Texas: the “Magnet State” for Business

Population growth and excellent business appeal in the Lone Star State make up the ingredients for a strong apartment market.

Boulevard, in the University Crossing neighborhood of Dallas, designed by Humphreys & Partners Architects

This year, Texas took top honors on CNBC’s list of Top States for Business. The state is home to more Fortune 500 companies than any other and is known for its many business tax incentives.

And, for the sixth year, Texas topped the list as the number-one “magnet state” in 2010, with the highest net relocation gains in the nation, according to Allied Van Lines’ Annual Magnet States Report, which tracks migration patterns.

Additionally, 11 of the top 25 metropolitan areas on the 2010 Milken Institute Best-Performing Cities Index (whose components include job, wage and salary, and technology growth) were in Texas.

“We are spending a lot of time and resources in the Texas market to try to find some opportunities. We view Texas as the bright spot of job growth in the U.S. right now,” says Brian Earle, partner at AREA Property Partners, a real estate fund manager that has recently acquired approximately 4,000 units throughout the state.

State-wide unemployment remained steady at 8.3 percent, as of December 2010, according to the U.S. Department of Labor.

“The four major markets (Austin, Dallas, Houston and San Antonio) are consistently ranked as the most desirable locations for multifamily from the investment side, and a lot has to do with the business climate, as well as the overall climate,” adds Walter Montague, a broker in Cushman & Wakefield’s Houston office.

“Each metro offers different attributes that we like,” Earle adds, pointing to Austin’s tech base and entrepreneurial culture; San Antonio’s stable economic base; and Dallas’ diverse employment and lack of new construction, for example.

That said, he acknowledges that pricing has become more challenging as more real estate investors are drawn to the area’s growth opportunities.  “Cap rates are still in the low 6s—some of the higher-end [product] might be in the high-5s,” says Earle. “A core buyer can buy in the high-5s, finance in the low-5s ,and with some rent growth feel like they can get 8 or 9 or 10 leveraged IRR. That’s good business for core buyers these days.”

Dallas/Fort Worth’s strong employment

Dallas’ ever-expanding employment base is a huge draw for multifamily investment, according to Lamont Rattler, associate director in Cushman & Wakefield’s Addison, Texas office. This is, at least in part, due to 24 Fortune 500 companies headquartered here, including JCPenney, Texas Instruments and Southwest Airlines.

And, with an unemployment rate of 8 percent, as of December 2010, the city is projected to add 75,000 new jobs this year.

“What is increasing the operating fundamentals on the apartment side is the growth in employment, especially in Class A,” notes Rattler. “What jobs are being attracted right now are more of the white-collar jobs, so we see Class A properties are really benefitting from that growth.”

Compounding the metro’s job growth is the relative lack of new construction. The number of deliveries scheduled this year for Dallas is forecast to be fewer than 4,000 units, which Brian O’Boyle, founder and managing broker of ARA’s (Apartment Realty Advisors) Dallas office, says is the lowest level the metro has seen in 18 years.

Overall occupancy in Dallas in the fourth quarter of 2010 was 91.5 percent, while Fort Worth experienced 90.8 percent occupancy. The projection for this year, according to O’Boyle, is an increase of 200 bps, for an average occupancy of 93.5 percent by the fourth quarter of 2011.

Meanwhile, same-store rents in the metro are projected to increase about 3.3 percent, according to ARA’s Dallas Market Update 1Q2011.

Demand for apartments is also picking up, as recent college graduates begin to find jobs, reports O’Boyle. In addition, Dallas is seeing a “decoupling of roommates,” as well as a relatively small number of single-family home starts. (Between 2000 and 2007, single-family starts ranged between 30,000 and 50,000 per year, while today it is fewer than 10,000 starts per year.)

A joint venture between AREA Property Partners, Prescott Realty Group and Northwestern Mutual recently broke ground on a mixed-use development in Dallas, near the campus of Southern Methodist University (SMU). The project, which will create 417 apartments and 9,100 square feet of retail, is to be the latest phase of the University Crossing area revitalization.

“We have been working in that neighborhood for a number of years … and we are very enamored with the growth of SMU. We like to invest near major universities and major healthcare systems. We’re an advocate of gentrifying neighborhoods … with excellent access to universities [and] transportation,” says Earle.

In terms of number of transactions, 2010 saw more activity than 2009. Many of these deals, Rattler notes, have involved special servicers or banks. “You either have real high-end properties … [where] projections or pro formas didn’t hit their mark … or you have the Class C units that the banks don’t want to hold on their balance sheets.”

The biggest buyer pool for Class A and B assets appears to be high net worth individuals and private equity funds, reports O’Boyle. While institutional investors may be involved, Rattler notes they are doing more recap, off-market deals.

