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January 2014 Newsletter
January 2014 Number 4

Houston named 'America's next great global city'

by Olivia Pulsinelli, Houston Business Journal

 

In the latest grand accolade for the Petro Metro, Forbes predicts that within a decade Houston will be known as “America’s next great global city.”


Forbes made the prediction in its article “A Map of America’s Future: Where Growth Will Be Over the Next Decade,” part of its “Reinventing America” series.


The article breaks the country into seven major regions, including the Third Coast — of which Houston is named the capital.


“Once a sleepy, semitropical backwater, the Third Coast, which stretches along the Gulf of Mexico from south Texas to western Florida, has come out of the recession stronger than virtually any other region,” Forbes writes. “Since 2001, its job base has expanded 7 percent, and it is projected to grow another 18 percent in the coming decade.”


Forbes notes two of Houston’s major economic powerhouses — energy and trade — as two of the driving forces behind the area’s success.


In addition to Houston’s energy prominence, Forbes also notes the racially and ethnically diverse metro has the world’s largest medical center and recently surpassed New York City as the No. 1 exporter nationwide. The diversification of the region’s economy will continue to increase as the area’s wealth grows, according to Forbes.


Last year, Forbes named Houston the coolest city in which to live, and the Bayou City has racked up numerous superlatives since then.


Click here to read what Houston's business and city leaders think of the "next great global city" designation.


Olivia Pulsinelli is the web producer for the Houston Business Journal's award-winning website.


Magnetic Attraction:

Investors remain drawn to multifamily assets.

By Beth Mattson-Teig


Rising interest rates may prompt apartment buyers to modify expectations and strategies, but these factors haven’t diminished their desire for multifamily properties — at least not yet. The voracious demand that has fueled transaction activity and capitalization rate compression across the multifamily sector in recent years appears steadfast in many markets. “We are seeing sales volume that is equal to or slightly greater than the same time last year,” says John W. Stone, CCIM, principal, managing director of Multifamily Services/Foreign Investments at Colliers Arnold in Clearwater, Fla. “There is no shortage of bidders. There is no shortage of cash. There is no shortage of want.”

National apartment sales activity surged during the first half of the year with $49.4 billion in properties trading hands — a 55 percent increase compared to the same period a year ago, according to Real Capital Analytics. However, sales volume spiked during the first quarter due to a large Archstone portfolio sale. Extract that sale from the mix, and apartment sales rose a more modest 9 percent, according to RCA.

Multifamily has been commercial real estate’s strongest magnet, drawing a wide range of investors during the past several years. The sector was the first to recover from the recession and the combination of solid occupancies, strong rent growth, and available financing have attracted investors seeking properties that deliver steady cash flow. Yet industry experts are beginning to question whether that demand is sustainable in light of rising interest rates and lower expectations for rent growth. Some institutional buyers have already pulled back due to the cap rate compression that is occurring among core properties in top markets.

“I think 2014 will be a slower year because those higher interest rates are going to impose themselves on the deal structure sooner or later,” Stone says. “You can’t keep lowering your yield requirements and think somehow you are going to survive.”

Yet, for now, the demand to buy apartment properties remains robust. Competition for deals has some buyers willing to adjust return expectations and price higher capital costs into a purchase in order to close deals. “Nine out of 10 buyers who come to the Tampa Bay market looking to buy apartments go home without anything,” Stone says. So, buyers are willing to absorb higher capital costs in order to clinch acquisitions in a still competitive market, he adds.

Solid Fundamentals Spur Demand
Demand remains strong across the board from the relative safe haven of stabilized class A properties in major metros to value-add and opportunistic buys among class B and class C properties where investors see more upside to boost rents and realize higher yields. That continued appetite for apartments is not surprising to some industry veterans. “There is almost an instatiable drive for yield since alternative yields are so low, and the dynamics of the apartment market are still strong,” says George Tikijian III, CCIM, president of Tikijian Associates, a multihousing investment advisory firm in Indianapolis.

