The D.C. Market Is Alive and Well

Strengthening already-tight fundamentals and a flood of capital has brought cap rates in the D.C. metro area to new heights.

The Washington, D.C. market has been one of the strongest in the country for job growth, and it has added jobs at a higher clip than other markets. “We think that will continue to be the case as the federal government expands and government-related job opportunities continue to grow,” reports T. Richard Linton, Jr., president of Harbor Group International.

Performance does vary by submarket, though, adds K. David Meit, CPM, principal of Oculus Realty LLC, a firm that provides alternative multifamily investment, management, and consulting services to investors and that specializes in managing rent-regulated apartment buildings in the Washington, D.C. metropolitan area.

“The unemployment rate in the District is actually higher than the national average, whereas the MSA is lower than the national average,” he points out.

The Department of Labor’s Bureau of Labor Statistics reports that the District of Columbia had a 9.8 percent unemployment rate as of November 2010. At the same time, the Washington-Arlington-Alexandria metro experienced a TK percent unemployment rate.

From October 2009 to October 2010, 43,700 jobs were added to the Washington, D.C. metro area, according to Stephen S. Fuller, director of the Center for Regional Analysis at George Mason University (source tk).

The district was the number-one ranked metropolitan area for job growth in the country (source tk), with suburban Maryland ranking third (Northern Virginia ranked 25th), reports Robin Williams, senior vice president and director of the Mid-Atlantic Multifamily Group of Transwestern.

The demographics of the metro comprise young professionals in the financial sector and in the government, as well as healthcare and education. In addition, “traditionally, whenever there is a major shift in party control, everyone will get a bit of a bump. [People] who come to work on the hill … don’t necessarily leave, but you have an influx of a whole bunch of new people,” which is likely to lead to an increase in occupancy in the first quarter of next year, points out Meit.

“When investors are looking for their acquisitions or we’re looking at doing our deals,” he adds, “it’s actually very important to take a look at specific submarkets. It’s a tale of two cities.”

Strong fundamentals

Vacancy for investment-grade Class A and B apartments was 2.5 percent as of the end of the third quarter 2010, down from 4.9 percent a year ago, according to Delta Associates’ Washington/Baltimore Apartment Outlook. While job growth has certainly been a huge factor in the market’s tightness, the lack of new construction has also helped. In fact, Delta is predicting stabilized vacancy for the Washington Metro to be near 1.4 period by the third quarter of 2013.

“There was a decline in construction starts as our economy started to wane,” notes Dean Sigmon, senior vice president and director of the Mid-Atlantic Multifamily Group of Transwestern. “Now that the market has regained pretty significant growth in occupancy and rents, you’re seeing a lot of those [projects] that had been stalled coming back into the pipeline; you’re seeing the race to get these started in the next two years.”

Taking this into consideration, The Bozzuto Group recently announced a joint venture with The Peterson Companies to build the first apartment building in the 300-acre National Harbor in Prince George’s County, Md. The 350-unit community is slated to break ground in the fall of 2011.

“We decided 12, 13 months ago, that things were slow and nothing was getting done, so we were going to put together an equity fund to buy assets below replacement cost,” recalls Toby Bozzuto, president of Bozzuto Development Company.  “As long as you could buy cash-flowing projects below replacement cost, you would do that first.”

But, he adds, “between January and March … the few projects that were for sale got run-up in value so you could no longer buy; that signaled that maybe development was worth it. If you tie up a project now, it takes two years to build so you’re talking delivery 2013-15. You’d be delivering perfectly into a supply-demand imbalance,” which is what the company is banking on.

The District’s Class A vacancy rate was 3.6 percent as of the third quarter, with Delta noting a significant variance among submarkets. The Columbia Heights/Shaw submarket posted the lowest vacancy at 2.5 percent, with the Capitol East submarket experiencing the highest vacancy, at 6.6 percent.

