National market holds opportunities for buyers & sellers; Marcus & Millichap expects the atypical pressure exerted from homeownership to begin to wane as the affordability gap continues to widen and interest rates climb. While appreciation is likely to slow over the next year, improving rental market conditions will allow fundamentals to catch up to prices.

The investment environment for multifamily properties in 2005 is strong due to a variety of economic and demographic factors for both the long-term and short-term private and institutional investor. Employment activity, interest rates and demographic trends all figure into the equation, adding up to improving market fundamentals and continued strong buyer demand in today's dynamic investment market. Some shifts have occurred nationwide as markets recover from the recent recession at different speeds, but overall high-growth Western markets remain strong--and popular with investors--along with large East Coast metropolitan areas and parts of South Florida.

An Economic Ally

The most significant gains in employment in 2005 are forecast in business and professional services along with the education and health care services sectors. Marcus & Millichap expects mortgage rates to remain low by historical standards, but they will slowly climb during the next 12 months, and home prices are also expected to rise at a moderate rate.

As white-collar jobs are created--at least at a moderate rate--and housing becomes less affordable, apartment owners will reap the rewards, particularly in the Class A sector. Class B/C properties will benefit from stabilization in manufacturing, immigration and growth in the leisure and hospitality industry, as well as from echo boomers who are entering the market looking for reasonably affordable rental housing.

Positive economic indicators are producing heightened expectations for recovery. Job growth is expected to accelerate to 2 percent, population within typical renter age groups will shift to long-term growth and continued immigration will help underpin an optimistic outlook for the year.

Dynamic Market Presents New Opportunities

Unique and extremely liquid best portrays the apartment investment environment. The strength and depth of the buyer pool has led to intense competition and appreciation unheard of in a recessionary market.

On a national basis, the median price per apartment is up more than 50 percent since 2001, while revenue fell 1 percent during the same period. Cap rates have compressed more than 200 basis points during the past three years and are expected to remain low over the coming year.

Large property sales are on the rise due to increased institutional activity, condominium conversions and the implementation of tenancy-in-common partnerships, which facilitate small investors participating in the acquisition of large-scale properties. A shift in investment activity is occurring as investors move out of heated metros to secondary or even tertiary markets to take advantage of more favorable yields, often through improvement and repositioning of value-added opportunities.

A key factor affecting many apartment markets and investors is the surging condominium conversion activity, fueled by a healthy demand due to single-family home price appreciation. More than $7 billion in apartment sales last year were slated for conversion. While an apartment building purchaser's return is going to be a function of the cash flow from the property and the perceived appreciation if he holds the asset for five years or seven years, a converter's financial considerations are much different, based on the near-term sale of the individual apartments. Because of this, converters can bid much more aggressively for properties.

There are regions where condo conversions are currently very hot, including South Florida, Southern California and some submarkets of Dallas and Phoenix. There is also a resurgence of interest for conversions in the Northeast--particularly markets such as Boston, New York, Hartford, Conn., and Stamford, Conn.

Record-Setting Prices in California

Many apartment owners are selling in California to capture record-setting prices. Some of these sellers are then looking to buy property outside of California, where they can capitalize on nominally higher cap rates. But that's not the whole story. A lot of money is leaving Southern California because investors want to avoid competing against 15 to 20 other buyers; they want to find surety of completing a deal, not just a better cap rate.

Long-term investors who can "afford to pay a lower cap rate in a market with higher rent growth--players with longer horizons such as REITs, institutional players or multi-generational investors--are buying in markets such as Washington, D.C., Boston and Los Angeles. They are betting on the long-term stability of those markets because of better-than-average rent increases. For an investor with a shorter time frame, it would be speculative to buy in Southern California with today's cap rate and assume a profit in the short term. There is a fair amount of math and art involved in dealing with these markets.

Investors looking to capture some upside in rents may consider some of the nation's high-tech markets, which are starting to show signs of revival after several years of economic malaise. With increasing business investment into equipment and software, markets such as Seattle; Austin, Texas; and San Jose, Calif., will realize employment gains that will translate into strengthening demand for apartments by residents.

National Rankings

The hottest markets remain those in Southern California, including Riverside-San Bernardino, San Diego, Orange County and Los Angeles, with nearby Las Vegas sizzling as well. These markets thrive on strong demographic and employment trends as well as low vacancy and solid rent growth. Riverside-San Bernardino tops Marcus & Millichap's National Apartment Index (NAI), a snapshot analysis that ranks 42 apartment markets based on a series of 12-month forward-looking supply and demand indicators.

The combination of supply and demand is causing certain markets to rank at the top. If an area has a prospect for higher demand with a combination of population growth, strong demographics and particularly job growth, coupled with difficulty developing apartment units to meet that demand, this combination creates the imbalance that makes rents go up faster than they would in other parts of the country. These are clearly the things investors see in Washington, D.C., Boston, many parts of New York, particularly Manhattan, South Florida and Southern California.

Short-term investors may target a market where they perceive there will be rapid growth and they will not have to pay quite as low a cap rate. Such high-growth markets as Atlanta, Orlando and Tampa are examples.

