However, the dynamics eroded rapidly as job losses went from the below-average job loss of 137,000 per month to approximately 550,000 per month since September of 2008 in response to the escalation of the recession and credit crunch to a global financial crisis.  

Market Fundamentals Erode          

The national apartment vacancy rate is 6.6% and is expected to climb 110 basis points during 2009 — the industry’s highest vacancy rate in more than 20 years. At the end of 2008, the national vacancy rate reached 6.6%. Also troubling is the amount of rental concessions appearing in submarkets across the country. As a result, the national net effective rental rate is expected to decline by 3% to 4% during 2009, with significant variation among various markets.

As of December 2008, the 10 U.S. markets with the highest vacancy rates include Jacksonville (11.6%), Tucson (11.2%), Phoenix (10.9%), Atlanta (10.2%), Houston (10.0%), Orlando (9.7%), San Antonio (8.7%), Tampa (8.6%), Columbus (8.1%) and Charlotte (8.0%). The 10 U.S. markets with the lowest vacancy rates included New York (2.3%), San Francisco (3.6%), Milwaukee (3.7%), San Diego (3.9%), New Jersey (4.0%), New Haven-Fairfield County (4.0%), Minneapolis (4.3%), Los Angeles (4.5%), Salt Lake City (4.9%) and Miami (5.0%).  

Capitalization Rates Increase — Market Velocity Plummets

The impact of the credit crunch and recession through September of 2008 on the apartment market had clearly been evident, albeit more moderate than other commercial real estate sectors. Not only had the fundamentals held up better, Fannie Mae and Freddie Mac’s ongoing funding of loans for apartments had helped offset the virtual shutdown of lending in the Commercial Mortgage Backed Securities (CMBS) market.

The velocity of apartment asset sales has fallen steadily since the onset of the capital markets disruption, which began in fall of 2007, as the price expectation between sellers and buyers began to widen. Buyers, lenders and equity providers cited increasing risks and more conservative lending requirements as reasons for their reduced pricing. Until the fourth quarter of 2008, most owners cited stable operations and a long-term favorable supply/demand balance as reasons for their reluctance to accept discounted pricing.

According to Real Capital Analytics, the velocity of U.S. apartment sales valued at $5 million and more declined by 62% in 2008 compared to 2007. Buyers and sellers simply could not agree on values, and only moderately to highly motivated sellers were willing to accept pricing that would “clear the market.” Capitalization rates during the first three quarters of 2008 increased by 35 basis points for Class A assets in primary markets, 75 basis points for Class B assets in secondary markets and by 150 basis points for Class C assets in tertiary markets. These cap rate increases reflect a discount to value of 7%, 13% and 22%, respectively.

Since the acceleration of job losses that started in September of 2008, buyers, lenders and equity providers point to deteriorating operating fundamentals to support their case for higher capitalization rates and lower values. As a result, downward pricing and sales velocity trends have continued. During the past six months, capitalization rates have continued to increase to a total of 65 basis points for Class A assets in primary markets, 125 basis points for Class B assets in secondary markets and 200 basis points for Class C assets in tertiary markets. The total price correction since October 2007 averages 12%, 21% and 30%, respectively for the asset quality/location scenarios detailed above.

Understandably, all but the most motivated sellers have opted to hold their assets rather than accept current market pricing. As a result, sales velocity declined by 83% in January 2009 compared to January 2008.

Investment Outlook for 2009

With challenging fundamentals and a stubbornly wide pricing expectation gap between sellers and buyers, investment activity will remain low for most of 2009. The only viable opportunity for increased market activity will be in the second half of the year, and will become a reality only if the CMBS loan servicers can work their way through the increasing number of assets hitting their “watch lists”.

Preliminary valuation activity on behalf of CMBS loan servicers has increased dramatically over the past few months, but sorting out the competing interests, determining value and committing the assets to the market is a complicated and time-consuming process. Individual “one-off” and portfolio loan and asset sales are beginning to clear the market, but the servicers have not yet streamlined the process.

