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Understanding multifamily markets.

Many factors led apartment developers and lenders to overbuild in the 1980s.

Poor market data, understated vacancies and unrealistic rent projections left lenders with a legacy of high vacancies and depressed rents. But better research of apartment markets should prevent history from repeating itself.

DESPITE THE CONTINUING DROP IN APARTMENT construction, multifamily rents in many markets are still not picking up, and vacancy rates are not falling.

There are some key demographic and economic factors fueling these rent and vacancy trends, and this article explores the primary factors shaping current conditions in the market.

The four main areas covered are the changing nature of vacancies, insights into how to read a vacancy report, the continuing vulnerability of large apartment projects and the use of "trended" versus "untrended" rents in pro formas (the statements of expected revenues and operating expenses used in project underwriting).

Vacancies: more than unoccupied units

One of the major problems encountered by the multifamily industry over the years has been the inability to get good data and standardized terms for evaluating the strength and feasibility of projects. As a result, multifamily decisions often are based on faulty assumptions. Not only are financing decisions affected, but also operational decisions, because effective pricing and marketing strategies must also be based on solid market data.

A prime example of this lack of good communication of information in the industry is the common usage of the term "vacancy." When examining vacancies, it is critical to understand what "vacancy" means in the context in which it is used. There are two basic types of vacancies, yet people in the industry rarely identify which type they are referring to.

The market vacancy rate is the number of unoccupied units available for rent divided by the number of rentable units. The market vacancy rate is primarily an indication of rental performance and market response to a project. This rate is generally the yardstick by which apartment project managers want to be measured.

The economic vacancy rate, however, is the vacancy rate that should be of most concern to owners and lenders. An economic vacancy is any unit not collecting rent or generating book revenue. An economic vacancy rate would incorporate the following in its measure of vacancies: managers' and model units; damaged units requiring an extraordinary amount of repair; and the time necessary for a unit to turnover to a new tenant. Also included in a measure of economic vacancies are discounts (such as for early payment or for senior citizens) and specials off of book rent (discounts offered for a short time as an incentive to renters).

As a result, an apartment project's economic vacancy rate is higher than its market vacancy rate. Many times, the difference between market vacancy and economic vacancy is the true measure of management's skills.

Economic vacancies

Turnover time is a key example of how the economic vacancy rate works. A project that turns around a unit in one week experiences an economic vacancy of 1.9 percent (one week divided by 52 weeks) for that unit for the year. Assuming an apartment project has an annual 50 percent turnover rate in renters implies that the project will experience a 0.9 percent annual economic vacancy rate just from turnover--even at 100 percent market occupancy, with a waiting list.

Another critical example of economic vacancy is rent give-aways. Giving away a month's rent free is the same as having that apartment vacant for the month, creating an 8.3 percent economic vacancy rate for that unit for the year. A 50 percent turnover rate creates a 4.2 percent economic vacancy rate, assuming all new tenants are offered the free month.

A third critical example of economic vacancy is the relationship of book rent to charged rent. If book rent, according to a pro forma, is $500 and a project is only able to achieve $475, then the project has an economic vacancy rate of 5 percent off the top--at 100 percent market occupancy.

Why is economic vacancy so critical for owners and lenders?

Vacancies are calculated into pro formas as economic vacancies--a straight percentage deducted from expected revenues to be generated by the project. Managers want to be measured on whether they are filling the units, and the only technique that many managers use during tough times is offering rent specials or discounts. This may enable them to report a low market vacancy rate to the owner or lender and, accordingly, make them feel they are doing a good job.

It is critical for owners and lenders to make apartment managers aware of the need to hold down economic vacancies by achieving rent increases as the market allows, cutting down on new tenant turnaround time and finding creative ways of filling units that do not involve rent specials or giveaways.

It is becoming increasingly critical for lenders to understand the factors that contribute to economic vacancies so they can bring that understanding to the table when it's time to evaluate pro formas in the financing process. During the easy-money, boom times of the 1980s, many projects, now in trouble, were financed without sufficiently critical examination of the assumptions followed in the pro formas. As a result, many of these projects now must meet unrealistic vacancy and rent projections in bad markets.

Beyond the aggregate vacancy rate

One of the tendencies in the multifamily industry is to determine the relative health of an apartment market by its aggregate market vacancy rate and median rents. Unfortunately, aggregates and medians can be deceiving--hiding both market weaknesses and strengths. A distribution of market vacancies by rent range will more accurately pinpoint trouble spots or opportunities in a market. This is the primary reason a 100 percent data base is critical.

