A Rising Star

Considering its diverse economy and comparatively low unemployment rate, The Lone Star State has had the reputation of being a stronger performer than the national economy as a whole.

“Texas was the last end of the recession, and many people think it [will be] the first out,” reports Ed Cummins III, senior vice president, Transwestern’s Multifamily Investment Services Group, Houston.

While employment has certainly had a tremendous impact on the big-picture economy (the state’s unemployment rate was 8.2 percent as of March 2010, compared to the national average of 9.7 percent, according to the Bureau of Labor Statistics), the state also didn’t have the run-ups in home prices or amount of speculative construction in the for-sale arena that many other markets experienced, which, in turn, has had a lesser impact on vacancies and rents in the multifamily market, reports Ron Witten, president of Dallas-based Witten Advisors LLC.

And the lack of a residential building boom in Texas, which Chris Stutzman, managing director of Transwestern’s Central Texas Multifamily Group, Austin, attributes to the tech wreck in the beginning of 2001, has led to an easier recovery. “It was a pretty rough period, so we never saw residential building take off,” a fact that now has left many in Texas sighing with relief.

While the state’s apartment markets are performing considerably better than those in other major metros, they do face some challenges, however, particularly as it relates to new supply. But new starts have essentially come to an end, Witten reports—a positive indicator for the future of the apartment market throughout the state’s most highly populated MSAs.

And though rent growth has not yet restarted, stronger occupancies have led many, including Gus Remppies, president and chief investment officer of Grubb & Ellis Apartment REIT Inc. and executive vice president of Grubb & Ellis Residential Management, to believe that it is only a matter of time before rents will push up.

Rents appear to have hit bottom throughout Texas in the fourth quarter of 2009, according to Remppies, who believes this is a sign that rent growth will be soon to follow. Coming into the primary leasing season, he believes, “carrying strong occupancies, our rents will go up slightly this year and we’ll have stronger pricing power” overall.

He adds that the prime indicator that the market is on its way to a recovery is flat effective rents. “We feel encouraged,” he notes. “As we see [fewer] jobs shed, there’s more confidence; more people [will] return to rentals. Rents are lower, but occupancies are higher, and we feel we have pricing power.”

Supply’s effect on fundamentals

In Houston, rents are down 2.2 percent from a year ago, and occupancy is currently sitting at about 84.7 percent, according to Apartment Data Services Inc.’s April 2010 Market Line report. Occupancy-wise, Class A assets are performing better than lower-tier properties, but this is mainly due to the fact that rents have also been cut the most at these higher-end properties.

But, “the good news is that although we have close to 50 properties and 13,000 units in lease-up, there are only 2,300 units still under construction,” Cummins points out. This is compared to a more typical delivery of 10,000 to 15,000 units each year.

Dallas, meanwhile, is experiencing occupancy in the 87 percent range, with Class A properties performing significantly worse than expectations. “There was a lot of property built with the expectations of getting rents in the $1.40 [per sq. ft.] range, and now effective rent is $1.05-$1.10” per sq. ft., reports Armand Charboeau, senior president, Investment Services Group-Multifamily, Transwestern, Dallas. “Even if they can afford better housing, in this recession, people are more conservative and more apt to go someplace that’s not as lavish. The chi-chi went out of style in this recession.”

Consequently, though Class B properties are softer than they were prior to the recession, they have not had as great a decline in rents as Class A properties. At the same time, C assets “have held steady,” observes Charboeau, though he admits, “that’s off a level that was pretty low to begin with.”

There is still a fairly large development pipeline, however, with about 5,500 (out of a total 8,000 to 9,000 units) additional units slated for delivery by the end of this year. The good news, reports Charboeau, though, is that there isn’t anything expected to come online between 2011 and 2013—“that lull in new supply will continue for quite some time, since financing is virtually impossible for developers and they have laid off so much of their staff. Even if conditions warrant new development, it will take a while to gear up.”

Austin, meanwhile, has suffered more than the other major Texas MSAs because it saw many more units added to the existing stock, reports Witten. Total stock increased by 4 percent, while demand grew only about 2 percent.

During 2009, 10,000 units were added to existing stock, with 5,800 units absorbed, according to Stutzman. That number, however high it may seem, is off its peak of 17,000 units, which, he notes, “was really the one thing that scared most people about Austin.” After another 1,500 units that were scheduled for delivery in the first half of this year came online, the supply pipeline has emptied out completely.

Rents were down 5.5 percent in 2009, with occupancy at 89 percent by the end of the year, down 1 percent year-over-year. While the city saw occupancies nearing 100 percent at the beginning of this decade, it went through a four-year correction period after the tech wreck, at which point occupancy was in the high-80s.

