When the apartment industry was mired in a serious recession in the early 2000s, many people called it a "perfect storm"–and it's easy to see why. A poor economy and low interest rates pulled people out of apartments, while a flood of new construction saturated demand for rentals.
Now the economy has improved, interest rates are up, construction has slowed, and rents are on the rise. So the question is: What to call this? In other words, it looks like smooth sailing.
"In 2007, we're drafting behind some of the best apartment metrics you could ever hope for," says David Fitch, president and CEO for Gables Residential, a large apartment owner and developer based in Atlanta.
Yes, 2007 looks very promising. But that doesn't mean multifamily executives won't continue to monitor some key trends as they look ahead. Here are a few variables on everyone's mind.
After years of deep discounts and empty apartments, 2006 brought strong rent growth to just about everyone in the apartment industry, no matter where a company's portfolio was located.
The reason? Simple economics. Condo conversions and unworkable construction and development costs for new projects reduced the supply of apartments, while a strong economy added to demand.
Will 2007 bring more of the same? Maybe, maybe not. While most apartment executives do expect rent growth in the coming year, the double-digit increases could remain solidly a 2006 trend. The reason: Apartments will be working off higher 2006 numbers, and it could be difficult to significantly improve over those. "But I think to have pretty good percentage numbers on top of what were pretty good numbers in 2006 will confirm the expectations that the multifamily space is terrific," says David Neithercut, president and CEO of Equity Residential, the giant Chicago-based public apartment REIT.
Scot Sellers, chairman and CEO of Archstone-Smith, a public apartment REIT based in Englewood, Colo., agrees. "When we look across our markets, we think next year could be better just because people can still afford higher rents," he says. "We look at our residents' incomes in New York City, Washington, D.C., and Southern California. Yes, they're paying a lot of money. But they can still afford more."
To Ron Terwilliger, chairman and CEO for Atlanta-based Trammell Crow Residential, rents look like they have returned to the high point of 2001's first quarter–before the apartment industry felt the full economic impact of the dot-com bust. And, with home prices still high, Terwilliger expects rents to continue rising in 2007. "Homeownership has become costly," he says. "People don't feel the need to buy a home if they think they're getting in at the top of the market."
There's just one shadow on these sunny expectations: the economy. While Equity's "extremely bullish" rent growth projections don't require "significant" new jobs, Neithercut admits, they also don't include the possibility of "a major economic disruption." With the for-sale housing market softening, that's a worry in many quarters. And Neithercut is watching a few statistics closely himself. "In some markets, residential construction jobs have represented a significant percentage of new jobs," he says. "I'm wondering if it won't have some kind of modest impact on expectations next year."
While Neithercut worries about demand, Christy Curry Freeland, co-CEO of management firm Riverstone Residential Group, frets about supply. As new condos reappear in certain markets as rental units, apartment rents at her properties feel the pricing pressure.
In Delray Beach, Fla., for example, rent growth reached the teens. Then a wave of converted condos showed up as rentals. Now Freeland finds her leasing agents giving away concessions. "I think you're going to see some of those impact your ability to rent," she predicts.
The Dow Jones reached unmatched highs in 2006, lessening investors' interest in apartments. Right? Not so, according to Eric Bolton, CEO of Mid-America Apartment Communities, a public apartment REIT based in Memphis. "There's still a lot of money chasing multifamily real estate," he says. "When you look at all of the long-term projections for multifamily and rental, [the returns] are still very compelling."
Strong fundamentals might drive demand even higher. Apartments have been "a great investment vehicle," Archstone's Sellers says. "As we're in an economy with stars aligning for rent growth, everyone wants to own the product. There's no shortage of demand for development capital as well as for acquisitions. People are willing to be aggressive."
The mix of buyers has changed, though. Tenants-in-common, or TICs, which are groups of buyers who pool their money to buy assets, are slowly disappearing from the scene. "We don't see them as much as we used to," Bolton observes. "Sooner or later, that influence runs its course, as these owners that sold these properties get wrung out of the system."
The same is happening with condo converters as condo sales slow around the country. "We are no longer seeing knockout bids by condo converters that are eliminating our ability to try to get some of these assets," Equity's Neithercut says.