While laborious, this methodology depends on surveying all modern units in a market area. Using this methodology instead of selected comparables, or samples, allows for a full assessment of the condition of that market at all levels. It also allows for comparisons between markets, as the surveys use the same methodology.

Based on our 100 percent data base surveys over the last few years in markets across the country, we have noticed many local market vacancy patterns that are vastly different, while overall trends remain similar. For example, two markets may be registering a 7 percent overall vacancy rate, while experiencing different underlying market characteristics. One market may be experiencing a 10 percent vacancy rate in entry-level units and a 4 percent vacancy rate in upscale units, while the second market may be experiencing the reverse, due to an overbuilt upscale market. If you are evaluating a market for development of a specific multifamily product, this difference is critical, and it cannot be determined from an overall vacancy rate.

Our surveys also are indicating similar vacancy patterns in most markets. Each market experiences these trends in its own way, based on the existing base of housing and demand for units, but some common vacancy trends are apparent in most markets.

The housing continuum

Before discussing market vacancy trends, it is important to understand the housing continuum. Typically, new households start their occupancy pattern in entry-level multifamily housing. As their income or space needs grow, households typically opt for move-up (midlevel) multifamily housing. From there, households typically move into starter single-family homes or upscale multifamily units.

Our research has indicated that mid-level multifamily renters are much more likely to buy a home than upscale renters. Upscale renters are often "renters by choice" because they like the amenities and services that come with renting. In addition, the increase in monthly payment that would accompany buying a single-family home of comparable quality to the apartment they currently occupy is often prohibitive for upscale renters. And many do not want to make a step down in perceived quality.

Market vacancy shifts

Three or four years ago, as the construction boom of the eighties was petering out, we found that market vacancies were typically clustered at the high end among newer apartments. Most of the new multifamily projects of the mid-to-late eighties consisted of three-story walkups designed to be either move-up or luxury housing. In many metro areas, these same-style units were not only built in the same price range, but also in the same neighborhoods. Because there was little variety in the style, location and price range of units available, these new projects often experienced extended absorption time.

Once multifamily financing tightened and the number of starts nose-dived, this upper-end product began to be absorbed as tenants stepped their way through the housing continuum into upscale units. However, new problems arose at the bottom end of the market.

Entry-level problems

During 1990, market vacancies began to increase substantially in the bottom-end of the market for several reasons. One crucial reason was the entry-level market started running out of baby boomers. In 1989, the tail end of the baby boom generation (those born in 1964) turned 25. This sent the total number of households with householders between age 15 and 24 down by 24.3 percent in the period from 1980 to 1990, as the end of the baby boom left this age bracket. This age group is estimated to have decreased an additional 0.8 percent between 1990 and 1992.

More importantly, the baby boomers are beginning to age out of the 25-to-34 age bracket. This age group is estimated to have decreased 1.9 percent between 1990 and 1992 and will decrease by another 6.6 percent between 1992 and 1997. The result: fewer new households starting at the bottom of the housing continuum in entry-level apartments.

Another factor affecting housing at the lower end of the market is the prevailing weakness in the domestic economy. During recessions the tendency is for household formation to decline. People who in good times would normally live on their own, instead double up to save money. Young college graduates postpone moving out and continue living with their parents after graduation. The result: fewer new households entering entry-level apartments.

A third factor affecting the increased market vacancy problems in entry-level units is the boom in construction financed with Low Income Housing Tax Credits (LIHTC). This program provides tax credits for investors who build apartment units for low-to-moderate-income households (making 60 percent or less than the area median household income as defined by HUD).

In many markets, due to the credit crunch from traditional financing sources, the LIHTC program was the only reliable source of financing for new apartment development. Income and rent restrictions place rents at most of these brand-new projects in direct competition with existing entry-level units, most of which were built in the 1970s. The result: more units chasing fewer entry-level households and increased market vacancies for those functionally obsolete projects that do not compete well.

A fourth factor is simply the age of most entry-level apartments. Many entry-level units are simply functionally obsolescent. They have very small bedrooms, little closet space, small living areas, and they often lack the appliances that younger new households want. In addition, today's renters don't want lower-level units in two-and-a-half-story buildings. The result: many entry-level units that cannot compete in today's markets, no matter how many rent specials are offered. Renters generally choose these units based on price alone and move out when they can afford something better.

These four factors have combined to create increased vacancies in entry-level product over the last two or three years, and there is no indication that this market segment will improve over the next year or so.

Move-up problems

Over the last 12 months or so, these changes in the entry-level market have begun to filter into the move-up market. The move-up market is dependent on the entry-level market for most of its tenants. So the decline in the number of entry-level tenants is beginning to affect the move-up market, which is now experiencing a tougher time attracting tenants.

