A Breath of Relief in the Mid-Atlantic

Industry experts don't expect the 2012 election to slow the pace of recovery for the top-performing Washington, D.C. metro; in Philadelphia, diverse economics continue to shine favorably on the market.

In the Mid-Atlantic region, Washington, D.C. is oft considered the top performing apartment market; in fact, the District is often thought of as one of the top performers in the nation.

But how will the upcoming national election affect the mood here? “It’s all politics all the time,” says Tom Bozzuto, chairman and CEO of The Bozzuto Group, which owns and/or manages approximately 32,000 units, the majority of which are located in the Mid-Atlantic region. “Around here, everyone’s mood is affected by what they read in the newspaper. The next nine months are going to be uncomfortable because the parties are going to do whatever they can to fight over the White House.

“But,” he adds, “once that’s behind us, there will be such a breath of relief.” Of course, a cutback in federal spending would have a tremendous impact on jobs in the metro, particularly since jobs in the private sector feed off of the federal government.

Robert Kettler, founder, chairman & CEO of Kettler, which owns and/or manages 19,000 units, however, doesn’t expect any real decline in federal or contracting jobs under any election outcome scenario. “Even if there are draconian federal cuts out there, nobody seems to be making plans based on severe job cuts,” he points out. “The government is so large and so embedded [in the metro] and functions on long-range budgetary planning, we don’t see it changing much regardless” of the outcome of next year’s election, he adds.

Meanwhile, further north in the region, Philadelphia’s diverse economy and lack of apartment starts has benefitted that market. “We’re not heavily vulnerable to any one particular industry,” points out Carl Dranoff, president of Dranoff Properties, which owns about 1,500 Class A units in the Philadelphia metro area. “Unless people stop getting sick and going to hospitals or stop getting educated in institutions of higher learning, we pretty much are going to sail along,” he predicts.

Additionally, after building the city’s tallest tower and purchasing a majority stake in NBC Universal, Comcast brought some of the media market from New York to Philadelphia—a real change to that market since New York typically tends to attract those employed in media. Additionally, the Navy Yard redevelopment is expected to become a growth market for R&D and manufacturing, points out Dranoff, which is business that normally would be relegated to a flex park in the suburbs.

Washington, D.C.’s improving infrastructure

Infrastructure around the D.C. metro area will cause the market to benefit from an influx of commuters. The Metropolitan Washington Airports Authority, for example, is currently constructing a 23-mile extension of its system, which will serve Tysons Corner and the Reston-Herndon area, two of the area’s largest employment centers. And, adds Dean Sigmon, co-managing director of Transwestern’s Mid-Atlantic Multifamily Investment Sales Group, the Silver Line metro, which has been on the drawing board for many years, is finally coming to fruition. Furthermore, in Maryland, the completion of the ICC (The Intercounty Connector), which will link development areas between the I-270/I-370 and I-95/US I corridors in Montgomery County and Prince George’s County, will have “a positive impact on traffic,” notes Robin Williams, co-managing director of Transwestern’s Mid-Atlantic Multifamily Investment Sales Group, adding, “now those markets can compete more directly with each other for residents who have commuting options.”

While the District of Columbia may have been the first in the metro to recover after the economic collapse of 2008, Northern Virginia has actually seen the most job growth year-over-year, points out Kettler. While the overall unemployment rate for the Washington-Arlington-Alexandria metro area was 5.5 percent as of November 2011, breaking the area down further paints a far different picture. In fact, the District of Columbia had a 10.6 percent unemployment rate during the same period (compared to 9.7 percent in November 2010), while Baltimore-Towson had a 6.7 percent rate (compared to 7.8 percent the previous November).

As of the end of the third quarter, occupancy ranged from 1.5 percent in northern Virginia Class B properties to 4.3 percent in suburban Maryland. Meanwhile, rent growth has been seen throughout the region, with Northern Virginia experiencing, in some cases, as much as 8 percent or 9 percent rent growth year-over-year, with market research provider Delta Associates projecting similar growth in 2012. Furthermore, there’s significant demand for efficiency and studio housing in Washington D.C., which suggests new household formation, adds Sigmon.

The strongest submarkets for rent growth and pricing, reports Kettler, are those with high barriers to entry; these include Alexandria and Arlington, Va. and D.C.’s West End and Mt. Vernon Triangle, in particular. “We think there could be some serious price wars in those areas—and oversupply potential,” he adds.

This potential for oversupply also worries Bozzuto. “I see that it’s a place where everyone wants to be, and I want to say, ‘go back [home],’ because they’ll overbuild, but there’s a lot of capital that all wants to be in Washington. It’s a hot place to be, [but] there is the potential for overbuilding.” However, he believes that of the markets in the region, Washington, D.C. is actually the least susceptible to overbuilding.

Furthermore, this potential oversupply won’t happen this year, and constrained deliveries throughout 2012 are expected to bolster rent increases throughout the marketplace. However, 5,000 units are slated for delivery in the District over a period of 36 months beginning in 2013, with additional deliveries expected in Northern Virginia, as well as Rockville and Bethesda, Md. Additionally, about 30,000 units in the metro area are currently undergoing some form of renovation, points out Sigmon.

Kettler currently has five Class A projects in the pipeline that are slated to break ground in the next 12 to 16 months, including a 233-unit community in the Mount Vernon Triangle; the 411-unit Acadia at Metropolitan Park, which will mark the final phase of the company’s project in Pentagon City; and 375 units that is a partnership with the Howard Hughes Corp. and is part of the redevelopment of Columbia Town Center in Columbia, Md.

Bozzuto, too, is breaking ground on three communities in the metro area. Most recently, the company began construction on Union Wharf, a $72 million mixed-use community that will add 281 apartments, 4,500 square feet of retail and nearly 500 parking spaces to Baltimore’s Fells Point neighborhood.