That demand is supported by very accessible financing and strong underlying fundamentals. “I think investors like the stability of multifamily in comparison to the other asset types,” agrees Thomas McConnell, CCIM, director of Marcus & Millichap’s National Multi Housing Group in Elmwood Park, N.J. National multifamily occupancy at midyear remained steady at 4.3 percent. The accelerated pace of rent growth that the industry has enjoyed in recent years has moderated, but not enough to scare off buyers. Asking rents rose to $1,110 per unit in second quarter — a 2.3 percent year-over-year gain, according to Reis.

While multifamily development is on the rise, it remains relatively controlled and focused mainly in areas where there is high demand and high growth. In addition, recovery in the single-family housing market is not expected to create a drag on performance in the apartment market going forward. Historically, when the single-family market has been healthy, the multifamily market has been healthy for the same reasons. Job growth generally sparks new household creation — for both home ownership and demand for rentals.

The apartment market in San Diego is “as good as it gets,” says Terry Moore, CCIM, director and principal at ACI Commercial in San Diego. San Diego’s stable rental market is attractive due to its diverse economy and barriers to entry for new development, including restrictive zoning and high fees. “Slow growth forces and NIMBY-ism have combined so that in 28 of the last 30 years our county has not built enough new apartments to satisfy demand,” Moore says. Apartment vacancies in San Diego are below 5 percent, which is standard for the area, and rental increases are higher than the inflation rate.

Despite those attractive qualities, San Diego is a tough market to enter for outside investors. Ninety percent of the apartment stock is valued less than $2 million with properties that typically range between 5 and 15 units, most of which are bought by local investors. “The bulk of the fortunes made in San Diego apartments are in renovating 1970s assets and raising rents more than 10 percent,” Moore says. That has been a common theme for a generation and is still prevalent in today’s market, he adds.

For example, Moore sold a nine-unit property last spring that had not been renovated in more than 20 years. The property received multiple offers and ended up selling above list price with a signed purchase agreement within two weeks. The new owners completed renovations and raised rents by more than 20 percent within six months. “It is still a seller’s market. There are still more than 20 buyers for every seller,” Moore says.

Price Correction Ahead?

Despite its continued performance, the apartment sector is not immune to the effects of rising interest rates and higher capital costs for buyers and owners. Since mid-May the 10-year Treasury rate has increased about 100 basis points from 1.9 percent to nearly 3 percent as of mid-September. Higher interest rates naturally raise questions about the subsequent impact on operating income and cap rates. Interest rates going up normally means that cap rates are going up. “We know that’s coming. It just hasn’t happened yet,” Stone says.


Despite its continued performance, the apartment sector is not immune to the effects of rising interest rates and higher capital costs for buyers and owners. Since mid-May the 10-year Treasury rate has increased about 100 basis points from 1.9 percent to nearly 3 percent as of mid-September. Higher interest rates naturally raise questions about the subsequent impact on operating income and cap rates. Interest rates going up normally means that cap rates are going up. “We know that’s coming. It just hasn’t happened yet,” Stone says.

During second quarter, garden apartment properties sold for an average price per unit of $85,046 and an average cap rate of 6.5 percent, while mid- and high-rise apartments sold for an average price per unit of $201,515 and an average cap rate of 5.2 percent, according to RCA.

One theory is that a rising interest rate environment means that the economy is improving, which will allow buyers to justify paying premium prices. Buyers could argue that they will now be able to underwrite more aggressively with expectations that they will be able to push rents higher more quickly. The problem is that apartments are already coming off a streak of rent increases, and most industry experts are projecting fewer rent increases in 2014. Rents in class A properties in particular have increased considerably during the past few years and are now bumping up against the ceiling in many markets.


