A bout with the economy. (Cover Report: Commercial).

Record homeownership fueled by low mortgage rates has dealt a blow to the apartment market. Rising unemployment has delivered another punch, but multifamily has proven its resilience before and will do so again.

The multifamily market is being hit with a one-two punch that is leaving investors and lenders searching for a corner in which to rest and take stock of a changed environment. Like most property types, apartments are suffering from a weakened economy. However, this recessionary period has put apartments in a different position than they were in during previous recessions.

Interest rates are at 40-year lows, turning would-be renters into homebuyers. In addition, buyers and sellers disagree about where apartments are situated in the real estate cycle. As a result, bid/ask spreads have continued to widen, leading to minimal transaction activity. Until either the economy picks up or apartment assets are repriced, buyers and sellers will remain in different corners.

Investors are discouraged from selling while occupancies are relatively low, and since many investors have solid equity positions and financed apartments at relatively low interest rates, they are choosing to wait until the economy revives rather than lower their asking prices now.

With expectations that home financing rates will continue to remain low--particularly for the short-term-what investment opportunities lie ahead for apartments? Although this is a more challenging environment than apartments have faced recently, there are opportunities for multifamily investment.

Hitting below the belt

Believed to be one of the most recession-proof of all investment property types, the multifamily sector is now feeling the ripple effect of the downturn in the economy. Waning demand in the face of low interest rates and practicality of homeownership, along with oversupply in many areas due to the construction boom of the late 1990s, have softened the normally strong apartment market.

One of the most significant factors affecting oversupply is the development of luxury units, which are the least desirable during economic downturns and when home purchasing may be the preference. Concessions, infrequent in the apartment industry during the late 1990s, are now common. Up to a couple months of free rent on a 12-month lease and other incentives are becoming standard for apartments to remain competitive.

Thin profit margins have deterred some developers, but because appropriately zoned land for apartments is hard to come by and the market generally responds quickly to economic recovery, many have purchased available land in order to have locations available to develop when the economy improves. According to the Real Estate Research Corporation's (RERC's) research, (see Figure 1) overbuilding risk increased during the last few quarters but as of first-quarter 2002 overbuilding risk finally began to subside.

Rental growth on the ropes

During past recessions, job loss caused many people to postpone home purchases until they derived a certain amount of comfort with economic conditions. This allowed apartments to remain a strong investment choice throughout the recession. However, with interest rates as low as they are now and the current economic downturn being more business-driven than consumer-driven, demand has begun to decline for apartment units.

This effect is noticed most in luxury (class-A) apartments, as renters are willing to downgrade the type of apartment in which they live in order to reduce housing expenses. These actions have led to a high vacancy rate in the class-A market and declining rent growth levels in all classes of apartments.

As illustrated in Figure 2, apartments have seen expected rental growth of more than 3 percent since 1995. However, expected rent growth levels over the last four quarters have begun to show the backlash of the increase in home sales. The last two quarters are the first time that expected rental growth has dropped below 3 percent.

It is expected that until interest rates increase and home sales decline, apartments will continue to experience lower-than-average rental growth and increasing operating expenses, especially in the form of security expenses--such as electronic key entry, surveillance, 24-hour security personnel, etc. These factors will be affecting bottom lines throughout the remainder of 2002. Even so, the long-term outlook for rental growth for apartments remains promising, given their quick reaction to market stimuli such as a pickup in job growth.

Backed into a corner

Corporate downsizing and unemployment have always affected the vacancy rates in apartments. Unique to this recession, however, is the increase in vacancies due to continuing low interest rates, smaller down-payment requirements and other attractive financing options currently available to homebuyers.

In this environment, it is often more practical for many apartment dwellers to purchase a home rather than rent, and as a result, a record 6.15 million homes were sold in 2001. This prompted the apartment vacancy rate to increase for first-quarter 2002 to 5.6 percent from 3.2 percent in first-quarter 2001. As shown in Figure 3, this scenario of doubling vacancy rates did not occur during the last three recessions. However, because vacancies have remained low during the last five years, with vacancy rates of between 2 percent and 5 percent from the late 1990s through 2002, apartments are in much better shape than in previous recessions.

