New York; Boston; Washington, D.C.; the Bay Area; Southern
California; and Seattle.
They're called the “sexy
six,” and they roused the multifamily industry out of
the recession. Investor interest in those core markets has been
intense since mid-2009, leading to rabid bidding wars and
ever-higher price tags.
But in some ways, the sexy six may have run their collective
course. Capitalization rates have gone so low in those
areas—declining to and, in some cases, going
below their pre-recession lows—that a growing
number of investors are searching for yield in less celebrated
cities.
“If all the money flows into the sexy six,
either not everyone will get fed, or people will get fed but
won't like the meal,” says Mike
Kavanau, senior managing director in the Chicago office of Holliday
Fenoglio Fowler. “At the end of last year, we saw
cap rates back up a little in the core
markets—you can only go so low on cap rates
before people start expanding their horizons and look at secondary
markets.”
Consider Behringer Harvard. Throughout the recession, the
Addison, Texas–based company was one of the
industry's most active and aggressive acquirers,
a beacon of opportunistic investment. In 2010, the company spent an
astounding $855 million on apartment buys, second only to industry
titan Equity Residential.
But last year, Behringer Harvard wasn't even
among the 10 most active buyers. “Cap rates have
compressed to a level where you have to be very selective and maybe
look at alternative locations to meet your return
expectations,” says Mark Alfieri, executive vice
president and chief operating officer for Behringer Harvard
Multifamily REIT 1. “We're
very deliberate about our investment style, and with cap rates
compressing, we've deployed capital in other
areas.”
Like many multifamily investors, Behringer Harvard sees better
yields in development these days. The company recently broke ground
on its first in-house development project, not far from its
headquarters. Behringer Harvard has also closed on a few land sites
in Austin, Texas; Atlanta; and Costa Mesa, Calif., and intends to
break ground in those markets in the next 12 months.
Financiers have also followed this trend. Life insurance company
Northwestern Mutual has always focused its commercial real estate
lending efforts on apartments—about 27 percent
of its loan portfolio is multifamily, as is about 31 percent of its
equity portfolio.
The life company had one of its biggest years in 2011, lending
$4.5 billion to commercial real estate deals, $1.1 billion of which
was in multifamily. Northwestern Mutual lent another $700 million
to apartment developers last year by pairing a debt execution with
its equity program—bringing its multifamily debt
volume up closer to $1.8 billion.
But like many financiers, Northwestern Mutual knows it has to
get creative to continue growing its book of business.
“We've already penetrated
enough into the big markets and big deals, and so suddenly
we've got to find some new tricks to expand our
market share,” says David Clark, a vice president of
Milwaukee-based Northwestern Mutual. “If
you're going to go into secondary and even
tertiary markets, the sector you want to do it in is
apartments. It could be that we just need to beat the
bushes to find more deals.”
Hottest Secondary Markets
The institutional investors that made the sexy six a bellwether
for the industry are now setting their sights on the second tier.
And the trickle-down of capital is well under
way—markets like Denver; Portland, Ore.; Dallas;
and Houston have captured increasing inflows of investment over the
past 18 months, a “sexy secondary
four.”
In fact, Denver saw a 170 percent increase in apartment
transaction volume last year, while Portland's
deal volume climbed 61 percent. And Dallas and Houston saw
increases of 41 percent and 27 percent, respectively, last year,
according to Real Capital Analytics.
“It was really in the second half of 2011 when
we saw the movement of institutional capital into secondary
markets,” says Hessam Nadji, managing
director of research for Encino, Calif.–based
Marcus & Millichap.
“It's still relatively fresh
in the cycle.”
The proof is in the pudding. The markets that saw the biggest
uptick in apartment values last year include Austin, Texas;
Raleigh–Durham, N.C.; Nashville, Tenn.; Palm
Beach, Fla.; Columbus, Ohio; and Detroit. This is hardly the sexy
six, but these markets have outperformed the
nation's top markets in some key metrics.