There are a substantial number of buyers motivated to enter the market to capitalize on distressed pricing, but most are attempting to time the cyclical bottom of the market and are “keeping their powder dry” for the time being. The most active current buyers are private individuals or partnerships that are motivated to acquire solid investment property with immediate cash yields of 8% to 10% or more, depending on asset and location quality. Other active investors see this as a time to pick up exceptionally well-located assets that might not be available when the market enters its next growth phase.

The other significant trend is the re-emergence of private syndicators who are able to raise significant sums of money from “Country Club” investors who have seen their stock market yields plunge, and who are now seeking hard assets with regular cash flows. Most deals offer a preferred rate of return to the investor of approximately 8% and then a decreasing waterfall of cash flow to the non-operating investor as the overall yield increases. Most scenarios target a minimum 15% yield over the life of the investment, which typically is 7 to 10 years.

While some private investors have been active, most institutional investors and fund managers have elected to remain on the acquisition sidelines. Investors with a high fiduciary obligation to their capital sources  generally are only  willing to enter the market for an opportunity that has clearly distressed pricing, or a very compelling story that supports long-term, above-average growth. It is also viewed as dilutive to enter the market for an average opportunity unless it is certain the market has bottomed out.

On the positive side, financing for apartment acquisition and refinancing is readily available, although less efficient and more expensive than at the peak of the past cycle. Unlike other major real estate segments, the apartment industry is fortunate to have both Fannie Mae and Freddie Mac as reliable lending sources. Financing volumes for both GSEs (government-sponsored entities) have been high for the past six months; however, the majority of activity has been refinancing.

Underwriting standards have tightened, spreads have increased, and loan-to-value (LTV) standards generally are not used because the “V” in this market is difficult to pinpoint. Instead, most loans are underwritten to a debt-constant ratio, with the average ranging from 1.25 to 1.3, depending on asset and market quality. In addition, it is becoming very difficult to negotiate any type of waiver or adjustment from their standard documentation, and a number of submarkets and markets require a specialized pre-review.  

The Case for Optimism

Despite the current challenges to the apartment industry, the long-term outlook remains bright for the following reasons:

1. Over the past 15 years, multifamily housing has emerged as a preferred product class, and demand for apartment investment will remain high. One need only compare the performance of the U.S. apartment industry to the stock market over the past year to understand why apartments are viewed as resilient. Most investors also view apartments as an inflation hedge, which will provide an additional, compelling reason for increased demand as we enter the next economic growth cycle.
   
   
2. The demand for multifamily housing will increase over the next 15 years. The maturation of the echo boomers into their prime renting years will create strong demand for multifamily housing. The 20- to 34- year-old cohort ebbed to 58.8 million in 1999 and is expected to increase to 68.5 million by 2020. Combined with both legal and illegal immigration, this boom in potential renters will have a dramatic effect on rents and values in the years ahead.
   
   
3. The social-engineering trends enacted by various policy makers that artificially increased the U.S. homeownership rate from 67% to 69% have proven to be misguided policy and an expensive failure. The homeownership rate has decreased by 1.7% from the peak in the second quarter of 2004, which has created an additional 3.7 million renter households. This trend will continue, with some experts believing the rate will drop to somewhere between 64% and 65%.
   
   
4. Multifamily construction starts have been dramatically reduced over the past 15 months. Starts decreased by 7% during 2008 compared to 2007, with the rate of decline accelerating towards the end of year. During the fourth quarter of 2008, starts fell approximately 40% compared to the same quarter a year earlier. We expect multifamily starts will decrease by an additional 34% in 2009. The result of increased demand and reduced supply as we head into the next growth cycle should result in a steeper than average climb out of the recession for the apartment business.
   

As a result of this projected demand for multifamily investment and a supply/demand balance that will favor increasing rents and appreciation, the National Multi Housing Group of Marcus & Millichap remains bullish on the long-term outlook for the U.S. apartment industry. However, for the next 12 to 18 months, be prepared for a continued ride in the vortex.

Linwood Thompson is a senior vice president and managing director of the National Multi Housing Group of Marcus & Millichap Real Estate Investment Services, based in Atlanta. He also is a partner of the firm. Contact him at 678-808-2700 or linwood.thompson@marcusmillichap.com. [ return to top ]