- Dec 15, 2013
Did you know that the second tightest rental market in the country is Minneapolis? Or that big real estate investors are acting as though Detroit is no longer in bankruptcy? The Midwest lagged in its apartment recovery, but there are locations that are now gaining traction. Here are reports from three markets in the nation’s heartland.
In the heated world of real estate today, Chicago is an alternative to other gateway cities. “Compared to coastal cities, where cap rates can be in the three percent range, Chicago is still a bargain,” explains David Hendrickson, managing director, Jones Lang LaSalle. “Investors look at Chicago and say, ‘We can invest in a “big city” with a real downtown, a 24-hour streetscape, and get that for 4 or 5 percent cap compared to purchases in New York City.’”
As in other top cities, there are signs of a supply-driven blip in the Windy City. Given this much new construction is coming on, the bad news is that experts certainly expect a dip in the Chicago apartment market, and the previous rent growth levels of 5 to 6 percent may be a thing of the past. The good news, however, is that any underperformance is expected to be mild and short-term just because the level of demand for urban living in Chicago is supposedly so strong.
Over the longer term, about 25,000 multifamily units have been proposed, says Hendrickson. “Typically, half of that will get delivered. The reality is that it takes so long to obtain zoning and financing, that 25,000 units may take seven to 10 years to complete.” Hendrickson surmises that 12,000 to 15,000 units may be delivered over the next five to seven years, but that is not a significant number of supply compared to the level of demand in the market.
According to Greg Willett, vice president, Research and Analysis, at MPF Research, in the first three quarters of this year, 2,326 units were delivered. Willett says there is currently a total of 8,441 multifamily units under construction in the Chicago market. This volume will increase the metro’s multifamily stock by 1.2 percent, according to MPF Research.
The increased supply this year will result in a short-term hike in vacancy of 1 to 1.5 percent in the next six to nine months, suggests Hendrickson. There may even be a few concessions, he says. However, the new supply should be absorbed by the end of nine months, and any concessions should end by then. “Ultimately, there are more people wanting to live in the city than there are apartments. Therefore, any oversupply will be temporary,” Hendrickson says.
Willett agrees, “Look for a mild dip in Chicago’s occupancy rate during the next couple of years, as the metro gradually digests the new product that will be brought on stream,” states Willett. Annual rent growth of 5 to 6 percent in 2011 and through the first half of 2012 will fall to a reasonably healthy rent growth rate of 2.5 to 3 percent. This level appears achievable depending on the submarket, according to Willett.
The middle-market apartment properties in the surrounding suburbs are where the highest value increases are expected to be concentrated. “Very solid rent growth numbers are anticipated for these markets,” Willett adds. On the other hand, “top-end properties in the urban core may be hard pressed to realize more than just slightly positive pricing shifts,” Willett says. This is understandable, as a full 68 percent, or 5,756 units, of the units currently under construction are concentrated in Chicago’s urban core neighborhoods—for example, The Loop area, Streeterville/River North and Lincoln Park/Lakeview, according to MPF Research.
Keep in mind that for investors, Chicago apartment properties are still a good deal. According to Hendrickson, multifamily property cap rates are 4.75 to 5 percent in the Central Business District, and 5 to 5.25 for the rest of the metropolitan area. Despite the expected rent growth slowdown, investment sales activity in Chicago is very strong if not aggressive, he says, driven by low debt cost and investors seeking alternatives.
Minneapolis has the distinction of being the apartment market with one of the lowest vacancy rates in the country. “We are the second tightest market in the country. Only the New York market is tighter than ours,” boasts Julie Lux, associate vice president in investment sales, Cassidy Turley.
The city’s apartment market is impressively tight; however, don’t let that fool you. The irony is that rent growth in Minneapolis is traditionally not as high as such strong occupancies would suggest. In the third quarter, consider that the Minneapolis vacancy rate was 2.5 percent, an uptick from 2.3 percent the quarter before, according to Lux. But in terms of rent increases, although rent growth did reach about 6 percent during 2011, effective rents for new leases were up just 1.8 percent year-over-year, adds MPF
The reason for the tamped down rent growth in Minneapolis is not only new construction, but rather tradition, suggests Lux. In Minneapolis, “it’s a very conservative market here. There are large portfolios of family-based owners” who focus on occupancies rather than rent growth, Lux says.
Like many other cities, Minneapolis is also seeing a lot of new construction. According to MPF Research, 7,377 units are under construction—translating to a 2.8 percent increase in inventory in the near term. “That’s not an especially aggressive building pace compared to the levels posted in many other spots across the country, but by local standards it’s phenomenal: about four times the 20-year norm,” Willett says.
