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This Does Not Compute

This is one schizophrenic multifamily downturn. Nationally, the vacancy rate is approaching a decade-long high, and developers have yet to slow new construction. Rental revenues are down; expenses are up. Now, instead of predicting a recovery within 12 months — as they have done for the past two years — executives are saying the turnaround is at least 18 months away. And, given the accuracy of their past predictions, it's anybody's guess when occupancy rates and rents will head north again.

But here's the crazy part: Prices have hit historic highs and are rising — there hasn't been a better time to be an apartment seller in decades. Low interest rates have helped push capitalization rates to record lows — generally between 5% and 7% — indicating continued upward pressure on the sales price of apartments, despite the sector's softness. By using cheap debt to fund up to 80% of their acquisitions, investors can still generate a high yield relative to equity or bond investments. The prospect is so attractive that first-time apartment buyers are joining the ranks of experienced owners in search of multifamily product.

“Most people have never seen such a disconnect between property fundamentals and the capital markets,” says Bruce Cohen, chief investment officer of Cohen Financial, a Chicago commercial lender that doubled its multifamily loan volume to $780 million from 2001 to 2002. “That's the general theme of real estate these days, and multifamily is the poster child.”

Sales Spree

So, how overheated is the market? Here's one sign: Experienced owners who are typically in the business of buying and operating apartments have become net sellers. One of the most aggressive is Denver-based Archstone-Smith, a real estate investment trust (REIT) that owns more than 90,000 units in major U.S. markets. After reassessing demand, Archstone officials recently announced that the company expected to sell more than $1 billion in assets this year, or more than double what the company predicted early in 2003.

Scot Sellers, Archstone's chairman and CEO, told analysts during the second-quarter earnings conference call that the company began pricing apartments at “ridiculous” levels in previous quarters but didn't really expect buyers to pay those prices. “We got a higher-than-ridiculous price,” he says, “and the same is happening this year.”

Case in point: On a couple of separate occasions over the last three years, Archstone marketed the same Dallas property for $30 million but received no takers. This year, even though the asset's net operating income had dropped, the company sold it for $33.5 million. “That's what has happened in the last two-and-a-half years,” Sellers says. “The buyer said the yield he could get from it was comparable to other assets, so it was a good buy for him. It was a great sale for us.”

For Archstone, the seller's market has accelerated a plan to shed non-core assets and properties in non-core markets. The strategy, which dates to 1995, calls for Archstone to reinvest the proceeds in major markets that have high barriers to entry and expensive home prices, such as San Francisco, Southern California, Boston and Washington, D.C. In the past eight years, Archstone has sold some 78,000 units for $4.6 billion. As of July 31, about 87% of Archstone's portfolio was concentrated in its core markets, up from 83.5% on the same date the prior year, the company says.

(Percentage change in total returns*)
Y-T-D (Aug. 14,2003) One Year Totals (Aug. 02-July 03)
Retail 27.06% 31.44%
Apartments 17.46% 9.11%
Office 17.16% 14.47%
Industrial 11.96% 10.41%
Lodging/Resorts 2.53% -7.78%
*Total return is share price appreciation/depreciation, plus reinvested dividends.
Source: NAREIT

So far this year, the company has sold nearly $700 million worth of assets at an average cap rate of 6.8%. The sales mark Archstone's exit from Charlotte, N.C., and Las Vegas, and have further reduced its presence in Phoenix and Raleigh, N.C. Archstone also has about $400 million of additional assets under contract.

In the second quarter, Archstone acquired a 229-unit complex in Santa Monica, Calif., for $57.5 million. But that's been the exception, not the rule. A scarcity of what Archstone considers favorable deals in its core markets — which tend to be pricey — has made it difficult to spend the capital from its asset sales on acquisitions. In fact, if the company is unable to redeploy its sales proceeds, the capital will flow to earnings and force Archstone to pay shareholders a special dividend this year.

But Lee Schalop, an analyst with Banc of America Securities, calls that a short-term problem. “The strategy should place the company in a better long-run position to outperform future cycles,” he reported shortly after the company released its second-quarter earnings.

Summit Properties is pursuing a similar strategy. With plans to exit Texas, the Charlotte-based multifamily REIT has sold one San Antonio community this year for $18 million at a 6.5% cap rate and expects to sell its four remaining assets in the state, which it values at $150 million.

