Back from the Brink

Just a few months ago, the Midwest was making headlines nearly every day, with reports of the auto industry on the verge of collapse. It was no wonder, then, that Detroit’s unemployment rate was the highest in the nation, and industry experts reported that the future of multi-housing in the city depended on whether General Motors and Chrysler survived.

Now, with the two major auto companies coming out of bankruptcy, some optimism and stability have returned to the marketplace, reports Kevin Dillon, associate partner in Hendricks & Partners’ Birmingham, Mich. office. The pace of “job losses has declined in the second half [of the year], and that is anticipated to continue.” He adds that the auto makers have increased production, consequently increasing overtime shifts and stabilizing consumer confidence, to some extent. “There is a feeling we have hit bottom and we are coming out of it,” Dillon notes.

According to the U.S. Bureau of Labor Statistics figures, the Detroit-Warren-Livonia MSA’s unemployment rate is 17.0 percent, as of August. This is certainly a staggering statistic, however, it is important to note that the rate decreased 0.7 percent from July 2009.

Meanwhile, the Chicago-Naperville-Joliet, Ill. MSA recorded a 9.6 percent unemployment rate during the same period, down 1.1 percent from the previous month, and finally putting the city at the same rate as the national average.

As Dan Rosenberg, co-founder of Chicago-based Building Equity, points out, “we seem to have a very well-rounded group of industries in Chicago…and the population keeps expanding. You have a huge number of people moving from the suburbs into the city.”

And while the Milwaukee-Waukesha-West Allis, Wis. MSA has also seen a decrease in its unemployment rate, it’s one of the few cities in the Midwest whose unemployment is below the national average. As of July 2009, unemployment was at 9.5 percent—down from its high of 9.8 percent in June (at press time, the MSA’s August unemployment rate had not been recorded).

Midwestern fundamentals

All things considered, the Detroit market is “faring pretty well,” according to Dillon. Perhaps the best explanation is the city’s limited new construction—only five multifamily permits have been issued this year, compared with 435 in 2008.

The Detroit apartment market has also seen some stability in rental traffic in the late-second and early-third quarters, Dillon notes, adding that this stability is mostly in the Class B and C sectors. According to Hendricks & Partners’ second-quarter figures, vacancy—as of June 2009—was 7.5 percent, an increase of 80 basis points year-over-year.

The Class A market, however, “is still suffering, due to less-expensive homes, foreclosure and higher-end residents buying single-family homes,” reports Dillon. Compounding this is the fact that most of the market’s concessions are seen in the higher-tier properties.

Furthermore, while the metro is not experiencing either rent increases or concessions—the year-over-year rent change was down 0.5 percent, or $6 per month—there is an increase in leasing traffic at properties with strong management and good price points, says Dillon.

Meanwhile, average occupancies in both Chicago and Milwaukee are above 90 percent—93.3 percent and 95.1 percent, respectively—with some fluctuation depending on the submarket, reports Ralph Depasquale, associate partner in Hendricks & Partners’ Chicago office. In the Windy City, the highest vacancy is in The Loop, at 8.9 percent, followed by Oak Park, at 8.5 percent. North of the Loop is experiencing the lowest vacancies—3.9 percent, according to Hendricks & Partners.

Comparatively, “the suburban market is faring okay in Chicago because we haven’t seen any new development in the last couple of years and probably will continue not to see new development going forward,” notes Depasquale. “The downtown area is obviously still seeing many new buildings coming online—mostly condos but some apartments—but a lot were already started or in the midst of being completed when the downturn in the economy happened.” That being said, however, 5,000 to 7,000 new units are slated to come online in Chicago this year, says Depasquale.

And, as Scott Harris, senior vice president of investments in Marcus & Millichap’s Oak Brook, Ill. office, reports, of these units, “there are upwards of 2,500 to 3,000 condos that are delivering [in the CBD]. And I don’t think there are   buyers,” adds Harris.

