By Neil D. Freeman, Aries Capital
The multifamily housing market is witnessing a resurgence, and developers see this sector as the first bright spot on the horizon since the Great Recession began in 2008. Financing for new developments is also making a comeback.
Major banks are again providing construction loans of 65 percent loan-to-cost on major-market apartment buildings. Interest rates can be 250 to 300 basis points over Libor, producing a rate near 3 percent. In addition, some insurance companies have provided 95 percent financing on a combined debt and equity structure with a senior loan of 60 to 70 percent LTC at rates of 3 to 4 percent and equity preferred yields of 7 to 8 percent.
On the permanent side, Fannie Mae and Freddie Mac rates are around 4 percent for a 10-year term, 30-year amortization loan, and some insurance companies are matching those rates. Clearly, the availability of inexpensive debt has allowed the institutional investors to accept the 4.5 to 5.25 percent cap rates being paid.
Lenders see strong multifamily conditions
Given strong institutional investment appetite for Class A apartments, new construction is taking hold and attracting financing. Capital sources’ confidence level is boosted by improving multifamily conditions. The combination of renting by choice, housing formation in the generation Y sector, a weak single-family housing market and an improving economy all make for a strong rental market.
One result of the tight rental market is rent increases. Rents that had languished between $2.25 and $2.50 per square foot have increased to the $2.75 to $3.00 per-sq.-ft. range.
Projections show rents on Class A buildings trending upwards of $3.25 per square foot when they can be delivered (there has been virtually no condo development initiated since 2006, and there is nothing on the horizon).
In Washington D.C., rents exceed $4 per square foot, and in New York, rents can exceed $6 per square foot.
With rising rents, developers and their institutional partners can once again selectively make profitable investments. Major apartment sales activity has occurred in New York, Washington D.C., Los Angeles and other major markets at attractive prices exceeding replacement cost. Recent sales activity in Chicago also provides some interesting examples of this. The EnV recently sold for $478,000 per unit, or $477 per square foot. Two West Delaware sold for $524,000 per unit, and the Flair sold for about $430,000 per unit. Echelon at K station, built in 2008, sold for $380 per square foot. Several older properties or units in inferior locations have also sold at close to $300 per square foot.
Institutional quality products led the multifamily recovery
The market has not always been so positive. During the recession, multifamily construction was difficult. Other than limited low-income housing units, new construction units were at historical lows. There were several forces holding this market down, starting with difficulty in securing financing. Such forces included: large unsold condo “shadow” inventory; declining rents and occupancies in most markets; lack of debt capital as banks withdrew from real estate lending and making construction loans; equity capital’s avoidance of new construction, preferring existing cash flow properties acquired below replacement cost; and high unemployment in the U.S. and a declining world-wide economy.
In 2011, the few institutional quality apartments that had been recently completed started to trade at attractive prices. Buyers included large REITs such as Equity Residential, pension fund investors (either directly or through private equity funds) and core real estate investment funds. As cap rates for existing multifamily started to fall below 5 percent, developers and institutional investors started to see the value of building new product that can be profitable when built at an unleveraged debt yield of 6 to 7 percent.
Today, most new apartment properties are being built in major U.S. markets that can attract high rental rates. Product is being built for younger, educated professionals whose career and family situation make them mobile, as well as empty nesters who prefer to stay liquid and rent by choice. Buildings feature high-quality unit finishes and strong amenities, which include lavish gyms, concierge service, Internet cafe, lounges in which to socialize, and more.
Social media is increasingly used to promote activities and allow residents to get together in an immediate and spontaneous manner to provide a rich social experience. Some developers are experimenting with smaller apartments and more interesting common areas consistent with the desires of today’s high-end renter.
Returns to equity
In addition to debt capital sources, there are also numerous equity sources interested in making apartment investments, and many are now considering new development. Equity investors range from institutional to entrepreneurial private equity and include overseas capital as well. Entrepreneurs see the benefit of building at a 6.5 percent to 7 percent yield and selling at a 4.5 percent to 5 percent cap rate. Even for a long-term hold, the availability of inexpensive debt produces strong cash-on-cash yields with less risk than other forms of real estate.
Return expectations can range from cash-on-cash returns of 6 to 8 percent and IRR total yield expectations ranging from 9 percent to as high as 20 percent. Some of the properties built in 2010 and sold recently greatly exceeded those yield expectations, while investments in office, retail, industrial and hotel in the same period had marginal returns.
Some experts are fearful that this new multifamily activity will produce a situation similar to the condo bubble in the mid-2000s. While there is a risk if capital does not measure supply and demand properly, this is unlikely to happen. As long as condo development is kept under control, the fundamentals of new households and demand in the major markets as such keep supply and demand in balance. There is a risk that rents and therefore returns will flatten, but a bubble is unlikely.
In sum, investments in major market new construction apartment buildings is booming and should remain robust over the next few years as long as interest rates stay below 5 percent permanent rates. However, we don’t expect to see secondary markets attracting the same large-scale new construction of market-rate apartments as the rents do not justify the risk.
Neil D. Freeman is chairman and CEO of Aries Capital, a national full-service commercial mortgage and real estate investment banking firm.