REGIONAL MARKETS: WEST

APARTMENT FINANCE TODAY • APRIL 2008

Hot Phoenix Market Faces New Challenges

Apartment builders added about 5,500 new units to this Arizona city in 2007, but that number will slow this year.

By Donna Kimura

Phoenix grew by 43,000 people between 2005 and 2006. That works out to about 118 new faces a day.

The desert community had the largest population increase of any U.S. city during that one-year period, according to the Census Bureau. To get an idea of the kind of rapid growth that has happened in Phoenix, compare it to other locales. Houston's population, for example, grew by 26,554 people between 2005 and 2006, San Jose by 14,268, and Denver by just 8,311.

The recent growth in Phoenix represented close to a 3 percent change in population. Some cities, including Fort Worth, Texas, had a higher percentage increase, but the actual number of people was lower.

Going into 2008, the dynamic economic and population expansion that has propelled Phoenix in recent years was slowing, and new wrinkles were surfacing for apartment owners. Still, some housing experts remain cautiously optimistic about the market.

Creating a lifestyle

One notable developer in the market is Tempe, Ariz.-based Trillium Residential, LLC, which is staying close to home by focusing its activities in Phoenix.

The apartment firm has a big year ahead with plans to start about 1,400 units in three communities this year. All are in the Phoenix region.

"We've seen good times and bad times," said David Dewar, founding partner and principal of Trillium Residential. "We think it's good times."

The company has been gearing up to its current production level and expects to stay at the pace for the next several years, according to Dewar. Overall, Trillium, which has developed roughly 8,000 units, has about 2,500 units in its pipeline.

Dewar cites the area's strong growth as one of the big positives. Phoenix recently moved up to become the fifthmost populated city in the nation, with 1.5 million people.

Dewar, who has focused on building in the core district, has also worked to make his apartment communities stand out from the crowd.

With new challenges emerging in the market, that's critical. Some of the operators who have done well have been those who have amenitized their properties to be different from competing condos or have created a "lifestyle community" targeted to a specific demographic, said Sam Chandan, chief economist at Reis, Inc., a New York Citybased real estate research firm.

Trillium Residential is doing just that.

The company's 360-unit Trillium Deer Valley development in Phoenix won a Paragon award from the National Apartment Association in 2007, and its 466-unit Trillium Rio Salado in Tempe, Ariz., earned a 2006 Paragon award.

Amenities at the firm's high-end properties have included demonstration kitchens, spas, and theaters.

At the heart of Trillium Deer Valley is a two-story great room. The first level features a lounge with retractable glass doors that allow residents to flow outdoors and enjoy fireplaces, canopy day beds, and a resort-style pool. The community also has a 32-seat movie theater and a sports bar with billiard tables and plasma televisions. The second floor features a wellness center, which includes a fitness center as well as spa facilities.

In addition, "lifestyle specialists," who work in the company's great rooms, are available until 11 p.m., said President Lesa LaRocca. They help residents with a wide array of services, including renting mountain bikes or even just playing Nintendo Wii with residents in the lounge. They can also help with different concierge-type services such as making dinner reservations.

"We will never have one of those clubhouses where the cover is over the pool table," LaRocca said.

The company has also created Trillium on the Move, a complimentary transportation program that takes residents to different events in the community.

Rents at the property, which opened last year, are leading the area at $1.19 per square foot.

The company was scheduled to open Trillium Cave Creek in Phoenix at the end of March. This 292-unit property will have a food and wine theme, including a demonstration kitchen to host appearances by guest chefs and other events. Residents can also reserve a bottle in the great room's wine lounge. The project will also have the company's first yoga and pilates studio in its fitness center.

To maintain a high service level, Trillium has instituted a "customer experience management" system to gain valuable resident feedback. The survey aims to extract information about what products and services are valued by residents. Even prospective renters are asked their opinions after visiting a site. In addition to gaining customer information, the survey is an incentive for employees. Staff members know that they have to perform.

One change in the future will be how Trillium Residential finances its projects. The firm will be looking to institutional partnerships, Dewar said. This is because with more projects in the company's pipeline, more equity is needed. As a result, it's time to look at strategic partnerships, he said.

In the shadows

Despite solid demographics that have helped boost the Phoenix apartment market, some worrisome trends are surfacing.

"The key issue in Phoenix is the competition from the shadow inventory of condos," said Chandan of Reis, noting that some investors who bought condominium units with the expectation of selling them are having to hold these units and rent them. As a result, condos are cutting into the apartment market.

The vacancy rate has risen to about 8.1 percent from 5.6 percent in 2006, Chandan said.

Phoenix is one of those markets where developers are going to have to take into account what's going on with the condos, he said.

More than 20,000 apartments were removed from the rental inventory for condo conversions in the past few years, according to a research report from Marcus & Millichap Real Estate Investment Services. In the firm's 2008 national apartment index that ranks 43 apartment markets, Phoenix dropped seven spots to No. 17.

An excess of single-family homes in some of the neighboring communities will also play a factor in the market.

People who would usually be in apartments are renting homes, said Elliott D. Pollack, founder of Elliott D. Pollack & Co., a real estate and economic research firm in Scottsdale, Ariz.

One of the most interesting, and troubling, trends for an apartment owner is a decline in the number of occupied units, he said. Pollack said the number of occupied units in the fourth quarter of 2007 was about 298,500, down from 304,300 a year earlier in the Phoenix metro area. "That's unusual," he said.

Developers delivered about 5,500 apartment units to the metro market in 2007. Observers estimate that this year's completions will fall to around 4,500.

Still, with more units in the pipeline, vacancy rates can't help but go up, said Pollack.

The big positive has been Phoenix's steady population growth, which has significantly outpaced its regional peers. The extent to which it is outpacing the national market is narrowing, however.

A hot-button issue in the region is the state's tough new employer-sanction law, said Bill Hahn, managing director for Sperry Van Ness, a commercial real estate brokerage firm, in Phoenix. Arizona businesses that knowingly hire illegal immigrants face having their business licenses suspended. Local news reports have said the law, which took effect at the start of the year, is driving illegal immigrants to leave the state, and apartments are feeling the effects, especially Class C properties.

Pollack also cited the new law as an issue to watch. "It could be significant for B and C properties," he said.

Still, Hahn is upbeat. He said sellers are getting more realistic because they know the wild appreciation of the past few years is over.

Cap rates on smaller Class B and Class C properties were about 7 percent or a touch higher. The rate on Aquality buildings was still about 5.5 percent to 6 percent, Hahn said, noting that was still better than in nearby California.

He and others also point out that people continue to move to the region. Maybe it's because the sun in Phoenix shines 300 days out of the year.