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Apartment lending after the boom.

The "field-of-dreams" era of multifamily development is over.

During the last 20 years, developers have become used to working under the assumption that "if I build it, they will come." In the 1970s, the baby boomers fueled the market for entry-level apartments, and as they aged, that whole generation fueled the market for the step-up development of the 1980s. As some of this group left the rental market to buy single-family housing, more baby boomers were waiting to take their place.

As a result, the industry became comfortable, and many got sloppy, indulging in bad habits that went unpunished simply because baby boomers needing housing continued to rent apartments at an ever-increasing rate.

The 1990s will not be as forgiving. The youngest baby boomers are now in their late twenties and have already entered the rental market. The group now leaving the rental housing market to buy single-family homes are being replaced by the "baby-bust" generation, which is not nearly as large. Therefore, the number of entry-level households is decreasing.

As a result, the multifamily industry must unlearn the bad habits that were bred from two decades of favorable demographics that created a nonstop supply of renters.

Demographics: here come

the twentysomethings

First, it is necessary to understand the demographic developments forging a changing approach to multifamily development. While demographics have long shown that there was a market that favored increased multifamily development, that data now shows that the market is backpedaling. The baby boomers are now giving way to the "twentysomething"--that is, those born in the "baby bust."

The most obvious difference is evident when you look at the total numbers. The total number of households between 15- and 24-years-old is estimated to have decreased 18.3 percent between 1980 and 1990 and is projected to decrease another 1.8 percent between 1990 and 1995. By contrast, the number of households in the 25- to 44-year-old range (baby boomers) increased 28.7 percent between 1980 and 1990. But, this group will increase only 3.6 percent between 1990 and 1995 as the leading edge of the baby bust enters this age range. The core, multifamily support group, that is, households in the 25- to 34- age group--is projected to decrease 5.8 percent from 1990 to 1995.

Another factor compounding this shrinking pool of young households to occupy entry-level rental housing is the tendency for the "twentysomethings" to stay at their parents' home. According to a recent article in Time magazine (July 16, 1990), 75 percent of 18- to 24-year-old males are living with their parents--the largest percentage since the Great Depression in the 1930s.

Persons in their twenties are also marrying later in life than the baby boomers did. Census statistics indicate that in 1970, 55 percent of men and 36 percent of women between the ages of 20 and 24 had not married. This increased to 77 percent for men and 61 percent for women in 1988. When considering 25- to 29-year-olds, 19 percent of the men and 10 percent of the women in that age group in 1970 had not married, compared to 43 percent of the men and 29 percent of the women in 1988.


Because there will be fewer replacement tenants, the industry must accept the fact that it cannot build multifamily units at the levels achieved in the mid-1980s. As Chart 1 indicates, total housing starts in the 1980s fluctuated from a low of approximately 985,000 units in 1981 to a high of roughly 1.77 million in 1986, averaging close to 1.43 million. However, new household formations averaged 1.24 million, producing an average of 190,000 more housing starts per year than there were new households created to occupy them. Compare that to the 1970s, when housing starts averaged 1.77 million per year and household formations averaged 1.74 million, producing an annual surplus of only 30,000 units.

Most of the excess housing is multifamily. An examination of Chart 1 indicates that single-family starts have remained relatively stable during the last several years and that multifamily starts are primarily responsible for the fluctuations in total housing starts.

In the 1980s, the industry largely threw the law of supply and demand out the window and built when it could borrow, regardless of whether or not a project could be supported by the market. The industry was saved from almost certain total disaster in the 1980s by the tax law changes of 1986. The mid-1980s, however, proved that the multifamily construction industry could build more than 700,000 units per year. Although the industry might have continued to produce units at those levels if the tax laws had not changed, consider that while multifamily starts decreased from 776,671 units in 1985 to an estimated 305,234 in 1990, the vacancy rates nearly doubled in most markets. Furthermore, the industry was hard pressed to achieve meaningful rent increases.

To survive the 1990s, multifamily developers will have to relearn the law of supply and demand--not of capital, but of tenants. The industry will have to carefully examine the pertinent demographics, considering not only the potential demand from household growth, but also the existing supply and the pipeline. Because determining the extent of the existing supply will become even more critical for the 1990s, market information based simply on selected comparables will no longer be adequate. Each market must be completely surveyed to develop a 100-percent database from which to identify open niches for potential development.