The latest blow to the multifamily sector came with FBI warnings in late May about terrorist plans to rent vacant apartment units and rig them with explosives. In response to this alert, landlords nationwide began tightening building security procedures, inspecting packages, banning food deliveries to apartment residents and conducting more comprehensive security and credit checks of prospective tenants. Such measures may help some apartment dwellers feel more secure, but other residents may see these measures as yet another reason to move out of their apartment building and purchase a home if they can afford to do so.

With security issues mounting, insurance premiums for apartment complexes also have become a greater concern. Terrorism threats, along with an increasing number of tenant claims for harm or injury, have nearly doubled the cost of coverage in many locations. The increase in insurance premiums and increased risk associated with apartments have resulted in stricter underwriting for valuing apartment properties, deterring some investors from projects that otherwise would be solid investment bets.

Rolling with the punches

Once the stronghold of commercial real estate investment due to its stable if sometimes lackluster performance, multifamily as a potential investment has been taking a hit from the combination of a weak economy and increasing unemployment, continuing low interest rates, overbuilding in some areas and new terrorism threats. In fact, independent research from the spring 2002 issue of the RERC Real Estate Report indicates that investment conditions for apartments declined to 6.6 from 7.0 last quarter, but apartments are still ranked the highest of all property types by investors. (Investment conditions were rated on a scale of one to 10, with one being poor and 10 being excellent.) Figure 4 illustrates RERC's investment criteria for the apartment market.

Stick and move

Property selection has become even more important as the economy struggles. Location, although still playing a prominent role in determining a strong multifamily investment, is only one of many factors needed to create better risk-adjusted returns. Amenities, aesthetic appeal and low operating risk are also needed when defining a strong investment opportunity. With many areas oversupplied, future growth for an area must be clearly analyzed to determine future demand for the property.

Creating opportunities

During this time of little or no rental growth and slowing demand, developers are looking for creative investments in order to maintain high returns and minimize risk. One way they are doing this is by continuing to rehabilitate older industrial/commercial buildings and converting them into apartments. Owners of these newly remodeled buildings are finding they are able to earn premium rents--up to 25 percent higher than in newer competitive properties.

Such revitalization of downtown communities is becoming a trend across the nation. Not only are these renovated properties aesthetically appealing, they are also raising the value of the urban neighborhoods in which they are located. Additionally, employment opportunities are usually more abundant in areas located near the heart of the city, suggesting higher demand in these locations for apartments.

These projects, however, do not go without challenges. Although capital is certainly available, the first significant concern is obtaining financing. This can be difficult due to the second concern--the physical aspects of the building being rehabilitated and the costs that can incur. Because many of these buildings were not built for residential use, functionality issues could exist, as well as the costs of bringing the building up to code. Proper design and due diligence before a project is undertaken is key to successful rehabilitation of older buildings.

'Price' fighting

In the past, the apartment sector was a seller's market with plenty of capital and potential buyers. However, sellers perceive the market differently than buyers during this economic downturn. As a result, bid/ask spreads continue to widen and the marketplace remains dormant.

To sellers, the downturn appears to be temporary and rent growth should pick up within the next year. Buyers, on the other hand, believe that the market has peaked and that oversupply in many markets will hamper opportunities, as well as rent and value growth, for years to come.

This situation cannot last forever. Some new projects--which are highly sought after by investors--were developed during the last few years when interest rates were relatively low. As owners developed these projects, they were able to take advantage of "cheap" money and highly leverage the properties. However, now occupancies have fallen and high leverage is working against owners, resulting in low profits, no profits or even deficits, which will prompt exit strategies. As loan-to-value (LTV) ratios in a property increase, so does risk, and buyers are not willing to pay a premium for this increased risk. Until some apartment assets are repriced, transactions will be nonexistent.

Knockout punch

With the heavy amount of apartment construction occurring in some areas across the United States, some markets are softer than others. Expected job growth is key in determining which multifamily markets represent the best opportunities.