One theory is that a rising interest rate environment means that the economy is improving, which will allow buyers to justify paying premium prices. Buyers could argue that they will now be able to underwrite more aggressively with expectations that they will be able to push rents higher more quickly. The problem is that apartments are already coming off a streak of rent increases, and most industry experts are projecting fewer rent increases in 2014. Rents in class A properties in particular have increased considerably during the past few years and are now bumping up against the ceiling in many markets.

“While we still expect some rental rate increases, they are not going to be the 5, 6, and 7 percent increases that we saw two years ago,” Stone says. Now owners are just hoping to get annual increases of 2 to 3 percent, he adds.

Although competition will keep pressure on pricing, a shift is inevitable, especially if rates continue to rise. The rising interest rates have yet to impact cap rates in markets such as northern New Jersey. Thus far, cap rates remain near historical lows in every county, generally averaging in the mid-6 percent range and dipping below 5 percent for top properties in the best locations, McConnell notes. However, that shift will eventually occur as both sellers and buyers adapt to the higher rates and adjust expectations. “Some of the properties I sold in the low interest rate environment in first quarter wouldn’t sell at the same price today,” he adds.

Quest for Yield Continues
The competition for properties coupled with higher interest rates is prompting buyers to adjust both return expectations and investment strategies. Buyers are continuing to venture into secondary markets in hopes of finding more favorable pricing. Although major markets such as Los Angeles, Washington, D.C., and New York City are still posting the highest sales volumes, there is a notable increase in sales in secondary markets such as Charlotte, N.C., Jacksonville, Fla., and Raleigh/Durham, N.C.

If buyers can’t find what they want at a price they are willing to pay in Tampa or Orlando, Fla., they are going to Jacksonville, which historically has been overlooked by investors, according to Stone. As a result, Jacksonville has claimed some of the highest per unit sale prices in the state during the past 18 months, with 26 properties sold during the first half of the year for a total price of $446.7 million, according to RCA.

Buyers are also shopping for properties that offer more opportunities to boost net operating income. “Right now, class A assets are pretty stable, but they don’t have a whole lot of upside left,” Stone says. Class B properties have more potential to improve occupancies and raise rates. In addition, class B and class C properties are likely to gain favor among investors because there is more opportunity for rent growth. “There are value enhancements that you can make to improve your rental structure and stabilize your occupancy,” Stone says.

Investment sales among class C properties are heating up in markets such as Phoenix. In 2012, Phoenix-based Gerchick Real Estate closed $45 million in multifamily sales and the firm expects to double that this year. “This market is incredibly active,” says Linda Gerchick, CCIM, designated broker and team leader at Gerchick Real Estate in Phoenix. Some investors have been tired of waiting on the sidelines and are ready to make a move, which is driving demand. The desire to buy investment property with good cash flow is another attractive incentive, she adds.

Phoenix is experiencing a flurry of rehab and retrofitting activity among older properties. The improvements make the rents “go over the roof” and properties have been selling “like crazy,” Gerchick says. That demand is driving prices higher. In the past year, prices for class C properties have doubled from $17,000 per door to $36,000 to $38,000 per door. Gerchick is currently negotiating with a California buyer who is interested in purchasing a 72-unit property in Phoenix that has been rehabbed and will likely sell between $38,000 and $40,000 per unit, she says.

Clearly, investors still have abundant capital to place and apartments remain an attractive choice. “Activity has not trailed off. There is still a great deal of demand from buyers, really across all segments,” says Tikijian. Tikijian sold 14 apartment properties in 2012 and expects to close on a comparable volume in 2013. “I see nothing on the horizon that will reduce the demand to invest in apartments,” he says. “If interest rates continue to increase, it could have a negative impact on pricing, but it won’t necessarily curb investment sales.”

Demand Drives Development
The economy’s continued recovery has launched a new wave of development in the multifamily market.

Construction activity is ramping up across the country in markets ranging from New York to Oregon. More than 100,000 new units are expected to be completed this year, and that resurgence is just the start of a new era of building over the next few years, according to Reis.