Austin saw the most dramatic improvement last year in apartment
values. The capital city of Texas led the nation last year in price
appreciation, with a 42 percent rise in price per unit over the
year before, reaching nearly $107,000. Cap rates fell about 160
basis points (bps) in Austin last year and are now averaging about
5.8 percent—putting it on par with markets like
Los Angeles and San Diego—according to New
York–based market research firm Real Capital
Analytics (RCA).
Along with Austin, Raleigh–Durham has popped
up on a lot of radars over the past year thanks to a concentration
of technology-focused jobs and a young, well-educated workforce.
Last year, the market saw a 21 percent appreciation in pricing,
reaching $99,589 per unit, and cap rates compressed about 60 bps
year over year, according to RCA.
Nashville, Tenn., has also risen in the
ranks—average price per unit jumped 18 percent
last year, to $77,262, and cap rates compressed by 110 bps. Another
standout was Palm Beach, Fla., which saw its average price per unit
rise 18 percent as well, to nearly $183,000, while cap rates
compressed an astounding 160 bps last year.
In terms of cap-rate compression, Detroit led the pack
nationally, with average cap rates falling 300 bps year
over year. But the Motor City was starting in a pretty tough place
to begin with—cap rates there averaged
nearly 11 percent in 2010.
Still, of the top 10 markets with the most cap-rate compression
last year, half of them were from the Midwest. Following Detroit
were Kansas City, Mo.; Minneapolis; Cincinnati; and Cleveland,
which all saw at least 100 bps of cap-rate compression in 2011.
“What we see in those Midwest markets right
now is that they are performing about in line with the national
norm, which is good for them, because they tend to underperform
compared to the country as a whole,” says Greg Willett,
vice president of research and analytics for Carrollton,
Texas–based MPF Research.
“There is some economic momentum across the
region as a whole.”
Willett cites the submarkets of Detroit as particularly strong,
as does Marcus & Millichap's Nadji, who
notes that Detroit's metro-wide vacancies are
just around 5.5 percent these days.
Attracting Capital
At the end of 2011, the nation's tightest
markets didn't include any of the sexy six. In
fact, that list was probably more slanted to tertiary markets than
anything. The nation's top five leaders, all
exhibiting occupancies of more than 97.8 percent, were Madison,
Wis.; Fort Collins, Colo.; Midland/Odessa, Texas; Syracuse, N.Y.;
and Pittsburgh, according to MPF Research. But that
doesn't mean that tertiary markets like
Midland/Odessa—which, by the way, had rent
growth of 16 percent last year—are getting their
share of investor interest just yet.
The trickle-down is only starting to be felt in secondary
markets, and it will take awhile before the trend reaches down
farther. Cap rates in tertiary markets have remained between 7.50
percent and 7.75 percent for almost two years, according to
RCA.
But apartment owners across the country are having an easier
time attracting capital. Even if you're in a
Fannie Mae pre-review market like Detroit,
there's always Freddie Mac, which tends to take
a more deal-centric approach. And as banks increase their
shorter-term business, and life companies expand their credit
boxes a bit, borrowers in secondary markets have more
options than they did a year ago.
“Lenders are still going to be very cautious
in the worst submarket of Detroit or L.A.,” says Nadji.
“But as far as getting an audience with a lender,
telling your story about what you want to buy, and finance, the
door is wide open.”
This is certainly true for permanent debt, but access to rehab
or new construction debt has proven to be much more difficult in
any market, doubly so in the nation's less
well-populated metros. So while the country's
secondary markets are seeing more acquisition volume, the flow of
new supply should continue to be constrained as banks remain
cautious.
“The biggest governor on new apartment
development is the availability of construction
lending,” says Kavanau. “Equity
really wants to achieve yield and probably will be a little
undisciplined to find it. But the construction loan market is still
highly disciplined—it won't
chase a deal just for yield.”
A Risk Premium Mirage?
One of the key metrics that multifamily investors consider
before pulling the trigger on a deal may not be what it
appears.