The problems in the entry-level market also affect rents in the move-up market. Our studies indicate that in most markets $60 to $75 more per month is the upper limit for "step-up support," or what entry-level tenants will pay to step up into a better apartment if they consider it a value. Many entry-level apartments are holding their rents down to keep tenants.

However, rent increases may have occurred for apartments at the top end of the market because of lower vacancies. Unfortunately, many have priced themselves out of their step-up support base and, as a result, are now having vacancy problems, both market and economic.

Homebuying hurting

The most important development affecting the move-up market is that continued low mortgage rates make single-family housing more affordable. As mentioned earlier, move-up renters are the most likely group to leave the rental housing market to buy a single-family home. This exodus has also affected the move-up rental market.

Total single-family home sales (new and existing) have increased 10.3 percent between 1990 and 1992, from 3.75 million to 4.13 million, according to the National Association of Realtors (NAR). During that time, the effective interest rate for first-time home buyers decreased from 10.4 percent to 8.1 percent. The median-priced home for the first-time homebuyer increased from $81,200 in 1990 to $88,100 in 1992, yet the monthly payment for that median home decreased from $657 to $602, according to the NAR.

By definition, half of first-time homebuyers bought homes priced below the median. The qualifying income for the median-priced home for a first-time homebuyer, assuming a 10 percent down payment, decreased from $31,538 in 1990 to $28,887 in 1992. Yet the actual median family income for first-time homebuyers is well below these figures, increasing from $22,842 in 1990 to $23,625 in 1992, NAR data shows. These actual median incomes for first-time buyers clearly fall within the range of tenants in move-up multifamily housing.

Adding to the momentum for move-up tenants to buy single-family housing is the variety of incentive programs offered by various governmental agencies to first-time homebuyers. By definition, a first-time homebuyer is either currently a renter or a new household formation. Either way, the rental housing market loses a tenant.

Upscale problems

Until 1992, it looked as if the upscale market had stabilized. The overbuilding in this area had been absorbed by tenants moving up through the housing continuum. In the last year, however, we have begun to see an exodus from upscale apartments into single-family homes. More than 150 owners and managers of upscale apartment developments across the country that we have talked to reported that upscale tenants are leaving the apartment market and buying move-up homes.

The decline in interest rates has made move-up homes more affordable for up-scale tenants, and while these renters generally do not leave the apartment market for entry-level homes, they will leave for nicer homes that maintain the same air of quality as upscale apartments. In addition, many upscale tenants are afraid that interest rates will not remain low, and they want to get into single-family housing before the "interest window" closes.

As a result, the upscale apartment market is beginning to experience increasing vacancies. Given this upscale exodus, combined with the loss of tenants in midlevel housing, we expect vacancies in upscale units to continue to increase over the next 12 to 15 months.

Bigger is not necessarily better

Another trend visible in the multifamily sector is that larger projects are experiencing problems filling units and increasing rents. Building on a larger scale was more economical during the boom years, when baby boomers were filling every unit as it was built. With decreased demand, however, these older, larger projects are vulnerable, and the industry must rethink attitudes toward large projects.

One key trend that has emerged over the last 20 years is that large projects once built as upscale apartments have shifted down the housing continuum to serve move-up or even entry-level renters, as apartment design has changed and bigger, better units have been built. As a result, these older projects are being hurt by the decline in demand.

This decline is particularly critical for large projects simply because they have more units to fill. A 150-unit project experiencing a 50 percent turnover rate must lease 6 units per month to maintain a 95 percent market occupancy rate. A 400-unit project experiencing the same turnover rate will have to lease 16 units per month to maintain the same occupancy.

Because large projects must attract more tenants, they must be priced low enough for potential tenants to consider them a greater value. As a result, large projects almost always have rents below those that can be achieved with similar units in a smaller project.

In addition, rent increases are limited by the same need to attract and retain as many tenants as possible. Rent increases, which make the project less of a value to renters, not only slow ongoing replacement, but also increase turnover, as existing tenants leave for projects perceived as better values.

When the need to attract and retain tenants is combined with the fact that many of these larger communities have units that are functionally obsolete, it is easy to see why older, bigger projects are often struggling in this period of decreased apartment demand.

The current struggles of larger apartment projects should provide food for thought for the industry as new projects are designed for the 1990s. Larger projects simply will not be able to achieve the same kinds of rents as smaller projects and are much more vulnerable to functional obsolescence. Smaller multifamily projects that target niche markets will maximize rents (often bringing premiums), minimize vacancies and turnover and keep tenants in the rental pool longer because the units meet renters' specific needs.

