Fundamental Growth

Unlike most markets, Washington, D.C.’s current conditions favor the apartment owner looking to sell

Viewed as one of the top five multi-housing investment markets in the United States in the past decade, the Washington, D.C. market rose to the top of the list in 2010 due to rent growth, low vacancy rates and favorable supply and demand dynamics. The market boasts exceptional job growth, and the presence of the federal government provides a unique advantage to the metro area, as it anchored the region during the economic recession.

Owners are poised to take advantage of the projected job growth and the constrained supply pipeline and are expected to increase rental rates over the next 18 to 36 months. Investors have flooded the region in the past six months looking for deals to quench their appetite for property in the Washington, D.C. region, especially Metrorail-accessible and core assets. Whether you are an owner, investor, potential seller or developer, there is no other market in the country that is as dynamic as the Washington, D.C. multi-housing market.

Economic snapshot

The old real estate adage “location, location, location” is still appropriate, yet the new mantra among owners, investors and developers has become “jobs, jobs, jobs.” Washington, D.C. has captured the attention of multi-housing investors nationwide as a result of its diversity in the main industry sectors, including the federal government, education, health services and information technology.

The metro area has a population of more than 8 million residents, many of whom comprise the employment base of 2.98 million workers, making Washington, D.C. the fourth-largest job base in the country. The Washington-Arlington-Alexandria, DC-VA-MD-WV metropolitan statistical area also maintains one of the lowest unemployment rates in the country, at just 6.9 percent (as of January 2010), according to the U.S. Bureau of Labor Statistics. Washington, D.C. is also ranked as the second-best city for job growth in the U.S., as employment is expected to grow at a rate of 2.7 percent over the next five years.

The region is just beginning to feel the effects of the $789 billion American Recovery and Reinvestment Act (ARRA), which should create an estimated 170,000 jobs in the immediate metro area. The Defense Base Closure and Realignment Commission (BRAC) is expected to bring another 60,000 to 65,000 new jobs to the Maryland/Virginia region over the next several years. In recent years, corporations such as CSC, SAIC, Volkswagon, Hilton Hotels, The Ignite Institute and Northrop Grumman have either moved or announced their intentions to move their headquarters to Washington, D.C.

Additionally, the area was a major beneficiary of TARP stimulus money, which further spurred job growth. The U.S. General Services Administration alone received $5.5 billion in stimulus money. As the majority of its locations are in the greater Washington, D.C. area, much of these funds were spent in the market through leases, contractors and construction. The federal government and contractors that support the government employ one-third of the region’s workers, directly or indirectly, helping the Washington, D.C. market prove itself resistant to fluctuations in the economy.

Apartment fundamentals

It is likely that the Washington, D.C. market will lead the nation’s rental market recovery in the near future. The area has an ideal demographic; it boasts a wealthy population (average annual per capita income, according to Moody’s, is $56,886, 46 percent above the national average) and an educated workforce (the area is home to 50 colleges and universities). The largest demographic among Washington, D.C. residents is 20- to 35-year-olds, an extremely mobile age group that is more likely to rent than any other demographic and is drawn to Class A properties. This will play a significant role in the area’s recovery, as the Class A market is beginning to see substantial upturn.

Washington, D.C. has a shrinking 36-month supply pipeline that is at its lowest level in years, and a high number of leases are scheduled to expire in 2010. This is promising news for the area’s already-low vacancy rate, which stabilized at 5.2 percent at year-end 2009 and is expected to drop even further, to 2.8 percent, by the end of 2011. Furthermore, rents are projected to increase more than 3 percent, with many submarkets projecting even higher increases. Concessions are anticipated to tighten significantly (according to CBRE Econometric Advisors’ Multi-Housing Outlook Spring 2010).