Many analysts have recently looked at multifamily housing starts from the last few years and have said the industry is in a slump. Compared to mid-1980 levels, this may seem true, but compared to realistic support levels, the multifamily industry is not in a slump, but rather is undergoing a correction for past overbuilding.

Although the attitude that prevailed in the 1980s toward multifamily development is no longer viable, neither is the post-savings-and-loan-crisis stance of the financial industry; which is not to finance any multifamily development. Surviving the 1990s will require an attitude adjustment on both sides of the financing issue. Good development should be encouraged and financed--but the 1990s will bring about some redefinition of what comprises a good development.

More than location

"The three most important criteria in real estate are location, location, location." This axiom previously defined what made up a good project. Unfortunately, many still believe it, though it is patently untrue. The axiom implies that if you have the right location, you can build anything and people will line up to move in.

Such an approach reveals no respect for tenants' good sense, anticipating that they will only react on a stimulus/response basis. Location is just one of many criteria weighed by tenants when making a residence decision. If location were the only important criteria, we would never see projects with "good" locations that have low occupancy rates--but we often do. There also would not be projects in so-called "bad" locations with waiting lists.

In order to survive the 1990s, the industry must go beyond location as the most important development consideration. We advise our clients to focus on three criteria that work together in multifamily development--economic, geographic and conceptual--building the right product at the right price in the right location.

The right product--conceptual


Our case studies of high-vacancy markets have proven that when the rental market is tight, most product is occupied regardless of marketability, but when the market is overbuilt, marginal product can be more readily identified by its high vacancy rate. Many developers, architects and man- agers fool themselves by attributing their success to what they believe is a well-conceived product, when actually their success may be temporary, prospering only because of good market conditions.

It is only when times get difficult that bad product becomes vulnerable. For example, when the vacancy rate is 4 percent, some apartment communities are at 3 percent and some are at 5 percent. It is tough to tell a developer then that his 95-percent occupied product is poorly conceived. Later, when times get tough and vacancies are hovering around 10 percent, the projects that were 3 percent vacant may increase to 6 percent vacant, but the ones at 5 percent will increase to 14-percent vacant.

One such example of marginal product is lower-level units in two-and-a-half-story buildings. During periods of market vacancies below 4 percent, these units will maintain high occupancies. However, when a market gets soft, these units will catch vacancies first and will have the highest vacancies in the market. These units were built in great numbers in the late 1960s and early 1970s--the baby boomers moved into them when there were few other rental choices. Developers thought that they had great product because the market reception was so good, but in reality all they had was a great market. Ultimately, when the market declined, so did the demand for this marginal product.

Other marginal product includes units with too little closet space or poorly designed floor plans. People initially may move into an apartment complex because they are impressed by the project amenities or because of the location, but eventually they move out if they run out of closet space or do not have sufficient room to put the sofa.

Other properties that will be marginal in the 1990s are large apartment complexes, primarily due to the reduced number of potential renters. For example, a 500-unit property that experiences a 50 percent annual turnover rate will need to rent 21 units per month to remain 100 percent occupied. Given the shrinking number of tenants entering the rental pool and the increased rental options that the multifamily development boom made available to the tenants already in the rental housing market, a high level of potential tenant traffic will become more difficult to achieve and maintain. Even a small drop in the number of units rented per month will result in high vacancies in large projects, which could force rent concessions and giveaways.

Conceptual considerations will become even more important in the 1990s as the entry-level renter pool continues to decline. It will no longer be feasible to develop the same product as always. As renters age and become more affluent, they become more savvy about finding the apartment that offers precisely what they want.

The apartment market has never consisted of a single, uniform "profile," even though recent multifamily development shows little or no variations. The apartment market has--and will continue to have in growing numbers--families, the elderly and divorced and separated people of all age ranges. We must realize that by targeting the young market exclusively (a market that is shrinking) we are missing out on other market niches--niches that have always existed but consistently have been ignored.

In addition, it is also important to remember that even the "typical" renters are not all alike, and that they may want different product. Car and beer manufacturers have long recognized the importance of niche marketing, yet apartment developers continue to put up product devoid of a specific focus and target market. Then they wonder why it is not meeting rent-up and rent increase expectations.