Leverage buyers have also slipped away. As interest rates rose and property prices remained steep, many leverage buyers could no longer make the numbers work on an apartment deal. "When the 10-year [Treasury note] got up to 5 percent and change, that might have knocked a few people out," Neithercut believes.
Of course, with rates sliding downward, this group of buyers will rebound. "The leveraged player will come back," predicts Tom Toomey, president and CEO of United Dominion Realty Trust, a public apartment REIT. "Leverage costs are down."
But they'll have plenty of competition. Institutional investors, public apartment companies, and foreign investors, particularly Australians, are expected to continue their capital splurges in 2007. "You will see continued escalation from foreign investors," Toomey says. "The American dollar is weak. They are buying the U.S. cheap."
Market report
Will the rental rebound continue in '07?
For many firms, 2006 brought rising rents at last. "Almost 90 [percent] or 95 percent of our markets improved last year," says Christy Curry Freeland, co-CEO of Riverstone Residential Group, who was thrilled with overall rental performance last year.
The best of the best? South Florida, where more than 50,000 apartments went condo between 2004 and 2005. Those rentals that remained enjoyed spectacular rent growth last year. Rents increased 13.8 percent just in the first half of 2006, according to McCabe Research and Consulting, a Deerfield Beach, Fla., firm that studies the multifamily market.
Things generally look good in many markets around the country. The key indicators for most: job growth and apartment (and condo) supply. The downturn of the past few years kept many people from building, in turn limiting apartment supply, while job growth has created more renters.
Ron Witten, president of Witten Advisors, a market research firm in Dallas, projects average rents will increase 4 percent or so across the country in 2007. "You won't have a tremendous number of substantial laggers or substantial out performers."
Here's a look at some notable markets:
Formerly hot condo markets (Florida and Phoenix): Though apartment executives expect the market to remain solid, they don't see 2007 being quite as strong.
"Florida may moderate a little bit. It is still a good market, but you have seen some pretty strong rent growth. Florida and Phoenix have seen strong rent growth this year. My bet is they will be a little slower next year." –Scot Sellers, archstone-smith trust, Englewood, Colo.
New York and the Northeast: New York should remain strong because it offers both supply and demand characteristics that apartment owners crave.
"New York has had a phenomenal year," he says. "It will probably have an equally good year next year. In some cases rents are over 20 percent there." –Scot Sellers, archstone-smith trust, Englewood, Colo.
On the demand side, wages are high and people crave the convenience of being able to walk to work and shopping. On the supply side, it remains hard to build in the area.
"New York and New Jersey have barriers to entry. It's too costly to build rental. You have to build for-sale. There's been very little competition in the rental business." –Alan Hammer, Kushner Cos., Florham Park, N..J.
Southwest and Southeast: These areas are entirely different when it comes to comparative advantages, but both spots remain well-positioned over the next couple of years. Generally speaking, both areas have seen job growth and rising home prices. But they're also susceptible to large influxes of new multifamily units. Still, apartment executives expect good things for the next several years.
"Even in the Southeastern and Southwestern markets, we're going to be in a period of muted supply for a couple of years. We expect the operating fundamentals to be strong going into 2007 and 2008." –Eric Bolton, mid-america apartment communities, memphis
Texas: Smack dab in the middle of the Southeast and Southwest sits Texas, a market that makes a number of apartment executives feel very optimistic. Tom Toomey, president and CEO of United Dominion Realty Trust, a REIT headquartered in Richmond, Va., sees high oil prices driving this ongoing boom in the Lone Star state.
"Austin is going to continue to be strong. It looks very good on the job growth side. 2007 looks very good because supply is down, but we think supply will come back eventually." –David Fitch, Gables residential, Atlanta
California: Things look good in the Golden State as well. "Our bet is Southern California gets stronger next year. It has been a great year for that market, but we bet it will get even better next year." –Scot Sellers, Archstone-Smith Trust, Englewood, Colo.
Others agree.
"Markets that have been good–and we think will continue to be good–include Los Angeles, Orange County, and the Inland Empire." –Ron Witten, Witten Advisors, Dallas
The Bay Area hasn't been as strong, but people see potential.