The core areas may have difficulty seeing additional rent increases, however. Almost two thirds of the new supply that is on the way will be completed in the urbanized Downtown/University and Uptown/St. Louis Park neighborhoods. As such, while new projects will perform very well, Willett maintains that existing properties in these urban neighborhoods may not get real rent growth while “that many units move through initial leaseup.”
Both Willett and Lux appear optimistic that the tight Minneapolis market may be able to sustain the huge amount of new inventory. “The depth of demand for urban product in Minneapolis has never been tested to a meaningful degree,” says Willett. However, he asserts that “the area looks chronically starved for new supply.” Indeed, so far, apartment absorption has been strong: 1,675 units were delivered in 2013 through the third quarter—and 2,317 units absorbed, Lux says.
Lux points to the outstanding strong economic fundamentals of the Minneapolis-St. Paul Twin Cities, which has one of the lowest unemployment rates in the country. And Minneapolis-St. Paul is the headquarters for an impressive roster of Fortune 500 corporations, including Target, UnitedHealth, U.S. Bancorp, 3M, General Mills, Land O’Lakes, Hormel Foods and Best Buy. The unemployment rate for Minneapolis is 4.8 percent, compared to a national average of 7.2 percent. Job growth this year is projected to be 41,000 jobs—a 2.3 percent growth, Lux says.
If anything, corporations will be expanding, and hiring is on an upward trajectory, Lux suggests. “Corporate profits are up. Businesses have been waiting on the sidelines and holding off, but we are more comfortable at this point with starting to see expansions.”
Appropriately, the investment market is very hot at the moment. The family owner-operators in the market also tend to hold onto the properties rather than sell. For that reason, “there are barriers to entry in terms of finding quality assets to buy in the market,” Lux says. “It is a very attractive market to invest in, but there is a shortage of quality listings, so transactions that come on are very competitively bid.”
Cap rates range from the mid-5 percent range for Class A properties to mid-7 percent range for Class C properties, says Lux. Class B properties may be found with the cap rates in the low-6 percent range. Lux says the market is beginning to see more “first time” apartment property buyers in the market from out-of-state.
Still think Detroit is hopelessly distressed? That is an incorrect assumption. In fact, the bad press about Detroit is focused on the fringes of the city. Outside of these regions, the other neighborhoods of the Detroit metropolitan area—downtown Detroit and the surrounding suburbs—are, believe it or not, economically quite strong.
“People cannot find places to live in downtown because all the apartment properties are full,” says Christopher Futo, senior associate, National Multi Housing Group, Marcus & Millichap. Employers, he says, are moving into the city center, and investors are building apartments and lofts. The apartment market in downtown, says Futo, has “really taken off.”
Indeed, the apartment statistics for the overall Detroit metropolitan area, are pretty mainstream. According to Marcus & Millichap’s apartment research, the apartment vacancy rate for Detroit was 4.7 percent, and rents increased a significant 7.4 percent in 2012. MPF Research’s Willett reports that apartments in suburban Detroit in particular have registered an occupancy rate of about 96 percent since mid-2011. Annual rent growth was 4 to 5 percent in 2011, and about 2 percent more recently—still fairly healthy.
Ironically, while the city is placed under bankruptcy, the overall economy had been improving in the recent past. Willett points out that while annual job production accelerated to an annual 40,000 to 50,000 positions from 2011 to 2012, “it has slowed to about 10,000 positions this year.” Nevertheless, PNC Financial Services Group forecasts that the Detroit economy, still largely manufacturing-based and tied to the nation’s fitful recovery, will be “steady,” though “unspectacular” in the near term.
Unlike other cities, there has not been a big construction push in the overall Detroit metro. This year, “developers are expected to complete about 500 rental units, down slightly from the 572 units last year,” according to a report from Marcus & Millichap.
But Detroit downtown is vibrant. Much of the construction activity here is focused on the rehabilitation of older or vacant buildings for conversion into luxury rentals. Bankruptcy or no, major revitalization efforts are underway to improve streets and parks, and a light rail is in the works.
Not surprisingly, investors, including Quicken Loans Chairman Dan Gilbert and Shanghai-based DDI Group, have reportedly been swooping down to buy properties in downtown Detroit for conversion into residential, mixed-use or other uses. “Investors see downtown as a great place to put their money. If a property is of quality, it [is likely to be] snatched up before any broker sees it,” says Marcus & Millichap’s Futo.
Cap rates can be as low as the high-5 percent range in the suburbs, while investors are targeting cap rates in the 9 percent range and up for older properties in the downtown, Midtown and New Center areas that they can convert to rentals, according to Marcus & Millichap.
“With only a handful of new units” coming on stream in Detroit in the near term, “look for occupancy to remain in very good shape,” asserts Willett. He projects “moderate” increases in rent growth in line with the metro’s pace of general economic expansion.
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