Washington, D.C., historically one of the strongest markets in the country, is expected to maintain its standing with one of the lowest vacancies at approximately 2 percent. It also appears likely to have solid job growth through the remainder of 2002. On the other hand, with construction completions remaining high, Atlanta is expected to have one of the highest vacancy rates of major metropolitan markets for 2002.

Some apartment markets, such as Phoenix, also will see a high number of construction completions, but that should be neutralized by solid job growth. In addition, as shown in Figure 6, some markets have much higher perceived risk, as evidenced by higher capitalization rates. These cities have seen heavy multifamily construction coupled with weak demand.

Getting off the canvas

With expectations that returns for apartments will continue to decrease, why is there so much interest in apartments? Investors still believe that although the short-term investment prospects for apartments are not favorable, the long-term viability of apartment investment is.

For those choosing to invest in real estate during an economic downturn, history shows apartments have continued to perform relatively better than other types of real estate. As shown in Figure 5, apartment returns have outperformed all other types of real estate during the last two recessions. Traditionally, apartments also have recovered at a much faster rate than other real estate types. Further, with a 10 percent to 15 percent allocation toward apartments, many real estate portfolios are under-weighted. As investors take advantage of the solid and stable returns associated with apartments, transaction activity will again be strong.

Going the distance

The outlook isn't all bad for the softening apartment market. In addition to typically being one of the quicker real estate segments to react to economic conditions, apartments still maintain the lowest vacancy rate of all property types. When the economy improves and job opportunities grow, demand for apartments also will increase as employees rent apartments near their new jobs.

The demographic trend associated with echo-boomers continues to play a significant role for the apartment market. As more and more children of the baby boomers leave home, they will become apartment renters. Along with the echo-boomers, demand from new immigrant households should continue through the next decade, fueling further demand. Lastly, although apartment development has continued to soften the market, there has been a slowing trend in apartment construction. Demand is expected to catch up to supply over the next couple of years.

Apartments have been and will always be the first off the canvas after a recession. They are the quick-response sector of real estate, which also means they are the first to get knocked down. An expected increase in job growth in 2003 will greatly benefit the apartment market.

The nation is and will be underhoused, due to supply constraints for development, making apartments the only logical alternative. As job growth increases, interest rates will also begin to rise, which will serve as a boon to the multifamily sector. Once assets are repriced to normalized levels and construction completions diminish, apartments will again regain the title.

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Figure 4

RERC National Apartment Investment Criteria

                        4Q01   1Q02

Pretax Yield           11.0%  11.0%
Going-in Cap Rate       8.5%   8.7%
Terminal Cap Rate       9.0%   9.1%
Rental Growth           2.4%   2.3%
Expense Growth          2.9%   2.9%
Renewal Probability      63%    63%
Time to Release          1.7    2.2
Vacancy Loss             6.1    6.1
Marketing Time           5.4    5.5
Holding Period           7.8    6.9
Buy                      35%    38%
Sell                     32%    31%
Hold                     33%    31%
Overbuilding Risk        6.6    6.1
Investment Conditions    7.0    6.6

SOURCE: REAL ESTATE RESEARCH CORPORATION
Figure 6

Metropolitan Capitalization Rates

                 4Q01       1Q02         Increase
               Cap Rates  Cap Rates  (in Basis Points)

Atlanta          8.6%       8.8%            20
Los Angeles      8.1%       8.4%            30
Miami            8.4%       8.6%            20
New York         8.4%       8.5%            10
Philadelphia     8.6%       8.7%            10
San Francisco    8.2%       8.4%            20

SOURCE: REAL ESTATE RESEARCH CORPORATION

Kenneth P Riggs Jr. is chief executive officer and Ryan W. Harms is assistant vice president of Chicago-based Real Estate Research Corporation (RERC). RERC provides research, valuation and portfolio services to clients throughout the United States. RERC is most recognized for the RERC Real Estate Repart and the RERC DataCenter, which provide investment criteria for major markets across the country, and for the RERC Industry Outlook, an annual forecast of real estate conditions.