The development drought appears to be over in markets such as Las Vegas where the future is looking brighter for both apartment owners and developers. “Developers are bullish for the next several years with some 10,000 units either planned or in the pipeline,” says Garry Cuff, CCIM, vice president at Colliers International in Las Vegas. The improving economy, including the addition of approximately 20,000 new jobs over the past year, has helped to fill existing apartments in the Las Vegas metro area, which spans a total inventory of about 160,000 units. Occupancies for class A properties currently stand at 94 percent, while class B and class C properties are only slightly lower at 93 percent.

“Barring some unforeseen downturn in the national economy or negative geopolitical event in the world, multifamily properties should perform very well compared to the past several years and I see Las Vegas climbing out of the basement compared with other parts of the country,” Cuff adds.

Although there are some concerns that the added inventory may have a negative impact on occupancies, most metros are likely to see those new units absorbed relatively quickly. Many of the properties are coming online at occupancies of 85 percent or more, indicating that demand for apartments remains strong, according to Reis.

For some investors, urban redevelopment projects are presenting an opportunity to tap into growing demand from renters to move into revitalized downtown neighborhoods. In Indianapolis, for example, recent redevelopments include transforming historic Bush Stadium into the new Stadium Lofts. The first 138-unit building opened earlier this summer. Such conversions are ideally suited to the growing demand for urban living. “Our downtown market has been the strongest market by far for years,” says George Tikijian III, CCIM, president of Tikijian Associates, a multihousing investment advisory firm based in Indianapolis.

Currently, there are about 5,000 apartment units located in downtown Indianapolis with an estimated 2,000 new units that will be added over the next 12 months. Although that activity will likely create some oversupply in the short-term, Tikijian expects renters to absorb those units by 2015. “All of the factors that have caused high demand for apartments over the last few years are still in place,” he adds.

About the Author
Beth Mattson-Teig is a freelance writer based in Minneapolis.

A Stronger Asset

New sources of capital and increased demand have strengthened the commercial real estate market

By William Hughes


The current economic landscape has assembled an array of factors to structurally change real estate investment standards. The intertwining of the U.S. and global economies, deeper integration of liability and equity markets, and the accelerated adoption of real estate investment trusts and commercial mortgage-backed securities as major components of the sector have all contributed to this evolution. Furthermore, increased access to a variety of capital sources, combined with a multitude of real estate investment vehicles, has resulted in real estate investment earning its place as a mainstream asset class.


For today’s real estate investor, advanced facts and figures, deeper liquidity, and a range of broad investment opportunities that reach beyond merely primary metros have all allowed the further mitigation of risk. As supply cycles continue their two-decade trend of stabilization, the sector remains less volatile as a whole. Convergence of these influences has refined the foundation for attractive real estate cost positioning, resulting generally in falling capitalization rates over the last 20 years.

Cap Rate Movement
Typically, cap rates are inclined to stay range-bound during economic inflection points, with a usual variance of between 100 and 130 basis points. Whereas the length and severity of the the 2009 Great Recession and the 2001 Recession were markedly different, the recovery trends of cap rate performance proved surprisingly similar.

During the peak of the financial crisis, cap rates expanded from 6.9 percent to 8.1 percent between 2007 and 2009 before making a remarkably accelerated recovery, especially given the depth of the recession, according to figures from Real Capital Analytics, CoStar, and Marcus & Millichap Research Services. While the annualized yield on the 10-year Treasury declined 280 basis points to 1.8 percent between 2002 and 2012, the mean annualized cap rate for all property types dropped 150 basis points. Since the end of 2012, the 10-year yield has abruptly expanded 100 basis points to 2.9 percent as of September 2013. In evaluation, the mean cap rate proved more steady, edging down only about 10 basis points to 7.2 percent. While a delayed effect is still a possibility, forecasting the potential magnitude requires deeper analysis.

