Midwest Market Cooling but Stable

Midwest Market Cooling but Stable
Published: October 02, 2008

The heartland is posting fairly healthy reports this year for the multifamily sector. Many owners in Chicago and Kansas City have increased occupancy rates and posted rent increases over the course of the last 12 months. However, sales of apartment communities have been a different story in both locales due to credit issues and rising cap rates.

In 2008, a number of Chicagoland apartment owners have seen continued improvement, or at least stability, in occupancies and even rent increases over the course of the last year, but the shadow market is poised to strike. Sales transactions of apartment communities, on the other hand, have been a different story. The credit crunch has led to a downturn in the volume of multifamily property sales in the first half of 2008. On the transaction side of the table, the apartment market can be summarized in a word: slowing.

Operationally, apartment owners have benefited from fairly strong occupancy rates and even rent increases. According to a second-quarter apartment update, the overall vacancy rate hovered at 5.2 percent in the second quarter, and we saw rents increase by approximately 4.5 percent over the one-year period ending in June of 2008. This was up from 3.7 percent a year before, propelling the Chicago metro average rent to $1,067 from $1,020.

With slightly more than half of all metro apartment communities offering specials, concessions are on the rise. Downtown Chicago renters are being conditioned by apartment communities to one-month free rent on a one-year lease, due to influential competition from the condo rental market, whereas the suburban submarkets are stronger, but are still inclined to advertise two weeks' free rent.

However, some Chicago neighborhood vacancy rates have approached 10 percent, while at the same time, a number of suburban areas recorded low, single-digit vacancy rates. The higher downtown vacancy was due in large part to condominium developments in these areas. Nearly 10,000 condominium units are set to be delivered by the close of 2009. Chicago's downtown apartment owners will likely see the greatest impact as this once-shadow rental market is truly coming out of the darkness and becoming a greater force on the overall rental market. For example, the number of condominium units included in the rental pool increased by nearly 50 percent since last year.

In contrast, suburban apartment development is very anemic, with fewer than 1,200 units slated in the collar counties. This lack of new units has helped existing properties, especially when coupled with 10 years of conversions that have taken thousands of units out of the rental market.

Historically, Chicago has been a low-volume sales market, typically averaging 15-20 sales per year of 100+-unit apartment communities. This is a fairly small number given the size of the overall market, especially when you consider that some other areas of the country, such as Texas, might have been doing 90 deals a quarter. During the early- and mid-2000s, things began to change and we did see an increase in sales. In fact, last year, there were approximately 38 sales of 100+-unit communities and buildings. It was also a record-setting year in terms of dollar volume, with some very large deals trading hands. This number was bolstered somewhat by sales of a number of Inland properties, at one time the largest owner in the area. In sharp contrast, 2008 has seen eight to 10 sales through August, with more than half of those done in the first quarter. We also saw a number of larger properties come to market in the spring, only to either not sell or be pulled from the market. It seemed that there needed to be some time for everyone to digest all that was happening on the credit side of the equation as lenders also figured out their game plans, some of which is still going on today. As a market, Chicago has also been fortunate not to be experiencing the amount of foreclosure activity that other parts of the country are seeing now.

Significant sales to date this year have included Thornberry Woods in Naperville, The Park Evanston (which traded at over $300 per square foot), and Lakes at Fountain Square in Waukegan.

The Chicago multifamily market continues to be a very desirable place for investment across all property classes. It is really the only city in the Midwest that is still in favor by most institutional investors. The economy continues to be the driving force. While job growth remained somewhat subdued in the first half of the year, things are expected to pick up steadily in the later half of 2008 and early 2009. Company relocations, such as the new MillerCoors headquarters and Rush University's plans for a $1 billion medical center expansion, continue to bolster the area's ability to attract even more new companies and jobs. Coupling this with the prospect of getting the 2016 Olympics, we see the continued improvement of Chicago market fundamentals.

Kansas City Market

Like many other cities during this credit crunch, a cool wind is blowing across the metro Kansas City apartment market, chilling down the velocity of transactions and putting a damper on seller expectations for those still seeking the heyday pricing of the past two years.

Not only has the number of deals slowed, but the time to get an acceptable offer seems to have lengthened. The reasons are multiple: buyers' expectations have shifted from buying on pro forma to being focused on historical financials, with no berth given toward "potential" rent increases.

But while brokers are taking home less money than in prior years, owners are seeing rents up 4 percent for 2008, compared to 2.6 percent last year; citywide average occupancy is up to 92.8 percent versus 92.7 percent in 2006; and average rents are $26 per month higher than the prior year.

Metro-wide, there are more than 340 market-rate communities of over 60 units in size, with a total topping 70,700 units. The second-quarter market report published by Hendricks & Partners calculates the first-quarter city-wide vacancy rate at 6.7 percent, compared to 6.8 percent for the second quarter the year before. Perhaps more importantly, the average rent is $700 per month, up $25 a month for the same period last year, about a 3.7 percent increase. For 2008, rent increases are projected to reach an average of 4 percent citywide. Since occupancy and rents have climbed, concessions have ebbed. This picture of success is anticipated to remain because higher construction costs have limited new construction. Permits for only 427 new units were issued in the second quarter of 2008.

Owners/sellers of Kansas City apartments tend to want to ignore that interest rates have climbed well above 6.25 percent, pushing cap rates even higher. They tend to focus more on the hefty rent raises.

Owners are also benefiting from the historically low level of new apartment properties being developed. By Hendricks & Partners' most recent count, only about 500 new units will enter lease-up this year, with fewer than 200 slotted for completion next year. There is a small cloud in this sky—about 1,800 new units are slated for rent-up in 2010.

The conversion of rental units into for-sale housing and the construction of new condo units has come to a screeching halt.Lack of available mortgage dollars, concern for the potential for declining values and a general slowdown overall in the "for-sale" housing market have even resulted in a few "broken" condo deals to be offered as rentals, and at least one complex being offered to investors as a "rental until the market turns" investment.

The one remaining strong condo submarket is the Country Club Shopping District, where the famed J. C. Nichols built an open-air shopping mall in the 1920s; this remains the city's most desirable retail area. There, mid-rise and high-rise units still command relatively high prices, and remain in strong demand, due to the convenience offered by the 24-square-block shopping district and to the fact that barriers to entry practically guarantee long-term retention of values. Buyers from around the country, longing for the stability of the Kansas City market with our "no bust, no boom" history, have been flocking to the few deals reaching the market here.

The near future bodes well for the apartment market in Kansas City, where more than 14,000 jobs have been added in 2008, and another 26,000 are to be created in 2009. A significant part of the growth comes from Kansas City's position as a burgeoning distribution hub, led by the Burlington Northern Santa Fe Railway's new intermodal hub in Johnson County, Kan., the most affluent portion of the metro bi-state area. Similar facilities are being developed at the airport.

Ralph A. DePasquale is a senior investment advisor in Hendricks & Partners LLC's Chicago office, and Phillip Brimble is an associate partner in the firm's Kansas City, Mo. office.