Slow and Steady

The Midwest remains fairly predictable as the region's markets gradually rebound. But is it all just relative?

Jonathan Holtzman, CEO of Farmington Hills, Mich.-based Village Green, is more optimistic about the Midwest than he’s been in decades. Not only has he seen occupancy improvements in every major Midwest city, but he believes that this year, a well-located, quality property could achieve higher rental rates than those last seen in 2008.

“The Midwest has experienced the worst and now it’s coming back,” he says. “We didn’t have oversupply of apartments; we didn’t have oversupply of single-family homes or condos, but we had unemployment, so that’s what created our Midwest problem.”

Pointing to a New York Times article he recently read, Holtzman notes that the Midwest is now outperforming other parts of the nation in many respects, as many of these metro areas are seeing job creation faster than other regions.

What’s more, the Midwest stood out in the latest S&P Case-Schiller Home Price Indices in terms of relative strength. Chicago, Detroit and Minneapolis all posted sharp monthly increases, and Detroit’s home prices were up 2.7 percent compared to August 2010, making it one of only two cities (in addition to Washington, D.C.) to post a year-over-year gain. (This gain, though, is fairly small when compared to how far prices had fallen.) Minneapolis and Chicago saw fewer foreclosures, and thus fewer sales and higher prices.

Despite these improvements, though, many Midwest markets still have high unemployment. The state of Michigan’s unemployment rate was 11.1 percent as of September, for example, and many of its metro areas posted even higher numbers. Illinois’ unemployment rate was 10 percent during the same period, while Missouri and Minnesota were both lower than the national average—at 8.7 percent and 6.9 percent, respectively.

As for the apartment market, Holtzman, whose firm owns and/or manages 40,000 units throughout the Midwest and is expecting to break ground on several new communities, believes 2012 is rife with opportunity. “What accounts for the ability to raise occupancies and economic occupancies … is a function of no supply and slow and steady improvements—and that’s really so much the nutshell of the Midwest,” he notes.

Institutional interest in the Windy City

“Of all the Midwest markets, Chicago was the only market that didn’t go off anyone’s radar screens, ever, over the last 10 years,” points out Ralph DePasquale, associate partner in Hendricks & Partners’ Chicago office, adding that Minneapolis is perhaps another exception, as there continues to be a high level of institutional demand and interest (see sidebar).

While vacancies throughout Chicago decreased from 6.6 percent in the second quarter of 2010 to 5.1 percent during the same period in 2011, and concessions have burned off, the downtown market is outperforming the metro as a whole, having actually seen some real rental increases, notes DePasquale. The Loop, for example, saw a 2.2 percentage increase in rents year-over-year.

Some of the suburban markets have seen significant improvements, though, he adds, including Naperville/Aurora (whose vacancy was 4.3 percent in the second quarter and whose rents increased by 2.7 percent year-over-year) and Northwest Cook County (whose vacancy was 4.5 percent and whose rents increased 2.3 percent), which, notes DePasquale, are where the main commuter lines run.

Little to no new development is expected in the suburbs, while the downtown market expects between 3,000 and 4,000 new units to be delivered before the end of 2012, with additional units in the pipeline potentially coming online in 2014 or 2015.

The investment market, meanwhile, has also picked up recently, according to DePasquale. “For quite a while, it seemed like the only thing that was selling were very high-end, institutional high-rises in downtown Chicago. We’ve seen quite a flurry of buildings on the market over the last 12 months,” which are mostly Class A apartments or condominium projects that weren’t completed. Additionally, there are a few suburban garden apartments on the market, some of which DePasquale calls “quasi-institutional,” though for the most part, he notes, the suburbs are comprised mostly of B product.

“Relative to some of the other [Midwestern] markets … Chicago hasn’t seen a ton of foreclosures, especially in larger apartment communities. We’ve seen probably a smattering of a few over the last 12 to 18 months,” adds DePasquale, but the bulk of these are smaller deals.

Well-located suburban Class B or better properties with 200 units or more are trading at cap rates between 5.75 percent and 7 percent. “A lot of what’s driving that is the fact that interest rates are so attractive right now that even a 6.5 percent cap rate can give you a pretty good double-digit, sometimes cash-on-cash, return,” points out DePasquale.

The more suburban-urban markets, those like Des Plaines, Evanston or Oak Park that have their own “mini downtown” areas, for example, are seeing properties trade somewhere between $200,000 and $230,000 per unit.

Meanwhile, downtown Class A deals are priced up to $450,000 per unit, with cap rates between 3.5 percent and 5.5 percent, which “surpassed what we were seeing even in terms of the peak of the market in 2007,” says DePasquale.

