Uncharted Waters

In the midst of turmoil in the investment and capital markets during the past two years, the multifamily industry has emerged as one of the strongest and safest investment vehicles. However, debate rages within the industry regarding its current health and its direction.

An obvious fact that has fueled concern is that although net cash flows from operations have decreased over the past two years due to concessions and even rent reductions in certain markets, capitalization rates have dropped by 50 to 100 basis points, and prices have actually increased. Many within the industry have raised the argument that we are in a "pricing bubble" that can't be sustained. However, despite the concerns raised by certain investors, there is no shortage of buyers in the market and tremendous demand exists.

The reality is we are in uncharted waters. Historically, the apartment market has behaved in a certain way as the general economy and the apartment industry has entered, occupied, and climbed out of the recessionary side of the business cycle. The current recession has been very different from those in the past and, as a result, apartment investors must reevaluate their strategies in order to recognize and take advantage of current and future opportunities.

A Different Apartment Recession The current recession in the apartment industry is distinctly different from those in the past, and these differences are creating uncertainty in the market. Here are five specific examples:

1) Usually in an economic downturn, the stock market outperforms the apartment market and as a result, there is a shortage of equity for apartment investment. Currently this isn't the case and it's having a major influence on apartment pricing. Two years ago an investor had the opportunity to invest in the non-dot-com sectors of the stock market and realize a 14 percent to 16 percent yield. At the same time, an investment in the apartment market might have returned a yield of 10.5 percent to 11 percent. Therefore, most of the investor's capital was allocated to securities, with only a portion invested in apartments for the sake of diversification and a potential inflation hedge.

Within 12 months this yield relationship flipped 180 degrees. Most investors now predict average yields in the stock market of 4 percent to 6 percent over the next few years while apartment fundamentals remain fairly stable. When investors were comparing 11 percent apartment yields to 15 percent in the stock market, apartments had one level of attraction. However, an 11 percent yield in apartments compared to a 4 percent yield in the stock market is a very different situation and as a result, investment capital has been pouring into the apartment industry. This has led investors to "bid down" yields and has decreased capitalization rates and increased prices.

Investors who raise concerns about this situation compare the low-9 percent yields today to the 11 percent yields of two years ago. They make the case that prices are too high. Investors who are actually closing transactions today are comparing the low-9 percent yields in the apartment industry to alternatives at 4 percent to 6 percent in the stock market. Investors remain ready, willing, and able to stretch even more for the right deal. It's a classic function of supply and demand. There is significantly more demand for apartments, and as a result, buyers must compete more aggressively to be selected as the ultimate buyer.

2) Ordinarily in this phase of the business cycle, debt is expensive and difficult to obtain. Again, this is currently not the case. Interest rates are still at historically low levels and although lenders are tightening underwriting criteria, financing for apartment investment is readily available. Seventy-five percent to 80 percent leverage is easy to obtain.

Low interest rates have supported the drop in capitalization rates because there is still positive financial leverage (and cash flow) with a 7.5 percent cap deal if you are borrowing 80 percent of the money at 6 percent. Also worthy of mention is that current financing is very flexible compared to the locked-in conduit debt that was placed on a large amount of apartments during the early to mid-1990s.

3) In the past, during a downturn in the cycle there were relatively few buyers in the market. During the early 1990s there were less than half the number of buyers in the market than during the height of the previous cycle of 1985 and 1986. Even though we are two years into the recession, there are more buyers in the market today than at the height of the cycle.

4) And while capitalization rates tend to increase during this phase of the business cycle, they have actually decreased during this recession.

5) Finally, the multifamily market is use to seeing a fair amount of desperation in the industry during a downturn. However, the desperation in the trough of the last cycle resulted in the formation of the Resolution Trust Corp.

Although certain markets have been affected more than others, in the aggregate the apartment market is relatively healthy. This has been a comparatively mild recession by any metric.

Hardest Hit Areas While every market has experienced the effects of economic downturn – the national vacancy rate has almost doubled from its low point in 2000 – those with a heavy reliance on technology, telecom, and travel have been hit the hardest. These industries have had the most severe job losses, which results in higher vacancies, rent concessions as managers compete for the remaining pool of renters, and general market softness. The hardest hit markets include Austin, Texas; Seattle; San Jose, Calif.; Portland, Ore.; Denver; Charlotte, N.C.; Orlando, Fla.; and Tampa, Fla. Meanwhile, conditions in more diversified economies, such as Atlanta, Dallas, and Phoenix have suffered from weak demand and oversupply.

Markets in Southern California are among the healthiest of the nation, with vacancies below 5 percent. This is due to positive job growth, high demand from investors and not enough supply of available properties to meet the demand, and low interest rates.

Market Direction 2003 There is no evidence the market is poised for a correction. It's doubtful the stock market will outperform the apartment market in the near to mid-term. Interest rates will not significantly increase until the Federal Reserve uses a series of rate increases to slow down an economy that is recovering too quickly. The practicality of this is that interest rates will not increase until there has been sustained job creation, which will certainly benefit the apartment industry.

Demand for apartments will remain high and should support current prices. In the event some unforeseen variable negatively impacts apartment operations, it will probably have more effect on lowering the velocity of transactions, not prices. Due to the lack of desperation in the market, most sellers will elect to hold their assets rather than accept a lower price. Current conditions in the San Francisco Bay area support this theory. Although most industry veterans are predicting a relatively flat 2003, most believe we are through the worst of times and that the recovery will begin during late 2003 or early 2004.

As is the case most of the time, whether an investor should hold, sell, or purchase apartment assets and in which markets this activity should occur should have more to do with an individual's specific situation, overall investment strategy, and time constraints than general market conditions. Apartments are selling for record-setting prices but those buyers believe that prices will only increase in the future.

–Linwood Thompson is managing director of the national multi housing group at Marcus & Millichap.