Transactions pick up

Because the supply of buyers is outpacing the amount of product currently available, the Texas markets, like many others, are experiencing a competitive environment for new deals.

In Houston, for example, Class A product, particularly in infill core locations, “is trading at real premiums,” at cap rates between 6 and 6.5 percent, according to Cummins.

Successful buyers in the Houston market—which appears to be a “higher transaction volume market than Dallas or Austin”—tend to be “local players who have been on the sidelines” and who are “not as driven by IRR,” observes Cummins. “They don’t have a three- to five-year exit strategy. They are buying for cash flow and they are buying [at] today’s numbers.”

Grubb & Ellis, for example, is looking closely at its Texas portfolio, since it has seen “more attractive cap rates, from the buy side,” notes Remppies. “Like many markets, we’ve seen pricing on a per-unit basis come down, and cap rates have risen. Now’s the time to acquire—not the time to sell.”

Meanwhile, pricing in Dallas is 25 to 50 percent below its peak, according to Charboeau. But cap rates have compressed and are down 50 to 75 bps from their high in the summer of 2009. And those assets that are sold on a per-pound basis are up 25 percent from last summer.

“If you’re a core asset or core-plus asset buyer, you’re now able to go in and buy product at 70 percent of replacement cost. You may not like the going-in cap rate…but to be able to buy high-quality assets at today’s prices is a tremendous opportunity,” Dallas’ Charboeau points out. “While it’s difficult to ignore the cap rate, you probably need to set it aside and say it’s a once-in-a-career opportunity.”

Demand in Austin has driven pricing up faster than in other markets, though Stutzman notes that market-rate transactions didn’t occur until the fourth quarter of 2009. “Austin always carries a bit of a premium,” Charboeau acknowledges. “It has a wonderful panache because it’s high-tech-oriented and one of the nicest cities in Texas to live and work.”

For that reason, well-located projects appear to be good investments, no matter the asset class. Class C developments, for example, may be prime candidates for land value when construction returns, says Stutzman. “People felt like they knew Austin was one of the best places to buy and that by the end of [2009] we had reached the apartment market bottom. The demand was there, multiple offers were submitted, cap rates were bid down” to the mid-6 percent range, recalls Stutzman.

Most buyers in Austin aren’t locals, though. Investors from both the East and West Coasts seem to view the city “as one of the strongest markets moving forward,” Stutzman observes.

A shining star

The experts all seem to believe that the markets in Texas have bottomed out and that they are positioned to be some of the first markets to recover. With the depletion of the supply pipeline, vacancy levels appear to have reached their peak and many operators are now watching for concessions to ease and rent growth to return. “As long as we continue to see occupancy tick up, it means we are continuing to absorb,” points out Stutzman.

But this may not be immediate; as Witten predicts, for example, rents throughout the major metros may drift lower this year, before turning around in the beginning of 2011 (likely sooner in Austin).

The Lone Star State is in a position to receive a number of corporate relocations, however, particularly as companies “begin to think longer-term strategy,” Witten points out. And companies that are “based in California, New York or other high-cost, high-tax areas have got to be thinking this is the time to move,” says Armand. In addition, both Houston and Austin placed in the top ten on Fortune Small Business’ “Best Places to Launch a Small Business 2009.”

With no state income tax, “Texas is a business-friendly state and should continue to grow into 2010 and on,” Cummins predicts. “Our market is jobs, jobs and jobs, so to the extent that job losses have leveled off and we can have job growth—it’s predicted we’ll have 40,000 new jobs in 2010—we have probably bottomed out operationally.”

In Houston, in particular, the Panama Canal expansion project should increase trade, and the medical center is expected to grow under the recent healthcare legislation. Meanwhile, the large government base and the University of Texas in Austin position the capital to lead the state out of the recession.

These job opportunities will only serve to create population growth in the Lone Star State’s largest cities, which has given Grubb & Ellis enough incentive to stay put in the Texas markets for the short- and long-term, notes Remppies.

On the flip side, Witten notes, if capital returns to the market faster than expected, new construction could spring up rapidly, as Texas does not have the long entitlement process that other regions do. Austin, in particular, could pose a problem—just as it’s good news that people want to live and work in the state’s capital, it will also be one of the first choices for new development. But, amends Stutzman, this would be a longer-term issue.

“Right now, there is so little construction, if we maintain [the current supply level], there’s a strong recovery ahead for the industry, nationally and in Texas,” Witten asserts.

To comment, e-mail Erika Schnitzer at [email protected].