Apartment Finance Today

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Pain in the Energy Capitol

APARTMENT FINANCE TODAY • November/December 2009

Houston takes a breather from the furious pace of new construction in recent years.

BY Craig LaFollette

TALK ABOUT SPIRIT OF SURVIVAL. Whether battling hurricanes as recently as Ike or working through the recession and regional financial collapse of the 1980s, Houston always seems resilient. However, difficult market conditions over the next 18 to 24 months will require intense navigation through a turbulent market in order to enjoy another liftoff beginning in 2012.

New Hands: The 312-unit Gables Augusta, a Class A, Houston development built in 2004, was sold by Gables Residential to Francis Management in June. (Photo: Todd Marix)

Multifamily owners are now feeling the effects of the global recession after a period of exuberant development. The Houston economy lost approximately 80,000 jobs between July 2008 and July 2009, and losses could approach 90,000 by year-end.

Yet in the face of a declining economy, multifamily developers added more than 20,000 units in 2008. Through September 2009, nearly 13,000 new units have been added to the market. But the good news is that there are only 3,991 new apartments currently under construction. By the end of 2009, absorption is expected to match or slightly exceed the 2008 level of 9,226 units, but still leave excess supply. Occupancy should level off at 85 percent.

Given the glut of new units, concessions are mounting. Owners are aggressively offering free rent as they try to attract tenants. The Inner Loop area, where 17 percent of the new construction has taken place, is experiencing up to three months of free rent in high-end developments.

Some notable new developments include Montage at Mosaic, a 394-unit high-rise located in the Medical Center submarket; Legacy at Memorial, a highrise with 330 units just west of downtown Houston; and the 423-unit La Maison on Revere in the Upper Kirby District.

Sales Velocity

As a result of the global recession and capital markets shutdown, sales volume is now a mere trickle as compared to 2005, 2006, and 2007.

Houston, although not as anemic as other major cities across the country, has only seen 33 apartment sales through August 2009, according to Real Capital Analytics. A closer look at the transactions by property class is indicative of the investment community mind-set today. Of the 32 properties sold, 24 percent were Class A, 12 percent Class B, and 64 percent Class C.

Most of the buyers fall in one of two camps—those attracted to the most stress and lowest prices and those looking for good assets at today’s cap rates. Currently, the highest stress levels have been seen in the Class C market. Overleveraged owners and a tendency for Class C property conditions to decline more rapidly have led to a number of foreclosures. High vacancies and a need for capital causes many of these offerings to be sold “by the pound” at pricing levels of around $10,000 to $15,000 per unit.

High-risk takers are getting bank loans, often signing personally and betting big on Houston’s recovery. Special servicers Ocwen, ING, and LNR are notable sellers. The Class A buyers are closing on “cash flow” deals—utilizing agency debt priced below 6 percent with two years of interestonly on a 10-year loan—acquiring assets at today’s cap rates of between 7 percent and 7.5 percent. The positive leverage is delivering current cash-on-cash returns with double digits. Although these opportunities are few, sponsors are easily able to attract capital for this type of acquisition. J.P. Morgan/Chase, BlackRock, and Trammell Crow are some of the recent Class A sellers in the Houston market.

Transaction volume should increase slightly over the rest of 2009. The second half of 2010 will see a more meaningful pickup. As we get deeper into the cycle, foreclosures will increase, loan maturities will increase pressure on the capital markets, new sources of capital will emerge, investors will tire of waiting on the sidelines, and sellers will acknowledge the new world order. All of these factors point to 2011 being a breakout year.

Looking Ahead

Houston is expected to gain more than 200,000 jobs through 2014, with population growth of more than 400,000 over that period, according to the Institute for Regional Forecasting.

Key employment sectors are trending upward. The domestic oil rig count is up more than 100 rigs from the trough in mid-June, according to the Federal Reserve Bank of Dallas. The Texas Medical Center has more than 6 million square feet of new facilities under construction.

Additionally, the Port of Houston is anxiously awaiting the completion of the Panama Canal in 2015. The canal’s widening, now under way, will allow supertankers to utilize Houston’s advantageous location and modern facilities to more efficiently transport around the globe. All of this activity will generate positive momentum for the local economy and, subsequently, the multifamily market.

The next year is likely to be painful for many landlords. At the same time, opportunistic, savvy investors will be excited about the opportunities. New construction is coming to a screeching halt, the effects of the recession are lessening, and job growth is in the cross hairs.

In two years, the fundamentals will be markedly better. Houston is positioned better than most to make a very strong recovery. The pace of activity may not be what it was in the mid-2000s, but it will feel like warp speed compared to today’s development climate. And, once again, Space City will lift off.

Craig LaFollette is a senior managing director in the Houston office of Holliday Fenoglio Fowler (HFF) with more than 25 years of experience in commercial real estate. LaFollette has negotiated sales of approximately $7 billion in more than 400 transactions and 115,000 units throughout the United States.