"There are some other markets that are kind of late to the party, like the Bay Area and Denver. I think they still have a good bit of upside. Those are the kind of markets that have some good prospects ahead." –Ron Witten, Witten Advisors, Dallas
Pacific Northwest: The tech resurgence will also help the Pacific Northwest, but that market isn't quite as strong.
"Seattle had a great year, but there's not as much depth to that gap to that economy and there's not as much gap in home prices as there is in California. But Seattle should have a decent year next year." –Scot Sellers, Archstone-Smith Trust, Englewood, Colo.
Midwest: After years on watching major players flee, apartment owners in the Midwest are just hoping for some growth.
"We're seeing tightening occupancies in the Midwest. In some markets, we're better now than we were." – Jeff Kittle, Herman & Kittle Properties, Indianapolis
Still, compared to other markets, many think the Midwest looks weak.
"Big-picture-wise, the Midwest is definitely a lagger." –Ron Witten, Witten Advisors, Dallas
Public Advancements
Public multifamily company performance improved right along with the apartment market in 2006. According to Green Street Advisors, a Newport Beach, Calif.-based firm that tracks public companies, apartment REIT net operating income is estimated to be up 7.3 percent in 2006. Total returns have risen as well, predicted to be up 32.2 percent this year as of press time.
"All the public companies have been doing quite well on rental growth and same-store operations because the water level has been rising for all of us," explains Edward J. Pettinella, president and CEO of Home Properties, a public apartment firm based in Rochester, N.Y.
While the market has been improving, REIT executives have been adjusting their companies' holdings, often opting for coastal markets where it's difficult to build new properties and easy to maintain high occupancy rates. "[The REITs] have moved their portfolios around in a good way," says Fitch, whose company was a public REIT itself until being bought by ING/Clarion in late 2005. "They've been able to weed out the non-performers because of the liquidity in the market. They're extremely well-positioned and will continue to be attractive real estate plays for those who want to be in that sector."
As leverage buyers, condo converters, and condo developers all leave the acquisition scene, it opens up the possibility for the public REITs to buy and develop more assets. "[Other public companies] have some very huge pipelines that they hope to bring out of the ground over the next two or three years," Bolton says. "I think that a lot of projects will be successful. They've got growth built into their balance sheet over the next three to four years."
Add to this the internal investments they've made, and it's easy to see how public apartment companies can capture even more revenue into the near future. "A lot of the public REITs have continued to look at new systems and new technologies, including yield management systems, that will enable us to be much more aggressive operators," Bolton says.
The markets have certainly rewarded REITs for such efforts in recent years, but not everyone thinks this will continue. "[The public companies] seem to be fairly priced, if not fully priced," says Terwilliger, whose firm is private.
In fact, the NAHB's Multifamily Stock Index, which tracks the stocks of 24 publicly traded firms including 20 REITs, hit 3,371 in September, which was its highest total ever. It represented a 1.25 percent gain over August 2006 and a 30 percent year-over-year increase from September 2005.
While rent growth helped drive these strong valuations, there is speculation that the sales and subsequent privatization of AMLI Residential, Gables Residential, and Town & Country Trust also played a role. But industry observers don't expect many more–if any–big deals like that to materialize in 2007. "I think we've seen much of the public-to-private transfers," Neithercut says. "The arbitrage that people were realizing by being able to buy these companies at meaningful discounts on replacement costs with the extraordinary low financing has gone."
Development Dilemmas
Multifamily builders have been busy in recent years, but they haven't been constructing apartments. Between skyrocketing costs in land, labor, and building materials, making the numbers work on a new rental development has been just about impossible, even for big public companies with access to capital. "Last year, we were getting outbid by two or three times what we could bid for land for apartments in the Los Angeles basin," Archstone-Smith's Sellers says. "There was no hope of building apartments."
Even in markets where apartment builders could find land, costs for building materials made it difficult to pencil out deals. It got so bad that Todd E. Sears, director of finance for Herman & Kittle in Indianapolis, hated even talking to his construction colleagues over the past year. "Every time you talked to someone in the construction department, it was about a price increase they were getting from another subcontractor," he says.