While there isn’t much product available on the market right now, there are quite a number of buyers looking for deals, he adds.  “Even for the A stuff—you’re looking at national to regional leveraged buyers that want to take advantage of locking in potentially 4 percent to 4.5 percent interest rates, and they’re just not finding the product to buy.”

In terms of new development, DePasquale believes the strongest markets will continue to be downtown near employment centers. (Unemployment in the Chicago-Joliet-Naperville metro was 9.8 percent as of September.)

“The sentiment among most investors—and one of the reason prices are so high for downtown markets—is that a lot of people are liking that urban feel, and that’s why you’re seeing places like Evanston, Des Plaines, Oak Park and Arlington Heights that have their own small downtowns as an option,” he says.

The market has, in fact, seen some available zoned land come on the market in the last 12 months as well, which is something that used to be very rare, but, as DePasquale points out, this is a function of the economy and the fact that developers have been unable to get construction financing in the last two years.

Positive job growth in Detroit

The economic drivers in Detroit are the opposite of what they were 10 years ago, says Kevin Dillon, associate partner in Hendricks & Partners’ Birmingham, Mich. office.

According to a report by the TechAmerica Foundation, the state of Michigan added more technology jobs than any other state in 2010. “That surprises a lot of people,” notes Holtzman. “It has a lot to do with Detroit [taking] the recession the earliest and the hardest. Everything has started to come back; that’s why job creation is so positive compared to other parts of the country. We were the first in the recession; we were first to come out of it.”

This doesn’t mean things aren’t still depressed. In fact, Detroit-Warren-Livonia’s unemployment rate is still 11.7 percent as of September, but this is down from a peak of 16.6 percent in July 2009. ”It’s the percentage of improvement compared to other parts of the country that stands out,” agrees Holtzman.

The Big Three—Ford, Chrysler and GM—have been adding jobs over the past two years, which trickles into other ancillary industries. In addition, Vanguard recently invested $850 million in the Detroit Medical Center, and an $80 million film studio recently opened in Pontiac. Both developments are expected to create new jobs.

And, similar to other cities, Detroit is “trying to diversify,” says Dillon, “but it’s hard to get away from what you have, and the [auto] industry itself is going through a significant change,” namely the transition to electric vehicles and the need for lithium-ion batteries, which has pushed Michigan to the number-seven spot in terms of number of patents granted in fiscal year 2010, according to Bloomberg. In fact, the state of Michigan received 4,000 patents and was the first state to open a satellite office of the U.S. Patent and Trademark Office.

This all bodes well—at least relatively speaking—for the apartment market. While Village Green was founded in 1919 in Detroit, it hasn’t built an apartment project in the city since the mid-1980s. But the company recently purchased an existing apartment community (to be known as Detroit City Apartments) that it is currently renovating.

“The mass transit rail lines connecting downtown to midtown are proceeding, so we are seeing companies … move out of the suburbs and move downtown,” notes Holtzman. “Detroit is not a 24-hour city yet, but you have to begin somewhere. Village Green is seeing some business opportunities in midtown and downtown Detroit.”

As far as apartment fundamentals, vacancy in the second quarter was 6.2 percent, down from 7.9 percent the year prior. Dillon notes, though, that there are substantial differences between asset classes. The Class A apartment market, he reports, is offering more concessions and has higher vacancy rates than the B and C markets. Most of this is due to would-be residents either looking to purchase distressed condos or single-family homes as well as those looking for better deals in B+ apartments. The market’s overall average rent increase was 1.2 percent.

The market has hit bottom on cap rates, though, according to Dillon. The metro has seen all asset classes trade this year, with top-tier assets achieving cap rates between 7 percent and 7.75 percent and lower-quality properties trading between 8 percent and 9 percent, with the exception of capital expenditures or immediate capital needs.

The buyer pool is comprised mostly of private equity from around the country, though the new buyers are not necessarily new to the Midwest or even Michigan, adds Dillon. “They are specifically looking for cash-on-cash yields that are higher here than they are in other parts of the country, and they believe the strength of the market is improving and that rent growth will be stable for the next five to 10 years.”

As for the future, the increase in job growth is certainly a determining factor for Detroit, as it correlates to higher occupancies and stronger effective rental rates. And the limited new construction also bodes well.

Other positive factors include the government’s work in trying to change the tax code. Gov. Rick Snyder, in fact, recently signed legislation that would cut business taxes, in an effort to spur additional companies to look at Michigan as an alternative spot for relocation.

What could make the market suffer, however, “would be an increase in interest rates that would affect the car-buying market and slow down auto sales,” asserts Dillon. “Something that would be detrimental to manufacturing and the auto industry would be our biggest issue.”