While the District has the lowest vacancy rate within the MSA, Dupont Circle, Adams Morgan and Woodley Park/Cleveland Park have shown very strong rent growth due to their desirability, according to Meit.

Meanwhile, Northern Virginia’s vacancy stood at 2.5 percent, as of September 2010, and suburban Maryland had a vacancy rate of 3.9 percent, the highest in the metro area. Baltimore reported Class A vacancy at 3.6 percent, down 60 bps year-over-year, according to Delta.

Metro-wide, rents increased 7.3 percent over the past year. Class A rents rose by 7.1 percent during this period; high-rise product inside the Beltway increased by 3.6 percent, while low-rises outside the Beltway saw an 8.8 percent increase. Williams reports that studios and efficiencies appear to be renting at a faster clip than other unit types.

Overall District rents were up 2.5 percent, with the largest increase seen in the Capitol East submarket, at 5.3 percent, according to Delta’s report. Concessions in the third quarter of 2010 were 3.2 percent of asking rent, compared to 6.3 percent the year prior.

“Class B rent growth has been almost in parallel with Class A rent growth,” reports Williams, “with the exception of maybe some double-A assets that exceeded some of those other market classes.”

Meanwhile, rents in Northern Virginia increased by 8.6 percent over the past year, with low-rise properties experiencing the highest growth, at 9.4 percent, according to Delta. Rents in Suburban Maryland increased by 6.4 percent over the past year, though some submarkets posted increases in excess of 10 percent.

In the Baltimore metro area, rents grew by 9.5 percent in 2010, with the northern suburbs experiencing 12.7 percent growth in effective rents during the same period, and the Fells Point/Inner Harbor submarket posted gains of 15.8 percent.

In general, A and B assets tend to outperform the C product, Linton reports, and key factors that tend to contribute to high performance levels include proximity to the metro or the Beltway, as well as employment centers. “Properties closer to the metro, on the Beltway or inside the Beltway have generally recovered more quickly than the more suburban assets in Maryland or Virginia,” he points out.

A record-breaking 16,476 Class A and B apartments were absorbed this year, mostly as a result of a surge in Class B absorption. In fact, Delta reports that this is the first time Class B absorption has outpaced Class A absorption.

“Right now, Class B is stronger than Class A because people are remaining very value-conscious,” Meit points out, adding that there is about a 30-bp difference between occupancies in the classes—5.8 percent and 5.5 percent for Class A and B, respectively. Delta Associates, however, predicts that these Class B residents represent future Class A renters, as consumer confidence gains ground.

The value-add play

Transaction volume in Washington, D.C. was up significantly throughout 2010, compared to 2008 and 2009, according to Delta Associates, which reports that $1.3 billion worth of Class A assets traded in 2010, with $95.9 million of land sales recorded in the third quarter.

However, there were fewer deals on the market at the end of the year. “Other than rare core-type assets, which would still gain very aggressive levels of interest, we’ve seen a slight pullback in the level of activity that we had seen this summer,” reports Williams.

While local investors are certainly interested in the market, institutional capital is also looking at D.C. “There’s been a lot of capital buildup on the sidelines that’s looking for good places to invest in,” Linton notes.

Average cap rates for the metro area are sub-6, but, as Meit points out, “some of the value-add stuff … is going from 7, 8, 9 percent caps, but you have Class A deals for 3.9 percent caps, and some of the new product that is beginning to trade is sub-5. That’s where you’re getting the 6 average, but there is nothing at a 6. It’s all 7and 8 and above, and 5 and below.”

Harbor Group International recently acquired the 320-unit Hanover Apartments in Greenbelt, Md., for $39.45 million. “We’re very bullish on that location,” says Linton.” It’s right off the 495/295 Beltway, and it’s very close to significant job drivers and employment centers in that immediate market.”

But it’s not just the location that was a deciding factor in this transaction; in fact, Linton notes, there was a specific asset play. The previous owner had begun significant interior renovations, generating “meaningful rent premiums” from the process.