The good news for both Sears and Sellers is that the for-sale housing slowdown will help them in 2007. Some executives say they're already seeing lower prices for lumber, shingles, and insulation. "Those materials related to single-family production are tailing off," Fitch says. "Lumber products are declining in costs."
Steve Fifield, CEO of Fifield Cos., a high-end condo and apartment developer based in Chicago, hasn't seen drywall prices fall yet, but he expects that will happen soon. "The one material that has been the most resilient [as far as pricing] the last six months is drywall," Fifield says. "I think that will quickly correct itself. With the public home builders cutting back, demand for drywall will go down."
So will the demand for–and cost of–workers. "As business slows, I think you will find labor that will need work," Fitch predicts. "The past few years ... everyone has been busy. It wasn't just carpenters, plumbers, or electricians. Engineers and architects were hard to find. When people are busy, everything costs more. With professional services, there will be less business, and prices will go down."
Multifamily executives also expect the for-sale housing slowdown to reduce the cost of land. "Land prices were generated by land grab for condo development," Fitch says. "That will bring land values a little more into balance than in the past, from our standpoint."
Finally, even oil prices have been dropping, easing the burden on multifamily builders and developers. "With petroleum costs coming down, the materials that have petroleum, like asphalt, will come down," Fifield says.
Future pricing for other building products remain uncertain, though, especially if there is overseas demand for those materials. "We're competing with Korea and China," says Hammer of Kushner Cos. "The competition is in hot economies like Asia, where everything is high-rise. If everything is high-rise, they're going to need the steel. A lot of steel and concrete are going to those places where they are booming."
Others say the impact of the China factor is overblown. "Commercial construction in China has shrunk," Fifield says. "Though we read about projects, the magnitude of construction is down. China has ramped up its steel production capacity and has seen the amount of construction done there gone down. It's taking the pressure off the demand for cement." Still, don't expect any bargains on cement soon. "With cement, the largest producers are in the catbird seat because there has been so much consolidation," Fifield says.
But top executives say they're optimistic about the climate for new construction in 2007. "I don't think [prices will] increase anymore," believes Terwilliger, who plans to start 12,000 to 14,000 apartments and 1,000 to 2,000 condos in 2007. "In fact, there's a higher probability that they go down than up."
Executive Predictions For 2007
Technology. Consolidation. Insurance. The list of challenges that multifamily leaders expect to encounter in 2007 covers everything from operational issues to land opportunities, as you'll read below.
–Margot Carmichael Lester
Q: Where do you think rents will go in 2007, and what factors will dictate their direction?
A: "Barring a recession, rents should rise in areas where demand is robust and vacancies are tight. For example, many areas in Southern and Northern California have vacancy rates below 3 percent. Last year rents rose from 4 to 8 percent and should continue to rise for 2006. By contrast, vacancy rates exceed 6 percent in many Texas and Midwest cities, and rents there will continue to remain flat." –Delores Conway, director, Casden Real Estate Economics Forecast at USC Lusk Center for Real Estate, Los Angeles
Q: What factors will cause pricing decisions toward or away from the property level in 2007?
A: "Even in the context of centrally managed rent management decisions, it all comes back to interest rates. If interest rates stay where they are or go higher, pricing decisions will continue to migrate away from the property level in 2007, and consumer confidence will continue to remain where it is today." –Allan Domb, president, Allan Domb Real Estate, Philadelphia
Q: Which apartment classes will grow the most next year, and what factors will cause that growth?
A: "I would expect growth to be pretty consistent across all apartment classes. At AEC, we have found that upgrades and renovations in most of our markets can be justified and result in higher rent increases. As markets have improved, residents are willing to pay more." –Jeffrey Friedman, chairman, president and CEO, Associated Estates Realty Corp., Richmond Heights, Ohio
Q: Do you see any more industry consolidation in 2007?
A: Of course we anticipate industry consolidation in 2007, as the more poorly capitalized developers cannot survive. The major players enjoy economies of scale on purchasing decisions from marble in China to insurance." –Alan Perlmutter, COO, Paramount Worldwide, Boca Raton, Fla.
Q: What amenities are you planning to offer residents in 2007?