Investment trends

The Washington, D.C. multi-housing market is one of the most dynamic in the country, with billions of dollars of capital chasing opportunities, optimism increasing amongst investors and continued compression of capitalization rates. Investors in 2010 have been significantly more active than in 2009; through the first quarter of 2010, more than $828 million of deals closed and numerous properties were under contract. By comparison, $27.8 million closed in the first quarter of 2009, with the full-year figure reaching just $1.2 billion.

The dearth of quality investment product and the flood of capital entering the market have combined to create a scarcity premium, resulting in further cap rate compression. Capitalization rates in the Washington, D.C. area have steadily dropped since reaching a cycle peak in May 2009.

As of March 2010, cap rates for Class A assets ranged from 4.8 percent to 5.4 percent, Class B from 5.6 percent to 6.0 percent, and Class C from 7.0 percent to 8.5 percent on in-place numbers. Due to the lack of available product and competition for Class A product, buyers will likely expand their focus to include more Class B assets for acquisition potential. However, before this expansion of appetite appears, strong buy-side opportunities in the lesser class of apartment property will appear. Investors will be able to seek better returns and less competition for Class B and C product through the first part of 2010 before the capital shift occurs.

A seller’s perspective

The pendulum in the greater Washington, D.C. market has fully swung in the seller’s favor. The abundance of cash chasing deals is significant. During the first quarter of 2010, approximately $40 chased every $1 of opportunity in the Washington, D.C. market.

A considerable amount of capital continues to stand ready for placement; an estimated $136 billion of institutional capital is committed but uncalled (according to The Institutional Real Estate Letter North America March 2010). A property that gathered five offers in September 2008 would now attract 50 offers. The investment sales volume has increased significantly in the past six months, and the notable decrease in investor going-in yields and cap rates has caused many owners to reevaluate their hold/sell options.

For owners who are contemplating a sale in the near term (12 to 24 months), the major impact on value may be interest rates. If they rise, as some financial experts predict, we will almost assuredly experience higher cap rates and lower values. Unfortunately for the sellers, a property’s NOI cannot increase enough to offset a significant rise in cap rates or a sharp decline in market fundamentals. For example, an owner with the ability to sell a property now at a 6.0 percent cap rate would have to increase NOI 8.3 percent if the cap rate increases to 6.5 percent. Should the market move to a 7.0 percent cap rate, an owner would have to increase NOI nearly 17 percent to achieve the price justified by a 6.0 percent cap rate on current NOI.

If an owner is contemplating the sale of an asset in the next two years, the owner should be in the market today. Historically low interest rates, declining cap rates, the large amount of capital in the market and the limited supply of quality assets for sale are creating a compelling sales environment that favors the seller.

An owner/buyer’s perspective

Owners and potential investors understand the long-term benefits of owning real estate in one of the most dynamic markets in the world. The anticipated and continued growth in jobs, coupled with limited supply, creates a situation where demand will outstrip supply in the near-term in the region. Furthermore, national trends that point to an increase in multi-housing demand include:

n            A psychological shift in preferences for renting versus buying

n            Population surge from the Echo Boomers

n             Pent up demand from Generation Y who have been doubling up or living with parents

n             An increase in renting due to foreclosure and home loss

With apartment fundamentals projected to tighten in the next 24 to 36 months, owners and investors will be able to underwrite rent gain projections for most submarkets in the region. Projected rent gains, limited supply and a burgeoning job base paint a compelling picture and allow investors to aggressively pencil in lower initial cash-on-cash returns, knowing that the bottom line will only get better.

A developer’s perspective

In the last 90 days, developers have begun to actively mine the region for land acquisition opportunities, as they do not want to be the last to the table. As the current cycle of construction, which began in mid-2008, comes to an end, there will be little to no new supply behind it, as there were no new construction starts in 2009. Considering projected job growth, positive net absorption over the past two years, a constricted supply pipeline, above-average rental rates and decreasing construction costs, developers’ apprehension to build has been replaced with a desire to take advantage of this window of significant future returns.

William S. Roohan is vice chairman and Andrew C. Boyer is executive vice president of CBRE Capital Markets’ Multi-Housing Group.