The bottom line is that today's market is large enough and very liquid, which presents opportunities for both sellers and buyers.

The Rankings

Following are some details on the markets ranked at the top of Marcus & Millichap's National Apartment Index (NAI):

No. 1 Riverside-San Bernardino. Demand for rental housing is on the rise in Riverside-San Bernardino as in-migration, a lack of construction and rising home prices keep the local apartment market among the strongest in the nation. Riverside-San Bernardino ranks No. 1 in this year's rankings, rising three spots from the No. 4 position last year. Recent spikes in home prices reduced affordability to less than 25 percent. Cap rates have fallen to an average of 6.5 percent in the luxury sector. In addition, the large number of private buyers in the market has kept competition for smaller properties intense, with the median price for buildings with fewer than 20 units rising by more than 32 percent during 2004 to $86,000 per unit. Overall, cap rates in Riverside-San Bernardino showed a 220 basis point decline from 2001 to 2004.

No. 2 San Diego. San Diego will remain one of the top-performing apartment markets in the western United States during 2005 as the improving job market, strong net in-migration and out-of-reach home prices drive vacancies down and rental rates up. The city holds the No. 2 spot again this year. San Diego expects a 2.8 percent employment boom, an increase of 35,700 jobs, most in the financial services sector, heightening demand for luxury units. Strong in-migration will further exacerbate the shortage in affordable housing, as only 10 percent of all San Diego residents can now afford the metro area's median home price of $580,000. The University Heights submarket will remain the most active as properties in this area generally have fewer than 20 units and sell for less than $5 million. Outside the central core, investors can expect South and East County to remain an affordable option with median prices below the San Diego County average of $120,000 per unit. The cap rate dropped 250 basis points from 2001 to 2004.

No. 3 Orange County. Rising interest rates will cool the housing market and, along with forecasts for an increase in employment of 2.3 percent, benefit the Orange County apartment market in 2005 despite the market falling to No. 3 from the No. 1 spot in the national rankings last year. The median home price ended 2004 at $660,000, which left the affordability gap at $2,400 per month. The median price overall ended 2004 up 17 percent, at $130,000 per unit, but the number of properties on the market and the time it takes to sell a property have increased. Investors will continue seeking Class C properties in Central Orange County during 2005. Orange County recorded a 230 basis point drop in cap rates for the period from 2001 to 2004.

No. 4 Las Vegas. Nation-leading job growth, forecast to continue with a 4.8 percent increase this year, has resulted in strong net in-migration to Las Vegas, the No. 4 market in the country, which ranked No. 6 last year. With home prices at record levels, condo developers and converters are wagering that an increasingly large portion of the population will be excluded from homeownership. In the near term, converters are paying top dollar for conversion prospects often at price levels that do not support cash flow from traditional apartment operations. Cap rates for the period 2001 to 2004 have dropped 270 basis points.

No. 5 Los Angeles. Declining affordability and an expanding economy will continue to benefit apartment owners in 2005 and will keep investors active in the market. Los Angeles takes the No. 5 spot nationally, down two places from last year. Employment growth will continue in 2005 with the creation of 60,000 jobs, and housing affordability is a low 15 percent. The median price increased by 10 percent in 2004, to $105,000 per unit. Institutional-grade properties posted the highest price growth last year, increasing 25 percent, to $130,000 per unit. Los Angeles's cap rate dropped 250 points from 2001 to 2004.

No. 6 Washington, D.C. Low and declining vacancy coupled with a solid job growth forecast and low housing affordability support Washington, D.C.'s strong multifamily housing investment market. The market ranks No. 6, up two places. Job growth will continue in 2005 at a 2.2 percent growth rate as D.C. adds 64,150 positions. The working-class areas of Anacostia and Deanwood might interest investors searching for higher returns as properties in these areas often sell for above-average cap rates. Although these properties tend to be more management intensive, the median per-unit price remains under $40,000, substantially less than the regional average of approximately $84,000. Washington, D.C.'s cap rate fell 260 basis points from 2001 to 2004.

No. 7 Boston. Boston will continue to exhibit economic improvement in 2005, which, along with declining housing affordability, will boost demand for apartments. Boston ranks No. 7 this year, up three places from last year. With employment forecasted to increase by 2 percent, the area expects net absorption to improve, especially at luxury communities. Many buyers were active in the market during 2005, but the median price declined slightly due to the predominance of sales in the lower end of the market. Trading was active in both Attleboro/Bedford and Saugus/Lynn, where properties sold for a median of $58,000 per unit and $78,000 per unit, respectively. Boston's cap rate from 2001 to 2004 dropped by 200 basis points.

Overall, the anticipated higher cost of capital will cause something of a market shift, but the need for low-risk cash flow will dominate the investment strategy of investors, who range from aging baby boomers to institutional investors and REITs. This macro trend, coupled with the durability of the expansion cycle and emerging echo-boom generation, bodes well for future apartment performance.

Steve Witten is Senior Director of Marcus & Millichap's National Multi Housing Group, headquartered in New, Haven, Conn. Witten can be reached at 203/495-8000 or e-mail [e-mail]. The complete 2005 National Apartment Report and regular market updates are available via e-mail.