This value-add play has been noted around the metro area. According to Delta, more than 18,000 units in the Washington metropolitan area currently have substantial renovations planned or ongoing, with an average renovation budget of approximately $20,000 per unit.

“When investors believe the value of buying something at a 5-cap really doesn’t work, they will start to gravitate toward value-add opportunities, more in the 6-6.5 cap range,” acknowledges Sigmon.

Meanwhile, investment in the southwest quadrant of the district is bleeding over into the southeast, according to Meit, “where a lot of people are very interested in doing acquisitions in this old product.” He adds, “there’s a lot of emphasis on providing better-quality housing; that’s bumped up a lot of value-add investment that people have made,” which, he notes, is good news for the construction renovation industry; once construction picks up, a lot of these workers will return to renting these apartments.

Despite this, Linton notes that it has become increasingly difficult to buy new assets in the D.C. metro area because “there is a flood of capital that is flocking to D.C., making pricing challenging. People are paying up to invest in the D.C. market.”

Cap rates have fallen about 200 bps since the market hit bottom. Core deals inside the Beltway and within infill locations are trading in the high-4s and low-5s. As Linton notes, “these are the same types of cap rates that people were paying at the height of the market.”

A bright future

While the metro’s future seems bright, the low cap rates could prove risky. “To make those returns work, you’re relying on cheaper cost of financing and cheaper cost of debt,” Linton points out. “It’s not so clear that cost of debt will be so cheap in the future.”

Sigmon agrees. The possibility of interest rates continuing to rise could “spook some deals,” he says.

And, notes Bozzuto, “the next shoe to drop will be that construction prices will far exceed what some people are penciling in as costs in their pro forma. There will be such a run on subcontractors in the next 12 months that we’ll be in another period of hyper-activity; to go into a project and not be cognizant of the fact that higher construction prices are going to exist in the market would be really dangerous,” he warns.

Another risk to the metro includes the fallout resulting from the deficit reduction. “If that resulted in very significant job cuts or a retraction in government jobs, then that could have an impact,” says Linton. “But,” he adds, “I think we’re a long way to the types of deficit reduction and job cuts that would create an issue in the apartment market.”

As Meit notes, this might not even have a truly negative consequence. If the President decides to hold off on raises, for example, Meit predicts that the “good talent will go to the private sector, and that will just bolster commercial [real estate], which in the end bolsters residential.”

The Philadelphia market

The Philadelphia economy has always been very stable, according to Joseph Brecher, executive vice president at Gebroe-Hammer Associates, which recently closed two transactions in Philadelphia, involving a total of 209 units for $10 million.

The diverse economy means there is not one single significant economic driver. “That’s why office vacancy rates haven’t been as large as other markets,” says Brecher. “It’s affected positively the apartment market.”

Metro-wide occupancy is approximately 95 percent, though Brecher points out that suburban assets tend to have larger vacancies than those in the city. “We’re talking over a whole region and metro area, so there are peaks and valleys, but in stable markets … such as Northeast and Northwest Philadelphia, [which have] always been B markets, occupancy has stayed steady in the high 90s.”

Center City, meanwhile, experienced a spike in vacancies and a drop in rents—between 10 percent and 20 percent for top-tier communities. At the same time, the shadow market has only really affected Center City.

Brecher notes that the metro has not seen much sales activity in the B market. “As pricing has obviously come down for apartments, that has affected the volume,” he says. “Sellers aren’t interested and not in real distress,” and the aggressive prices they are seeking are not in line with reality.

There has, however, been a rise in foreclosure sales and sheriff sales for distressed B and C assets. “For the really distressed properties in C areas … the buyer says, ‘I have a lot of work to do, but I am getting it for pennies on the dollar.’”

A recent Class B transaction that sold in Northeast Philadelphia traded for just above a 7 percent cap rate, for example, Brecher reports. This is off from the 6 percent and below seen at the cycle’s peak.  And unlike the D.C. metro, most of the interest for stable assets has come from local and regional investors.