Multifamily developers must identify target markets that are not being served by existing properties in an area. Specifically targeted and designed product will create three advantages. First, by responding to specific requirements, targeted product will retain tenants in the rental market longer, increasing the size of the rental pool. Second, targeted product will decrease turnover. Third, rents will be maximized, as the targeted groups will pay more for housing that fits their special needs.

Typical target markets could include families, older adults, elderly, single women, single parents or the home-office market. In tenant surveys, we find that nearly 50 percent of upscale "twentysomethings" intend to move into single-family homes at the time of their next move; however, only 8 to 10 percent actually do. Usually this is because they cannot afford to buy the single-family housing that is on par with their present standard of living in an upscale apartment. In typical markets, a rent of $600 to $800 places a tenant among the best apartment communities available. Market research demonstrates that a step up in shelter cost might bring the housing cost to $800 to $1,000 per month. That amount will not purchase a single-family home nearly comparable to the perception of their existing living conditions.

Apartment communities that can take advantage of markets that are "stuck" in rental housing, that is, those that are financially unable to step-up and move to single-family housing, will likely do well in the 1990s. For example, our surveys indicate that up to 25 percent of households in two-bedroom units have children, and this is at a time when the industry designed product that is not particularly appealing to households with children. Therefore, apartment developments designed to attract families with children would compete relatively unobstructed. Families with children are more likely to live in a townhouse unit than a garden unit by 55 percent to 45 percent, yet most large markets contain less than 5 percent townhouse units. In addition, programming, such as on-site day care or after-school activities, can make apartment housing even more attractive to families.

Another market segment that should be targeted is the older renter. Older renters will continue to enter the rental market for a variety of reasons, including divorce, death of a spouse and the moving out of grown children. In the last six years, the number of older adults in upscale housing has nearly tripled during a period when the industry built mostly two- and three-story walk-ups. Product designed for and marketed to older renters can be a successful, profitable niche.

There are other creative ways of filling a market niche. We have seen apartment communities that cater to the growing number of renters working at home by providing second bedrooms with extra telephone lines for computers or facsimile machines, deep closets for filing cabinets, secretarial support and package service. Such properties, because they fill an existing need, are likely to do well in the 1990s.

The right price--economic


Traditionally, renters start in entry-level housing, move up to moderately priced housing and then move toward upscale housing or single-family ownership. This tenant continuum has expanded dramatically with the step-up building of the 1980s. As a result, identifying economic opportunities in the market has become more complicated.

It is absolutely critical to price product appropriately in order to take advantage of available price niches. These niches can only be identified through a 100-percent database of a particular market's existing development and the apartment construction in the planning and building phase that is coming onto the market. Such a complete market picture will be necessary, not only to identify an appropriate price for the amenity level offered by an apartment complex, but also to take full advantage of step-up housing demand in the market and to lessen tenant drain to the exit impact area (units with greater amenity level and prices).

Studies show that tenants will step up their rents by up to $100 for product that they consider to be a value, depending on rent range. Generally, 50 percent of all tenants in a apartment complex come from another complex in the area. The pool of tenants living in area apartment communities priced within the step-up rent range is considered the step-up based population. In order to succeed, a rental complex must keep its rent prices within the step-up range of the tenants in its step-up base. A property that prices itself out of the range of its step-up base will find it difficult to replace turnover.

In addition, an apartment complex must be aware of others nearby with higher rents and better amenities. These rental communities comprise the exit impact area, because they are most likely to be the apartments into which these departing tenants will move. Apartment management must be careful not to allow rents to get within easy step-up range of apartment developments in the exit impact area. Unless this is prevented, it will result in an acceleration of tenant drain.

This tenant continuum affects not only the placing of a new development into the right price niche so it can benefit from the most step-up support and the least exit impact drain, but it also affects expectations for rent increases. An apartment community's rents will always be constrained by rents of those projects above and below it, if it is to remain successful. Therefore, rent increases for pro formas, that is, for projected operating statements, must reflect the market in the 1990s in order to make realistic multifamily loans that will perform effectively.

The right location--geographic


Two primary geographic considerations are integral to finding the right location: finding the right market and finding the right site.

First, developers must identify markets that can support additional development. One of the mistakes made in the 1980s was not understanding what it means for a market to be "hot." Just because there is a construction boom or high population growth in a market, this does not necessarily mean that it is a good market for multifamily development. In the 1980s, developers rushed into fast-growing Sunbelt and western cities to build units without examining the entire market picture. Many builders ended up being burned by their own haste, because they built units without matching supply and demand and without checking the pipeline. The result: overbuilding in the so-called "hot" markets.