The spread between the yield on the 10-year Treasury and a given
capitalization rate is often referred to as the
“risk premium”—and
the wider that spread, the better. In the frothiest days of the
last boom period, in late 2006, that spread averaged around 90
basis points (bps), a razor-thin margin.
With the 10-year Treasury still around 2 percent, and the
average cap rate around 6.5 percent, today's
average risk premium is a healthy 460 bps. But given the Treasury
Department's concerted effort to keep interest
rates low, can today's risk premium be
trusted?
“We're in a world with
artificially low interest rates—and the question
is, are cap rates also artificially deflated?” says
Mike Kavanau, senior managing director in the Chicago office of
Holliday Fenoglio Fowler. “That relationship
between cap rates and Treasuries is not as valid an indicator as it
was for the last 50 years.”
Fundamentals also come into play in a big way when penciling out
a core deal—many investors are hanging their hat
on aggressive rent growth. But rosy forecasts of rent growth also
must be taken with a grain of salt. Sure, the apartment industry
has demographics on its side, but how much can rents be pushed over
the next five years?
“That's the bad news: Will
the rent growth be there?” asks Hessam Nadji, managing
director of research at Encino, Calif.–based
Marcus & Millichap. “If you look at wage
growth for renter households versus the kind of rent growth that
some of this modeling requires, you wonder if the wage growth
really supports it.”
There's also a widely held assumption in the
multifamily industry in “renter
nation,” the belief that there's
been a paradigm shift in this country, that homeownership
isn't as desirable as it once was. For the
immediate term, that's
true—it's harder to qualify
for a mortgage than it was six years ago.
But is the falling homeownership rate really a structural shift,
or is it cyclical? In a couple of years, interest rates may still
be low, and job growth might come back in earnest.
“At some point, maybe in 2013 or 2014,
there's going to be a wave or two of renters
buying homes and condos again,” says Nadji.
“That's another threat to the
logic that we're going to see tremendous rent
growth.”
The risk premium is just one way of looking at a transaction. An
unleveraged internal rate of return is a primary metric for many
investors, and a movement in interest rates
doesn't impact that as much. And if a buyer is
underwriting a deal based on the availability of a 10-year loan
priced at 4 percent—and then interest rates move
suddenly—they can do a little
“duration migration,” and move to a
seven-year deal with a lower rate to make the assumption work.
But in terms of fundamentals like rent growth, and demographic
considerations like the flight to homeownership, a word
of caution is in order. And for the many investors using
today's low yield on Treasury bonds to justify a
purchase, you might want to look for a different baseline.
Top Picks
When asked to pick the five most promising secondary markets
for multifamily investment this year, many of the sharpest industry
watchers agree on the big three Texas
markets—Austin, Houston, and
Dallas—as well as Portland and Denver. Here are
the next markets on their lists:
Hessam Nadji, managing director of research, Marcus
& Millichap: Tampa, Orlando, Phoenix, Inland Empire,
and Detroit. “These are all recovery markets;
they've been hit very hard and are starting to
add jobs and have reasons to capture capital.”
Greg Willett, vice president of research and analytics,
MPF Research: Nashville, Charleston, Charlotte,
Raleigh–Durham, suburbs of Detroit.
“Pretty much all the markets in the Carolinas are
doing well. They have healthy employment numbers, and Nashville is
behaving very much the same way.”
Ben Thypin, senior market analyst, Real Capital
Analytics: Raleigh–Durham, Phoenix,
Seattle, San Jose. “Institutions are now
venturing into those secondary markets in search of
yield.”
Mike Kavanau, senior managing director, HFF:
Minneapolis, Salt Lake City, St. Louis, Kansas City, Oklahoma City.
“I asked Freddie Mac the same question recently,
and these were a few markets where they have very strong
portfolios—what they deem as markets people
should consider.”
AFT's Picks: Based on job
growth projections, supply and demand figures, demographics, and
recent gains in value, here are Apartment Finance
Today's picks for top secondary markets: Austin,
Portland, Denver, Raleigh–Durham, Nashville,
Palm Beach, Columbus, Minneapolis, Philadelphia, Houston.