Rent problems

Just as miscommunication exists over the term "vacancy," it's also fairly common when it comes to the term "rent." A variety of types of rent exist, including "gross rent," "street rent," "contract rent" and "net rent." Definitions of these various kinds of rent are as follows:

Gross rent--the total cost for a unit, including utilities.

Street rent--the total rent for a unit as quoted by a leasing agent, regardless of the utilities involved.

Contract rent--the term used by the U.S. Bureau of the Census to designate street rent.

Net rent--the rent for a unit adjusted according to typical utility payment patterns. Net rents are adjusted as if the landlord pays water, sewer and trash service, and the tenant pays other utilities, including heat, electricity, gas and telephone. (The Danter Company uses net rent in all its field surveys in order to judge all rents on the same standard.)

A major problem in the multifamily industry is the general lack of reliable data upon which to base informed decisions. Rent and vacancy surveys are available, but they all gather and process the information differently.

For example, most rent and vacancy surveys, including those conducted by the U.S. Bureau of the Census, are based on sampling. However, such sampling is subject to sampling error and may not actually be gathering the information that multifamily professionals really need.

For example, Census Bureau reports generally define multifamily developments as units in structures of five units or more, regardless of the number of units in the development. A large complex of fourplexes would not be considered in many Census Bureau reports.

In addition, many reports use street rent, and thus the rents from one project may not actually be comparable to the rents from another project within the report because of the value of included or excluded utilities.

A third problem is that reliable information is not generally available across markets. Each market usually has a local firm, agency or association that gathers local data, and each of these uses different standards, with the result that different geographic markets cannot be compared.

A fourth problem impairing the market's ability to get good multifamily data is the prevalence of lying: in order to look better, or to discourage potential competition, many, if not most, apartment managers will fudge figures.

Another factor contributing to this problem is that most reports do not list the assumptions behind rent and vacancy reports; thus, industry professionals end up misreading them. Because they misinterpret the data they receive, many end up making poor decisions.

One such misinterpretation arises around the concept of increases in median rents. In many markets during the 1980s, lenders and developers assumed that continual increases in median rents were the result of existing projects achieving substantial rent increases. The real cause of these median rent increases was the addition of a substantial amount of new product at the upper end of the market. This new product caused the median (which is, after all, only a midpoint) to increase.

As a result, many projects built during the 1980s experienced problems because their pro formas were based on unrealistic assumptions. A typical pattern of financing in the late 1980s was to assume a loss at opening, after which the apartment property would become profitable through rent increases after the project became established. Unfortunately, these rent increases were based on the increase in the area's median rents, which were not really indicative of rent increases achieved by existing projects in the market.

Compounding these problems was the size of many of the projects being built. Because their financing (and the resulting mortgage payments) was based on continually increasing rents, many large projects increased their rents to meet their mortgage obligations. Unfortunately, they found they had priced themselves out of the market, and they either had to scale back rents and fall behind on their mortgage payments or had to operate with the higher rents and thus maintain high market and economic vacancies and still not meet their obligations.

Because of the failure of such projects in the 1980s and an inability to find reliable data, many lenders now use "untrended" rents, or projected rents that do not allow for market-driven rent increases. If a project is not economically viable at today's rents, then it will not receive financing. This use of untrended rents has forced developers to be more careful and develop product that responds to the needs of the market. However, the use of untrended rents also has caused many worthy projects not to receive financing, as lenders turn down good projects because they are afraid of getting burned. Developers and lenders should be allowed to expect reasonable rent increases based on actual rent increases being achieved in the market by existing product that is similarly targeted or similar in quality or size of project.

The only way to avoid repeating many of these mistakes is to make accurate market data more widely available and educate multifamily professionals as to how to use it. As long as tenant demand for apartments remains low, it becomes even more crucial to the success of multifamily projects for all new development to be based on sound market analysis and pro forma expectations.

Kenneth F. Danter is founder and president of The Danter Company, a national real estate research company based in Columbus, Ohio. The Danter Company has been researching multifamily markets since 1970 and has pioneered several research methodologies, including the 100 percent data base principle, which it currently uses in its multifamily rent and vacancy report.
COPYRIGHT 1993 Mortgage Bankers Association of America
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1993 Gale, Cengage Learning. All rights reserved.

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Title Annotation:multifamily housing
Author:Danter, Kenneth F.
Publication:Mortgage Banking
Article Type:Cover Story
Date:Jul 1, 1993
Words:3889
Previous Article:Multifamily money.
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