Like Archstone, Summit Properties plans to use the proceeds to build an even greater presence in its core markets: Atlanta, Washington, D.C., Southeast Florida and Raleigh and Charlotte, N.C. In those markets, new construction permits are down 10% and jobs have increased 79,000 over the last year, according to Summit Properties CEO Steven LeBlanc.

Denver-based Apartment Investment & Management Co. (AIMCO) is another big seller. So far this year the REIT has sold $376 million worth of assets and expects to sell an additional $625 million in 2003, all for an average cap rate of 7.5%, according to AIMCO officials.

Ambitious Buyers

Given the poor apartment fundamentals and scant hope of an imminent recovery, just who are the buyers of these assets? Small regional and local investors are the biggest bunch in the pool, and a good many are first-time buyers, says David Rich, national director of multifamily at Sperry Van Ness in Los Angeles, a full-service real estate firm. But syndicators, institutional investors and entrepreneurs intent on converting apartments to condominiums also are driving the market, report REIT officers.

Investors not only are plowing money into multifamily as an alternative to equities and bonds, but they're also using property as a hedge against higher interest rates. “If interest rates go higher, they think it's going to cool the housing market,” Rich says, “and that would shift a lot of would-be homebuyers into apartments.”

Investors who already own apartments typically are pulling equity out of other projects to help finance acquisitions. Meanwhile, short-term holders are stacking instruments such as mezzanine debt on top of their primary financing to acquire properties, says Richard Orlich, a senior vice president at PW Funding in San Francisco, a direct mortgage lender that specializes in the multifamily sector.

Generally, investors are counting on an improving economy to increase occupancy so that they can either refinance and pull out equity or sell at a favorable price. “If you think the economy's improving, then I don't see a lot of concern on the horizon,” says Orlich, whose company has a loan portfolio of some $3.9 billion. “But all bets are off if it continues to go in the tank.”

The latter scenario is appearing less and less likely, judging by an uptick in commercial mortgage rates. During the second week of August, 5-year rates rose to 5.2% and 10-year rates rose to 6.2%, up from 3.75% and 4.75%, respectively, in mid-June. That may cool the multifamily seller's market. Rich of Sperry Van Ness and Cohen of Cohen Financial both anticipate that continued higher interest rates will eventually put downward pressure on prices. “We're not seeing a slowdown in buyers yet,” Rich says, “although it is making deals less attractive when you're buying at a 5% or 6% cap level.”

A Perfect Storm

If buyers willing to pay lofty prices are to succeed, the fundamentals must improve to the point where they can boost rents. But in most parts of the country, demand is tepid. Several multifamily experts have referred to the latest downturn as “the perfect storm” for rental apartment demand: job cuts, oversupply and low interest rates, which have induced renters into new homes, further sapping demand.

As always, the most important driver of apartment demand is job growth. Although the corporate earnings picture is improving and the Gross Domestic Product increased at a 2.4% annual rate in the second quarter, up from 1.4% in the first quarter, U.S. industry continues to shed jobs. The economy, in fact, cut 44,000 non-farm payroll jobs in July, the sixth straight month of job losses.

“We'll see a turnaround in the multifamily market about three months after we see a sustained pickup in job growth,” says Mark Obrinsky, chief economist for the National Multi Housing Council in Washington, D.C. “But when is that going to happen? I don't know” (See NMHC column, page 26).

Gloom and Doom

How bad are the fundamentals? In the first quarter of 2003, the vacancy rate hit about 7.1%, a full percentage point higher than the first quarter of 2002 and double the vacancy rate in 2000, according to Dallas-based M/PF Research. Based on preliminary data for the second quarter, M/PF officials say the vacancy rate is holding steady.

Meanwhile, apartment absorption suggests that demand is on the upswing. In the second quarter of 2003, the market absorbed 29,000 units, according to Reis Inc., a New York-based real estate research firm, an indication that the number of renters moving into apartments exceeded renters moving out.

That represents a dramatic turnaround from the negative absorption of 21,500 units in the first quarter, but experts are quick to temper the positive news. First, they point out that apartment demand historically picks up in the spring and summer months.

Second, although renters occupied 23,000 more units in the third quarter of 2002, the market quickly reversed course and headed back into negative territory through late 2002 and early 2003.