Consequently, as Depasquale notes, “We are seeing a much larger shadow market where condos are being offered as rentals. That will probably continue. The spigot will be turned off in early 2010 and going forward, we won’t see a lot of new development.”

Milwaukee hasn’t seen quite as dramatic a drop in occupancies as Chicago has, but, as Depasquale points out, “it was never quite as high either. It just doesn’t fluctuate as much as Chicago, which, in and of itself, doesn’t fluctuate much either,” compared with other major metro markets throughout the nation.

Despite this, however, Rod Engel, principal at Deerfield, Ill.-based Legacy Real Estate Development LLC, maintains that the downtown Milwaukee area has seen new construction both on the condo and rental sides. “In just the Milwaukee area, there have been 545 units slated to come online in 2009—well above 230 units that came online last year,” he notes, adding that the units slated for delivery this year may pose a problem in the market’s ability to absorb them.

Rent-wise, both Chicago and Milwaukee are offering concessions, decreasing rents slightly. According to Marcus & Millichap’s third-quarter Apartment Research Market Update, Chicago’s asking and effective rents are expected to drop 2.1 percent and 2.6 percent, respectively.

Meanwhile, Hendricks & Partners reports that Milwaukee rents have decreased 1.7 percent year-over-year. And in the city’s condominium sector, the market is experiencing more negotiations when it comes to pricing, notes Engel. For the developer’s latest Milwaukee project, the Flatiron—a 38-unit condominium development in the Park East Corridor—for example, prices are down about 5 percent, but Engel notes this is a conservative model, since the project was “at or below the market to begin with.” He reports that pricing for other projects in the market has come down more significantly.

“The question is, ‘is that price going to make money, break even or lose money?’ We were fortunate that when we planned this, we were able to sell it for reasonable prices and therefore we haven’t been hit as much,” Engel recalls. “Milwaukee has never been a stellar market either—we also budgeted a sell-out of several years, so we had the wherewithal to finish this up. Considering the market, this is a highly successful project.”

Slowed transaction velocity

Similar to elsewhere around the nation, transaction velocity throughout the Midwest has slowed considerably. However, that is not to say there is a lack of opportunity—if you know where to look.

In Detroit, for example, Dillon says, “I see a strong increase in opportunities right now; buyers are ready to go. I believe volume will pick up over the next three quarters. Buyers understand the market conditions today—the REO market—and are looking for additional REO properties as they come online.

“The investor here a few years ago was focused on quality assets in good locations with stable resident profiles,” he adds. “Today, investors look to take advantage of REO opportunities with higher vacancies and management troubles that can be rectified and corrected fairly easily.” Cap rates have increased 150 to 250 basis points in the past 12 to 18 months, but the gap between buyer and seller expectations has closed.

In both Chicago and Milwaukee, Depasquale notes that the buyer profile has changed. “In the short-term, we have seen a dramatic pullback from the institutional buyers,” he notes. Chicago, he says, is the only Midwest market that ever really had any significant institutional interest, even one to two years ago. “In the last 12 months, let’s say, the institutions have pulled back, so you’re seeing more entrepreneurial local or regional players, or national players that might have 5,000 to 10,000 units—leveraged buyers basically.”

While Depasquale reports that some larger suburban sales have taken place in Chicago, there “hasn’t been much to speak of” in the downtown area. As Harris points out, though, “buyers had anticipated that there would be more product on the market by now than there actually is, so the number of deals that are available is somewhat disappointing.

“I’m in the process of selling a bank foreclosure situation up in a northern suburb of Chicago, but this was a property that we had really significant interest in—there’s a lot of interest in these properties and this is one that has some upside,” Harris adds. “It’s being purchased at a good ratio, relative to replacement cost—65 percent of replacement cost—so I think those types of opportunities are not real prevalent, but when they are out there, there is definitely significant demand,” from both local and out-of-state investors.

And for those deals that have been done, pricing has decreased about $15,000 to $20,000 per unit, reports Rosenberg.