St. Louis continues its
steady growth

The St. Louis metro area is experiencing modest economic growth in the manufacturing, auto sales and services sectors. The unemployment rate improved to 9.1 percent in August of 2011, down from its peak of 11.1 percent in February 2010.

“We do not have dynamic growth in St. Louis,” says Kenneth Aston, Jr., partner in Hendricks & Partners’ St. Louis office. “It’s just steady growth with not a lot of peaks and valleys as far as the economy goes.”

Activity in the residential real estate market continues to decline, and the median single-family home price fell by 8.1 percent in the second quarter of 2011.

Over the last 24 months, meanwhile, apartment rents have increased, with consecutive increases every quarter since early 2010. Rents in the second quarter of 2011 were up 1.4 percent compared to 2010.

Vacancy, meanwhile, is trending downward, after peaking at 9.2 percent in late 2009, reports Andrea Kendrick, associate in Hendricks & Partners’ St. Louis office. Since then, the vacancy rate has improved every quarter. Vacancy was 6.9 percent in the second quarter, down from 8.8 percent one year ago. This is the lowest vacancy rate on record since the third quarter of 2008, and Kendrick adds that the metro expects to see the rate decline even further.

The submarkets of Crestwood/Jefferson County, Bridgeton/Northwest County, Chesterfield/West County and St. Charles County all reported vacancies lower than the market’s average, at 5.1 percent, 6 percent, 5.9 percent and 5.1 percent, respectively.

New apartment construction has been relatively flat throughout the recession. Just 523 new units were added to the market this year, though this is a tremendous uptick from the 38 completions last year. Absorption has been positive for six consecutive quarters and is projected to continue on this trend. Year-to-date absorption is 712 units, up from 562 units recorded one year earlier.

Currently, the major buyers in the metro are regionally based. “St. Louis is a second-tier city, as seen from the eyes of institutional investors,” points out Aston. “It’s a market that investors want to invest in because you can generally receive higher cash-on-cash returns [and] higher capitalization rates.”

Year-to-date ending in the second quarter of 2011, there was $105.8 million in sales volume, which represents six properties, or 1,569 units.

“We haven’t made up the ground yet, but the nice thing is interest rates have continued to fall and now they seem to have leveled out,” notes Kendrick, who adds that investors can get 10-year money 75 percent LTV at 4.4 percent to 4.5 percent interest.

As for the future, Aston points to apartment loan maturities as a potential challenge, though he recognizes this is not unique to St. Louis. “Values have not recovered to the peak. There will be a lot of developers/owners that won’t be able to refinance their properties or come up with the additional capital needed, and that will create a strong purchasing opportunity for investors,” he notes. “Every city is in the same boat. One of the saving graces is the fact that rates are low—that will help the developer bail himself out in some instances.”

Minneapolis: The Bright Spot of the Midwest?

Industry experts in the Midwest repeatedly compare Chicago to Minneapolis, citing the two cities’ diversification, as well as the amount of institutional interest.

The Twin Cities’ job market has held up relatively well, reports Solomon Poretsky, regional manager of Marcus & Millichap’s Bloomington, Minn. office. The unemployment rate in Minneapolis-St. Paul was 6.7 percent as of August, perhaps one of the lowest rates in the region, if not the country.

Additionally, because rents are relatively low and construction costs are relatively high, Minneapolis is seen as a stable economy. “We’re not at the level of New York City or San Francisco … but people doing a flight to quality are looking at Minneapolis,” notes Poretsky.

The metro-wide vacancy rate is expected to reach 2.7 percent, according to the firm’s third-quarter report, though Class A properties will see slightly higher vacancies, at 3.2 percent. Effective rents, meanwhile, increased 2.6 percent year-over-year.

The market is beginning to see some concern, however, because of the number of apartments currently in the pipeline, points out Poretsky, whose estimates are approximately 8,500 units over the next five years. “It tends to be concentrated toward high-A—A and A+—properties, so there’s some question of whether we’ll generate enough demand in the short-term to fill every one of those units as they come along.”

Sales velocity is trending up this year, reports Poretsky—about a 40 percent increase. He notes that the interest has been from both institutions and those seeking out C stock, where there are many smaller private assets. Average cap rates rose to the low-8 percent range, though top-tier assets have traded in the mid-5 percent to low-6 percent range.

While the metro surely remains a bright spot in the region, Poretsky does note that potential challenges could arise “in the A space, because of the new development, which will get a little tougher if you’re not a strong operator and manager,” he predicts.

“We will never be overbuilt in apartments, but there will be certain areas for a short period of time, that will be overbuilt with apartments.
I think you’ll see some concessions in very limited localized areas.”