The same may happen this year, suggests Ron Witten, president of Witten Advisors, a Dallas-based apartment market advisory firm. That's because renters who took advantage of June's historically low mortgage rates to buy houses generally began moving out of apartments after the second quarter ended.

“We think that's going to limit apartment absorption later in 2003,” he says.

Nationally, average effective rents dropped almost a full percentage point to about $850 a unit in 2002 from 2001, reports Marcus & Millichap, and experts anticipated a slight decline or, at best, flat rents this year. Typically, free-rent concessions have pushed down rents. In some of the more distressed markets, such as Denver and Austin, landlords are forking over as much as four months free rent, while the national average is about one month.

The concessions have contributed to plunging apartment revenues, which fell about 3% in 2002 and were down roughly 2% in the first quarter of this year, according to Witten. During the second-quarter earnings season in late July and early August, REITs consistently reported declines in net operating income (NOI) from the same period in 2002. The decline ranged from 3% at Houston-based Camden Property Trust to 9.2% at Summit Properties.

In markets hit particularly hard, apartment owners are struggling to keep NOI in the black. Shea Properties in Aliso Viejo, Calif., which owns 5,800 units throughout California, acquired a 200-unit project in Fremont when rents were peaking and expected rents to keep climbing, says Bill Gaboury, president of Shea Properties.

But rents have dropped nearly 25% in the area to $1,222 a month from more than $1,600 a month in 2000. “We have one loser, but that's probably not too bad for that market,” says Gaboury, noting the 300,000 jobs lost in Silicon Valley over the last two years.

Nationally, developers aren't helping matters. Despite the soft demand, apartment developers keep building at a brisk clip. Between 2000 and 2003, developers started about 175,000 new units annually, according to Witten. Reis anticipates that 111,000 new units will be delivered this year and 101,000 in 2004. Reis predicts that vacancy will peak at 7.2% in 2004 and then drop to 6.8% in 2005.

“That construction is off the highs we saw in the late 1990s and early 2000s,” says Andrew Wright, a Reis senior consultant. “But there's still a lot of construction coming through that pipeline over the next 18 months to two years. People just aren't backing off.”

Stay Alive 'Til 2005

Multifamily executives and economists still remain optimistic about a recovery in 2005. Rather than counting on a big increase in jobs, however, the experts now anticipate a slow recovery in employment. But experts also predict construction will slow down enough to move the market closer to equilibrium.

In fact, while new construction will outpace absorption over the next 18 months, in 2005 the trend should reverse with renters moving into about 98,000 units and developers completing about 80,000, Wright says. He predicts that effective rents will jump 3.2% in 2005 after a modest 1.6% climb next year.

The continued rise of home prices and recent run-up of interest rates, which will help shut more renters out of the home-buying market, also will help. Nationally, the median home price rose 7.7% to $176,500 in June 2003 over the same period in 2002, reports the National Association of Realtors. Meanwhile, 30-year mortgage rates climbed to a one-year high of 6.34% in the first week of August, which was up from a 30-year low of 5.21% seven weeks earlier, according to Freddie Mac.

Historically, the mortgage rates are still the lowest they've been in decades. However, apartment economists and executives contend that rates rise much faster than they fall. Thus, experts anticipate rising rates for the foreseeable future, which will help stimulate apartment demand. “A little uptick in interest rates is going to kill a lot of home purchases,” says David Lichtenstein, chairman of the Lightstone Group in Lakewood, N.J., which owns 15,000 units primarily east of the Mississippi River. “At that point, I think we'll start seeing some recovery in occupancy rates.”

Over the long term, multifamily experts also anticipate a wave of new renters as the kids of baby boomers, or so-called echo boomers (born between 1977 and 1997), roll through the market over the next 15 years. The echo boomers represent about 25% of the population, according to the U.S. Census Bureau. Between 2005 and 2010, the number of people between 20 and 34, or the prime renting age, will grow by about 1 million.

By contrast, the number of people aged 25 to 34 declined by 1.3 million between 1995 and 2000. But absorption remained strong even while new apartment construction rose, which reveals the positive influence an average annual employment growth rate of 2.5% to 3% has on apartment demand. It will be the same for the echo boomers. “We know that they're coming,” Obrinsky says. “But they aren't likely to be renters — or homebuyers — unless they actually have jobs.”

Joe Gose is a Kansas City-based writer.

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