As far as where in the market he would advise investors to look, Rosenberg suggests, “anywhere near the El stop, within two blocks. Right now, I would stay in the Class A locations because there is less risk.”

In Milwaukee, Engel notes that his firm has no new construction in the pipeline at the moment, but that he is “in acquisition mode right now,” looking at properties “that make sense financially, based on existing incomes at a reasonable cap rate.” He adds that while there aren’t many transactions taking place, “there is definitely a thinning of the gap between buyers and sellers,” that, he predicts, will continue as distressed properties come on the market.

Depasquale adds, “What I tell investors is, it’s impossible to time the bottom of the market. We might not be at the very bottom, but we are very close. If you are buying a good, well-located property where you can improve operations and you’re planning on holding it for at least five to seven years, you will do well, even if the market turns down a little. You have to factor that in when you do your underwriting. If you do something in hopes of flipping it in six months to a year, you probably won’t do very well.”

Time to buy?

Despite the fact that the Midwestern markets appear to be somewhat better-performing than just one quarter ago, they still have a long way to go. So how can the industry know when the market has finally started to turn itself around?

Hendricks & Partners’ Dillon believes that three signs will point to a rebound in the Detroit market: the pace of single-family homes sales, declining job losses and the stabilization of the “Big Three.” Since all of these appear to be taking place, Dillon adds, “it’s just a matter of turning it around—the only other issue is the overall financial condition of the country and how we come out of the recession.”

While all markets seem to be looking at Washington for signs of a recovery, the experts maintain that there are some things to look for in each individual market. For example, in Chicago, Depasquale questions whether the city will get the 2016 Olympics. “If we do, that’s going to have a major impact, at least on the downtown market—and maybe the suburban market.”

And as far as which area of the Windy City will turn around first, Depasquale believes the suburbs will bounce back faster than the city. “The suburban market, even in its heyday of development in the early- and mid-2000s, never saw a lot of development, relatively speaking,” he notes.

Harris adds that, compared to many other Midwestern markets—particularly those with few barriers to entry, such as Indianapolis and Columbus, Ohio—Chicago does not have much room to grow and therefore does not generally experience the same operational problems for owners.

In Milwaukee, there are opportunities for companies to expand in areas such as Pleasant Prairie and Oak Creek, notes Depasquale, but he cautions that these areas will also have the most amount of new product coming online. Despite this, however, Engel adds that the city “didn’t have the run up and rapid appreciation that popped. It had a normal appreciation.

“I think that now is the time [to buy], because you’re seeing more and more positive news,” he adds. “Six months ago, a year ago, everything was negative. Granted, the bar is low, but that’s what you need to get to the bottom. If we’re not at the bottom, we are certainly close. Sellers are now pricing things properly, so as a buyer, you can get a deal. I think the next year or two could be historically one of the best times to buy in a long time.”     

Price Adjustments

“On the investment side we have seen a fair amount of demand, and prices definitely have adjusted,” reports Ralph Depasquale, associate partner in Hendricks & Partners’ Chicago office.

Two recent major sales in the Chicago metro area include the 592-unit Amli at Chevy Chase in Buffalo Grove, Ill. and the 206-unit Landings of Lake Zurich. The latter of the two, Depasquale notes, is “a perfect example of price resetting.” It was traded at $135,000 per unit just a few years ago, and was recently purchased by local investors for less than $90,000 per unit.

Meanwhile, the Amli project recently traded for $58 million, but Depasquale estimates that it would have sold for closer to $80 million a few years go.

Depasquale also recently closed a deal on a 235-unit community in Oak Creek, Wis. that “sold for a little under a 7 cap—a deal that a few years ago in that area (south suburban Milwaukee) would have traded in the high 5s to 6-and-a-quarter range. Deals today—if you can find any—are probably north of an 8 cap,” he adds. The community, which was listed for $12.3 million, sold for $11.25 million, or $47,872 per unit, in May.