A: "We have patiently waited for wireless technology to become more commonly used among residents. Since laptop computers and PDAs have come down in price, we will include WiFi technology in our current multifamily projects, Oasis and Dwell, in Orlando, Florida." –Alon Barzilay, vice president of development and development partner, The Klein Co., Philadelphia
Q: What do you expect to happen with insurance costs in 2007?
A: "[I hope] this spike will resolve itself over the next few years. Long-term, the impact is uninsured losses due to higher deductibles and limits on wind-storm coverage. This will be felt in all areas prone to hurricanes." –David Abbenante, president, HRI Management, New Orleans
Q: What are your expectations for land costs in 2007?
A: "Land costs are likely to remain stable or drop slightly. Buyers that jumped in late with the intention of flipping their property bought too high and now face a cooling market. Considering the high cost of land, construction, and insurance, it's tough to make the numbers work at these elevated levels." –Andy D'Jamoos, vice president, sales and marketing, The D'Jamoos Group, Naples, Fla.
Q: Where will energy costs go, and how are you dealing with them?
A: "Prices are going to remain high and go higher. Multifamily executives should look for new technology that helps us manage these costs, like thermostats or lighting systems with motion detectors or timers on natural gas boilers." –Dusty Wolf, president, Centra Asset Partners, Houston
Q: What major training programs will you undertake in 2007?
A: "RSVP, an acronym for Responsive Service Visit Program, is part of our expanded resident retention training focus. Our expectation is that our frontline teams interact with our residents proactively and as often as possible–not just when they have a problem. This is one of the reasons our annualized resident turnover is 56 [percent] to 57 percent." –Jeffrey Friedman, chairman, president and CEO, Associated Estates Realty Corp., Richmond Heights, Ohio
Q: What forms of capital do you see leaving and entering the multifamily arena in 2007, and what will prompt those movements?
A: "Smaller exchange buyers will ease up on investments as they evaluate alternative investments outside real estate. They're not necessarily looking to divest, but they're probably not going to be as active as they were in last five years. Institutional investors will be more aggressive, as real estate has now taken its rightful place in inst portfolios as an investment class." –Steven Ludwig, principal, Coastline Capital Partners, Hermosa Beach, Calif.
Q: What is the major threat that could derail the multifamily recovery?
A: "An economic recession that resulted in serious job losses to local areas. Demand for homes and apartments would fall while the supply of vacant units would increase." –Delores Conway, director, Casden Real Estate Economics Forecast at USC Lusk Center for Real Estate, Los Angeles
Q: Which under-the-radar issue will come to light in the next year, and what will bring it to the forefront?
A: Local government intervention: bond issues to raise capital for affordable housing, a moratorium on condo conversions, and more controls on re-development. Tensions between the city councils and the apartment industry could escalate." –Barry Baker, vice president, Grubb & Ellis Co., Los Angeles
Q: What will the opportunities in multifamily be given the weakened condo market?
A: "The housing market is notorious for operating on a cyclical basis. The pendulum is now swinging from benefiting condo developers back towards the apartment developers. From a consumer perspective many 'would-be' condo buyers may stay in their current housing scenario, or they may shift their dollars towards high-end rental communities and wait for the next cycle in the condo market to take its effect. Land deals are destined to become more favorable to apartment developers. However, it may take anywhere from 6 to 18 months for us to witness the impact." –Alon Barzilay, vice president of development and development partner, The Klein Co., Philadelphia
Q: What will be the challenges in multifamily after the condo fall-off?
A: "Energy, labor and materials costs are going up. And there's no reason that will stop unless there's a big recession. So rents will continue to go up but it'll be a close race which–rents or costs–will go up faster." –John McIlwain, senior resident fellow and J. Ronald Terwilliger chair for housing, Urban Land Institute, Washington, D.C.
Q: What big innovations in management are around the corner?
A: "Utilities reform. With energy costs varying wildly, it's difficult for operators to pinpoint where annual expenses will be. That makes it difficult for us to hit our pro forma annual budgets. Tenants don't feel it in their back pockets as California doesn't allow landlords to pass on expenses that can't be individually measured. I expect to see more energy-efficient construction of new properties and submetering on existing ones." –Steven Ludwig, principal, Coastline Capital Partners, Hermosa Beach, Calif.