As far as transactions, there was a tremendous increase in the volume of properties available on the market at the end of 2011. The market, Kettler recalls, “got hit by a taser in 2008 and early 2009; it literally hit the wall.” For a period of six to eight months, it was difficult, if not impossible, to determine property values. But now Washington, D.C. is a magnet for out-of-town multifamily investors and developers, causing cap rates to compress to 4 percent and 5 percent for trophy assets, he adds.

Properties gaining the most interest seem to be either well-located, core properties or suburban, quasi-distressed assets. For the former, cap rates are in the sub-4 percent range, reports Williams. For the latter, “if people can acquire them at realistic prices, there’s a strong appetite to come and to spend capital on improving real estate in order to get higher rent levels,” he adds.

Suburban, quasi-stabilized 1960s and 1970s product, meanwhile, is trading in the mid-6 percent range, while newer suburban product is closer to the low- to mid-5 percent range.

Kettler’s current strategy is to buy either “nicely performing or under-performing assets to reposition or refinance them for a 10 year-plus hold,” though he admits these assets are hard to find.

“There are so many people willing to bid prices that we don’t think make sense that we are finding it hard to put together new development deals on an economic basis that make sense,” Bozzuto adds.

As Sigmon points out, investors are not being as aggressive, from a cap rate perspective, in Baltimore as they are in Northern Virginia and suburban Maryland.

Williams adds that the next value-add opportunity will be the mid- to late-80s or early-90s garden property located in northern Virginia or in a good location—such as close to commuter access—in suburban Maryland.

Other potential areas for investment include those located near BRAC (Defense Base Closure and Realignment Commission) locations, such as Alexandria, Woodbridge and Fort Belvoir, Va. And in terms of asset class, Kettler sees Class A and C properties performing far better than B-Class properties. “The C market has risen the most, from what we can tell,” he reports.

Philadelphia’s favorable demographics

Four out of the five counties in the Philadelphia metro area are below the national average for unemployment, says Eli Rosen, senior vice president, Gebroe-Hammer Associates. The overall metro area reported a 7.9 percent unemployment rate in November.

“Philadelphia is more than holding its own,” agrees Dranoff. “Because our economy is so heavily weighted toward ‘eds and meds,’ we’ve [seen] a more nominal impact from the downturn than other cities.”

There are dozens of colleges and universities in the metro area, and a large percentage of graduating doctors attended school in Philadelphia. Additionally, Philadelphia recently saw the expansion of its convention center, which is stimulating tourism and hotel construction. And, adds Dranoff, “because of the strong downtown resurgence, Philadelphia is one of the few cities that has gained population over the last 10 years. People are moving back to the downtown area in droves,” he adds, pointing out that young families are keen on remaining in the city, as there are more options for secondary education.

Overall occupancy in the Philadelphia market is in the 90s, with Class A assets closer to the high-90s, Class B between 93 percent and 95 percent and Class C assets in the lower-90s, reports Rosen.

Rent growth, he adds, is mostly due to renovations rather than a market increase as a whole. And while he does continue to see some properties continuing to offer concessions, he doesn’t see it as an overall market trend, as he did several years ago.

“In the last year, vacancies have decreased, concessions have largely dissipated, and I think that all owners are looking at rent increases over the next three to five years before the next round of new construction kicks in,” predicts Dranoff.

The shadow market that impacted the Class A Center City in 2008-2009 has mostly been absorbed, and rents and occupancies in the traditional rental communities are on the rebound, adds Rosen.

Meanwhile, the Class B market—which is the majority of Philadelphia’s apartment market—is much more dependent on individual operators, and rents have begun to rise slowly. At the same time, the Class C market took a dip, though Rosen again notes that performance was based primarily on the management team of a particular building. Overall, however, the market is starting to come back, which Rosen mostly attributes to the housing market and the fact that most of those renting the lower-tier apartments cannot afford to purchase a single-family home.

Dranoff has also observed that more commuters are choosing to live in Center City—commuters not only to the Philadelphia suburbs but also those who work in New York, due to the favorable price differentials. And 30th Street Station is being refurbished, making access to public transportation easier—and if Philadelphia gets high-speed travel on the northeast corridor, the city’s residents can be in New York in just 34 minutes, points out Dranoff.

While there is not much new development taking place in the Philadelphia market (it is an extremely high barrier-to-entry market), Rosen does point out that quite a bit of redevelopment has been occurring in the areas surrounding Center City. In some of the more blighted areas of the city, he adds, some high-rise properties have come down to make way for new construction, however.

The current “hot areas” in the Philadelphia metro are the Avenue of the Arts, which has hundreds of millions of dollars in investment over the past 15 years. The neighborhood has become somewhat of a residential haven, notes Dranoff; his company has built two properties here and expects to break ground on a third this summer. And West Market Street, though currently undeveloped, is beginning to fill with housing. In addition to these “growth nodes,” Dranoff points out that the metro is seeing a lot of infill housing of townhomes  between three and nine units.

Part of the reason for this, says Dranoff, is that Philadelphia is a high barriers-to-entry market, and it is difficult to assemble land and/or get zoning approved—not to mention that it can often be difficult to make the numbers work.

As for the transaction market, the Class A Center City and suburban markets have seen an increase in institutional buyers. Other classes, however, are mostly drawing interest from local and regional investors.

Cap rates for Class A properties range from low- to high-6 percent, while Class B assets are trading in the high-7 to high-8 percent ranges, and Class C is trading in the 10 percent cap rate range.

While investors tend to be gravitating more toward downtown Class A properties, Dranoff notes that there are hardly any sellers in Philadelphia since many of these assets are family-owned. Suburban Class B properties, however, do see more transaction activity, as there is a wider array of ownership in this asset class.