality of markets evaluated in our Apartment Consolidated Indicators Scale (ACIS) increased again this year. ACIS evaluates local apartment markets by examining market occupancy trends, rental pricing patterns, demand indicators and construction volumes. This year, in keeping with increased interest in multi-family markets, Landauer expanded our ACIS analysis from 33 to 44 markets.

Las Vegas tops our multi-family list this year. Ranked among the leading markets since ACIS inception in 1991, Las Vegas benefits from extremely robust population growth and an above-average ratio of renter households. Per capita housing construction continues to lead the nation, but apartment vacancies are still falling. Recent figures put the vacancy rate at 3.7%, down from 5.7% in 1993. The proliferation of alternative gaming venues will eventually erode job growth, but the outlook for housing demand is highly favorable.

Honolulu, last year's strongest market, dropped to number two this year as a result of Hawaii's onging economic difficulties. Dependent upon tourism, Hawaii's economy contracted again in 1994, one of only two states (California was the other) to do so. Although single-family housing remains the least affordable in the nation, demand for multi-family units has been softened by the lack of job growth and by a high number of condominiums entering the rental market.

Several Sunbelt markets that benefit from strong demographic growth but were hampered by overbuilding in the mid-'80s have returned to the top of our quality rankings. Raleigh-Durham and Charlotte both had average vacancy rates above 10% at the close of the '80s but have since tightened considerably. The vacancy rate in Charlotte averages 4.2%, while in Raleigh-Durham vacancy has dipped to just 2.2%. Low annual construction totals combined with brisk employment expansion have improved the investment quality of these two cities markedly.

Also benefitting from swift job gains is Austin. The high-tech industry is booming, contributing to a 16% increase in the employment base since 1991. Fleeing California's battered economy and the specter of increasing taxes, many technological firms have moved here from Silicon Valley and the L.A. Basin. Following the glut of the mid-'80s (the vacancy rate peaked at 16.9% in late 1985), apartment construction was essentially dormant until recently. Rapid inmigration and the steady levels of demand afforded by the University of Texas (48,000 students) pushed Austin's average vacancy to under 1% in 1992. Although multi-family development has proliferated since then, vacancy still remains under 3%.

None of the other Texas markets ranked within the top ten this year, although San Antonio did receive a Market Quality Rating of three. Like Austin, employment growth is strong in San Antonio and availabilities have declined considerably. Last year Dallas appeared poised to move up the ACIS scale but a sudden burst of new development stalled the advance. The addition of nearly 5,000 new rental units has prevented any improvement in the average vacancy rate which remains lodged at 8%. Houston continues to struggle near the bottom of the ACIS. Part of the problem is its highly affordable single-family market, but the primary drag is sluggish demand for an estimated 63,000 vacant apartments.

Tampa earned a Market Quality Rating of three this year, with Ft. Lauderdale and Miami rated an acceptable four. The most dramatic improvement occurred in Tampa where vacancy has dropped considerably. Home ownership rates are high in Tampa but a strong core of preference renters continues to fuel demand for multi-family housing. Occupancy in Ft. Lauderdale also remains high, averaging close to 98% since Hurricane Andrew displaced thousands of South Florida residents. Ft. Lauderdale is capitalizing on in-migration from nearby Dade County as Miami becomes increasingly crowded. Following Southern California and New York, Miami is the third most popular destination among newly arriving immigrants. These new residents tend to be renters and as a result, Miami's percentage of rental households in 1994 (46%) is well-above the national average (36%).

Economic and demographic woes notwithstanding, most of the California markets remain relatively strong. Some slippage has occurred over the past year, but the state's historically high single-family housing costs continue to support a healthy rental market. Oakland and San Jose rank among our top ten markets this year, while Sacramento, Anaheim, San Francisco and San Diego are among the top 25. None of these markets are expected to witness dynamic job or population gains in the near future, but ironically it is such uncertainty that is buoying rental demand. Los Angeles is the exception to the California rule. Out-migration is reportedly strong in the wake of economic losses, the riots and the Northridge earthquake. Vacancy in the apartment market averaged 8% as of second quarter 1994, up considerably from the 5.2% rate reported in late 1992.

Another traditionally strong apartment market that dropped in rating this year is Atlanta. Contributors to demand (job and population growth) remain favorable, but vigorous development is eroding occupancy.

Some analysts have argued that the end of the recession will spark a rise in renter demand as adult children are finally able to find employment and leave home. The probability that this phenomenon will have a measurable impact on the number of renters in the market is slim. While people between the ages of 18 and 34 (22.1% of the U.S. population) generally comprise the largest group of renters, those most likely to still be at home fall in the 18-to-24 year old category (9.9% of the population).

The "easy money" has already been made by those contrarians who bought into apartment investments two to four years ago. Our market-by-market analysis suggests that these investors now have a stable period of healthy supply/demand balance in which to pocket their income yields and realize their capital gains through sale and refinancing. For new money, however, the yield-to-risk profile of lower-priced property types should be eclipsing multi-family opportunities in the coming years.

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