In the 1990s, the multifamily industry must change its thinking on what constitutes a "hot" market. Hot markets for development are not those where new units are opening every day; they are, rather, those markets where not enough units are being built to satisfy the demand for new units. Every year, The Danter Company, Inc., based in Columbus, Ohio, publishes a ranking of the top 150 metropolitan statistical areas (MSAs) in the country and lists their potential for housing development. The company examines a 10-year record to housing starts in each MSA and looks at how these starts relate to demand factors such as household growth, housing stock replacement and internal mobility. Based on these factors, the company determines which markets have high housing deficits (markets that can support higher development levels) and which markets have housing surpluses (markets on their way to overbuilding).

This has led to substantial insight into the multifamily development game. For example, we found a general lack of understanding about the basis for common market statistics. A developer hears that "market X" is hot, and so he builds units in market X without determining who is doing the talking. Because most industry indexes are based on action rather than inaction, "hot" lists tend to be places where high levels of development and building are occurring. This mentality runs counter to the rationale behind real estate development. Real estate is most valuable when it is mose scarce. Therefore building where everyone else is building, when everyone else is building, is counterproductive.

Our analyses during the last several years have tended to identify housing deficits in areas that were often ignored by developers rushing south and west to the high-growth markets. Of the top 26 markets identified in our 1990 ranking, 11 were located in the Midwest. People in "rust belt" cities such as Cleveland or Milwaukee have the same desire (internal mobility and internal household formation) for a new apartment as people in Tampa or Phoenix, yet developers in the 1980s were often reluctant to build in such markets because of low household growth figures. Such markets should remain ripe for moderate development because of the relative lack of new multifamily housing in many of these areas during the last several years.

Once a potential market has been identified, developers should change their definition of what makes a good site. Having a good site is more than being prominently featured on a major thoroughfare. To properly evaluate a site, it is necessary to consider mobility patterns, supportive growth trends and demographic and economic perceptions of the area. Some "good" locations turn out to be marginal when examined in the light of these additional criteria that help forecast future tenant support levels.

Mobility patterns are critical forecasters of area market support. It is not enough to have a good location relative to major arteries or shopping or schools; it is important to understand where potential tenants are likely to come from. People tend to move in a radial pattern outward from the central city area in a direct line, moving father out with each successive move. Identifying the characteristics of the nearby population most likely to move to an area will be a critical step toward success in any real estate development project, particularly in multifamily. A project can have a great location, but if it is priced so as to not be affordable to the people most likely to live there, then the project is doomed to fail.

These are some of the reasons why a 100-percent database is critical to identifying the state of the market. Tenants exist at all economic levels, but developers tend to overlook some levels in order to cater to others. Often, developers experience success in one or two markets with product at one price, and then try to make the same product work at the same price in every market--sometimes with disastrous consequences.

A portrait of a market produced by a 100-percent database is also helpful to identify trouble spots that could affect potential development. For example, if an area's mid-priced developments are having trouble maintaining occupancies, it could spell trouble later on for upscale developments that draw their tenants from such apartments. Furthermore, it could be an early warning sign of a declining pool of potential renters. A survey of selected

comparables will not identify such potential problems.

The multifamily industry is at an important crossroads. There is ample opportunity for multifamily development, even in so-called "bad" markets, if proper attention is paid to building product that meets the needs of a new generation of less numerous but more selective apartment renters. If those needs are ignored, and it remains business as usual, however, the multifamily industry will be putting its financial future at risk.

Kenneth F. Danter is president and founder of ] The Danter Company, a real estate research firm based in Columbis, Ohio. This article is adapted from topics discussed in his workshop, "Surviving the Nineties."
COPYRIGHT 1991 Mortgage Bankers Association of America
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1991 Gale, Cengage Learning. All rights reserved.

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Title Annotation:with the baby boom over, apartment lenders will have to relearn the laws of tenant supply and demand
Author:Danter, Kenneth F.
Publication:Mortgage Banking
Article Type:Cover Story
Date:Jul 1, 1991
Previous Article:A question of value.
Next Article:The ABCs of apartment lending.

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