Throughout the Great Recession, the Federal Reserve has held the federal funds rate to nearly zero while infusing huge volumes of capital into the financial markets. The expanded period of monetary easing and the absence of government-supported distress sales have boosted the national mortgage market. This paved the way for cap rates and real estate values to bounce back far more quickly than in previous recessions and well ahead of an actual operating recovery. The exception to this trend occurred in multifamily properties, which recovered even faster than the other sectors.

Whereas tough credit underwriting continues to be an obstacle for potential borrowers, the Federal Reserve’s accommodative policies aimed at reducing near-term interest rate risk have aided in the refinancing and restructuring of maturing and difficult loans. This has resulted in more capital entering real estate as a comparatively sound alternative to reduced yield bonds and volatile equity markets.

A Hybrid Investment
Since the market bottomed in 2009-10, commercial real estate investors have favored the greater certainty of top-tier markets and properties with proven cash flows, despite their generally lower yields; this focus on prime markets limited meaningful price recovery to coastal and urban core markets, until investor interest began to spread a year-and-a-half ago. With most gateway primary markets having substantially recovered, occupancy and rent growth momentum has expanded to late-recovery secondary and tertiary metros. These areas may garner higher yields and offer room for net operating income gains, but they also carry higher risk. Many of these areas face relatively higher overdevelopment threats, less consistent demand, and more shallow liquidity, all of which could affect investor exit strategies. Reflecting these trends, the maturing primary markets have faced slowing cap rate compression and even rate upticks. Conversely, cap rates in secondary markets have tightened, supported by stronger operational momentum and sales volume. Naturally, investor risk will depend in part upon a market’s position along the arc of the real estate cycle and the investment time horizon.

The hybrid nature of commercial real estate makes it a compelling investment option, with a bond-like cash flow component even during economic downturns, as well as an appreciation component that often acts as a hedge against inflation, considering that property owners benefit from increasing rents and property values when inflation rises. In addition, many long-term leases contain consumer price index rent increases, while shorter-term leases allow investors to quickly adjust to market rates.

Rising Interest Rates
A period of falling cap rates helps elevate returns via appreciation. Rising interest rates — reflecting stronger economic activity — generally exert upward pressure on cap rates, requiring an increased emphasis on income growth to offset slower appreciation and higher financing cost. However, healed and expanding credit markets, strong global investor demand for U.S. real estate, and continued recovery in property fundamentals will help counterbalance the magnitude of rising rates, and lend support to property values. Having already absorbed a significant increase in interest rates, further cap rate changes should tie less to speculation regarding Fed policy and correlate more with measurable economic performance.


Debt and equity markets should remain stable for the foreseeable future. However, the environment is not without risk, and near-term volatility should be expected. The pending appointment of a new Federal Reserve chief, looming debt ceiling discussions, geopolitical tensions in the Middle East, and the effects of sequestration and declines in federal spending will hamper economic growth.

In addition, changes in monetary policy always present a risk to the economy. In this light, the Fed has demonstrated considerable dexterity, and should gradually exit qualitative easing in an orderly manner by slowly decreasing bond purchases and letting some securities mature. The Federal Open Market Committee has issued interest rate guidance, stating that the federal funds will remain range-bound between 0 to .25 percent at least until mid-2015, underscoring that monetary tightening would begin only after an economic and employment recovery has been well established. The Fed also noted that the tightening process would occur at a more gradual pace than historical precedent.


Surely, higher interest rates will impact investors across the board. As financing costs rise, so will investors’ required returns. At a minimum, increased financing costs will decay some of the cap rate arbitrage of buying into secondary and tertiary markets, or value-add and opportunistic assets. However, the stride of occupancy and lease growth is likely to exceed that of primary markets and core assets for the midterm outlook. Demand for all commercial real estate, sustained by the reinforcing economy, remains solid, and supply risks are negligible for most property types. As a result, performance profits and other components will considerably counteract the effect of rising interesting rates, at least for the near term.

William Hughes is the senior vice president and managing director of Marcus & Millichap Capital Corp., based in Irvine, Calif. Contact him at william.hughes@marcusmillichap.com

 
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