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Mixed signals for apartment investment.

In today's real estate environment, property types once favored by investors may be losing out to apartments by default. Nationwide, glutted office markets continue to stymie rental growth; industrial properties trade at prices that do little more than exceed replacement cost; retail jitters dim the luster of shopping center; and hotels are an economic disaster. No property type is immune.

The problem is that the comparative attractiveness of apartment opportunities may blind investors to the contradictory signals in this property type's market profile.

Supply and demand

From an investment standpoint, apartment complexes enjoy better supply and demand fundamentals than any other property type. Demand for apartment units (as opposed to "multifamily units" - a team that embraces both for-rent and for-sale units) is estimated at 350,000 to 400,000 units annually. Since 1988 production has fallen short of this range. Figure 1 shows that in 1990, only 260,000 units were started - and only 216,000 of these were for rent. In 1989, the rental component of multifamily construction numbered 253,000 starts.

By comparison, annual apartment production during the 1983-to-1986 period substantially exceed demand, pushing up vacancy from 6.4 percent in 1981 to more than 11 percent in 1988. Since then, as Figure 2 indicates, the recovery has been slight. At the end of 1990, the vacancy rate for buildings with five or more units was 9.5 percent.
Multifamily Vacancy Trends, 1980-1990
 Vacancy Rate in
 Overall Rental Buildings with
Year Vacancy Rate 5 or More Units
1990 7.2% 9.5%
1989 7.4 10.4
1988 7.7 11.4
1987 7.7 11.2
1986 7.3 10.4
1985 6.5 8.8
1984 5.9 7.5
1983 5.7 7.1
1982 5.3 6.5
1981 5.0 6.4
1980 5.4 7.1

Overall rental vacancy (in rental units) has risen as well. After hovering between 5 and 6 percent during all but a few years between 1969 and 1984, it increased to more than 8 percent in the latter part of the 1980s and still exceeds 7 percent.

What do these statistics suggest? First, if lenders continue to exhibits restraint, the excess supply of apartment units could be absorbed during the 1990s. But production must stay below 300,000 units annually. A 9 to 10 percent vacancy rate indicates almost 2.5 million vacant units - an overhang that should give pause.

It is true that supply and demand vary significantly by region, and that vacancy rates are undoubtedly skewed by the numbers of physically or economically obsolete dwellings. Nonetheless, the national picture is not as bright as many investment sponsors would have prospective investors believe. In the early 1980s and for decades earlier, "good" apartment investments were thought to be those at a stabilized occupancy of 95 percent of above. With today's stock at 90 percent to 91 percent occupancy, few projects - either new or operating - pencil out as investment.

However, the economics are beginning to improve. As construction volumes drop, apartment rents in many markets are increasing at levels at least equal to inflation, and occupancies are rising.

Complex demographics

On the surface, the forces that drive apartment demand provide little support. One of the best demand predictors, the rate at which new households form, is down considerably from recent decades and should stay relatively low for some time. The U.S. averaged nearly 1.7 million new households per year in the 1970s and 1.4 million annually in the 1980s. During the 1990s, new household formation is expected to run at an annual rate of 900,000 to 1.1 million. Adult population growth, another important demand factor, also is declining.

Camouflaged by these slowing rates are trends in household characteristics that favor apartments. The fact that most new households comprise only one or two people is particularly relevant, because smaller households are frequently attracted to rental rather than ownership housing. This change in household size is one reason why the home-owning segment of total households shrank in the 1980s. The drop from early 66 percent in 1980 to under 64 percent (the lowest rate since 1968) in the late 1980s reflected a move of almost 9 million households to rental units.

Another offset to the decline in household formation is the sizable increase in immigration. This is a particular boon to apartment markets in coastal cities, despite the apparent gap between what many immigrants can afford to pay and the cost of the housing that is a available.

Conflicting investment considerations.

As noted, a nationwide apartment occupancy rate of 90 percent to 91 percent - implying the existence of nearly 2.5 million vacant rental units - is hardly a cause for enthusiasm among investors. For many, this concern is compounded by today's relatively low interest rates, which make it easier for more renters to afford home purchase.

On the other hand, the recession has caused many prospective homeowers to put off purchasing for a while. This hesitation is a factor behind the consistent demand for new rental units, which has stimulated an upturn in effective rents in a number of markets. (Notable exceptions are in the Southwest, where rents are below 1986 levels in some submarkets.)

However, most of the credit for attracting investors to apartment goes to the current pricing situation. In general capitalization rates around the country still range from 7.5 to 8.5 percent for the best apartment properties and from 8.5 to 9.0 percent for good ones. Recently, for the few complexes that have sold, deals have involved 35-to-50-basis-point increases from the capitalization rates of a year ago. In depressed markets, many existing complexes are being purchased at a discount to current replacement cost.

These depressed prices position investors to reap substantial benefits when rents recover. As new construction becomes economically feasible, better quality existing complexes should "ride the coattails" of new project to higher rents, and values should rise.

On the horizon

It is hard to envision what apartment investment will be like in three to five years, but some predictions for the next 12 to 18 months are possible: * Productions of new apartment units will stay below 300,000 annually. Of the 250,000 to 275,000 multifamily starts projected for 1991, 200,000 to 230,000 will be apartments. * The values of most apartment properties will stagnate. Thus, the current pattern of few transactions but low prices for those that are occurring should continue. It is distressed sellers that are driving this phenomenon, not a deterioration in investment fundamentals. Exceptions will be found in markets that experienced real estate depressions in the mind-1980s. * Quality apartment communities will continue to be popular with pension funds and their advisors, but the funds are having a hard time finding what they want. Most are searching for quality complexes in economically diverse metropolitan areas; they want going-in capitalization rates of 8.5 percent or above - with no leasing risk.

The current market for such properties seems to be holding in a cap-rate range of 8 to 8.5 percent. Unless price expectations among buyers and sellers are reconciled and capital markets loosen, a surge of transactions in the apartment market is unlikely. * If the recession subsides and interest rates stay relatively low, apartment complexes will suffer. Positive publicity about the economy could convert renters into new homeowners, especially in the markets where housing is comparatively affordable. * For the next 12 to 18 months, there will be more in-city apartment investment an infill developers. This trend will continue through the rest of the decade. * Markets in the Northeast will remain relatively stagnant, while California - now experiencing a decline in apartment economics - should stabilize and recover within a year or two. Investor attention over the next 12 to 18 months will focus on San Diego, Los Angeles, San Francisco, the Chicago collar countries, major cities in Ohio and Texas, and parts of Florida - provided there is an improvement in the flow of capital

Figure 3 highlights the danger of generalizing about real estate. Some metropolitan areas continue to have vibrant apartment markets. while others are lethargic.


* High unit turnover rates, the increase in real estate taxes imposed on apartment complexes, and the credit crunch will continue to be key investors concerns. Handicapped- accessibility legislation passed last year probably affected supply in 1989 and 1990. But now that HUD's guidelines are out, the new regulations do not seem quite so onerous.

The contradictions outline in this article may help apartment investors develop strategies that capitalize on positive trends and minimize costly mistakes. It is important to select markets carefully and be fully cognizant of the financial risks. If possible, buy at a discount-to-replacement cost and at capitalization rates that afford some near-term potential of obtaining positive leverage.

Finally, limit investments to fundamental sound real estate, and inspect every unit before deciding to proceed. Then apartment investment remains as viable strategy.
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Title Annotation:Asset Management
Author:Stern, Richard G.
Publication:Journal of Property Management
Date:Nov 1, 1991
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