Cap rates for infill locations, meanwhile, are trading in the 5 percent range, while suburban Class A deals achieve between a 6 percent and a 6.25 percent cap. Meanwhile, the Class B deals tend to trade slightly higher, between 6.75 percent and 7 percent. But Rattler isn’t convinced that cap rates are a good barometer for the market, as so many of the deals were distressed.

“We’ve got a tremendous number of new buyers coming through our office … that are bullish on the operating fundamentals that Dallas has,” notes O’Boyle. “Outside of the coastal markets—the East Coast and West Coast—Dallas has one of the best long-term fundamentals of any other market.”

Rattler agrees. “The outlook is good, overall, for Dallas. Investors want to come here; they like the growth scenario,” he says. “Value-add properties work now; you will start to see some benefits from low new supply. You are going to start seeing that value-add scenario make sense.”

Austin’s lessons learned

Austin is poised for an extremely strong economic recovery, according to ARA’s Year-End 2010 Austin market report.

“It’s not that we didn’t get hit hard [by the recession],” points out Patton Jones, principal in ARA’s Austin office. “It’s that Austin took its pain from the tech bust. … The economy was more diversified when this recession came.

“We feel that the multifamily world will tighten really nicely within the next two to three years, so the city may see 5 percent to 7 percent rent growth annually for the next three years. That’s hard to find in the U.S.”

In the last 12 months, 30,000 people have moved to Austin, and the city experienced a record absorption of 7,500 units, reports Jones.

As of December 2010, the unemployment rate for the Austin-Round Rock-San Marcos MSA was 6.8 percent, down 30 bps from the month previously, according to the Department of Labor.

“We are coming off heavy supply and going into an environment of zero supply,” Jones points out. “When the recession hit, Austin was seeing heavy apartment development, delivering 7,500 [units] annually between ‘06 and ‘08. Today, there are zero conventional units under construction in Austin.”

With this lack of new supply, the market is beginning to experience aggressive concession burn-off and increasing net rents. Annual rent growth across the Austin MSA market was 7.01 percent, according to ARA’s report. The CBD submarket, however, experienced a 15 percent annual growth rate. But, notes Jones, the city as a whole has not made up the difference just yet, as rents slid about 10 percent between 2008 and 2009.

At the same time, while occupancy dropped to 88.7 percent in 2009, 2010 saw a slow, steady improvement; citywide occupancy at the end of 2010 stood at 93.6 percent.

Meanwhile, the investment market has seen Class A assets trade at a 5 percent cap rate, with those in urban locations trading at slightly lower rates than those in the suburbs. Class B deals are trading at approximately 6 percent.

The highest sales prices have occurred in and around the CBD, according to Jones, where Class A product has traded between $150,000 and $180,000 per unit. Suburban Class A product ranges between $75,000 and $85,000 per unit, while Class B product has traded in the $40,000 to $50,000 range. Class C apartment transactions have averaged between $15,000 and $35,000 per unit.

Jones adds, “The current owner/operators are still bidding on product because they feel Austin is one of the best place to reinvest their dollars—and we’re getting plenty of new interest from private, wealthy families who are first-time Texas buyers that typically would buy in Arizona or Nevada.”

While Austin is aggressive in recruiting employment from other states and has also been a major beneficiary of the green energy movement, Jones points out that the city’s infrastructure is not keeping up with its growth. “Our traffic is as bad as California’s, because we have lakes, hills and environmentalists—you cannot just lay down a road in Austin.”

Houston diversifies

“Economically, Houston is still a little sluggish, but it feels like it’s picking up as the oil and gas industry prepares for this next run,” says David Oelfke, founding principal in ARA’s Houston office. “The largest driving factor [for Houston] is the energy sector … A lot of these shale plays are creating a ton of activity and demand, and certainly now with oil and gas prices over $100 a barrel, I think it’s really going to take off here in 2011.”

In addition, Montague points to the growing presence of the medical center as a driving force behind Houston’s expanding economy. “In the past, we lived and died by the energy sector, and we’ve learned to try to diversify our economy.”

Job growth next year is expected to be between 50,000 and 75,000 new jobs. In addition, the market absorbed nearly 16,000 units in 2010, reports Oelfke, while only 3,400 units were delivered. Perhaps part of this is due to the metro’s tremendous population growth; Montague notes that the Houston MSA has grown by a million people over the last decade and is projected to grow at that clip for the next few decades.

Rents increased 1.9 percent, according to ARA’s 2010 Houston report, though concessions continue to be offered market-wide. Meanwhile, the overall market is close to 87 percent occupancy, though  Class A properties have reached occupancies in the low- to mid-90 percent range, says Oelfke. Class C properties, meanwhile, are in the low-80 percent range. The good news, however, is that the construction pipeline is minimal, with only 1,737 units currently under construction.

Transaction activity is somewhat slower than Montague had expected. “We do a lot of valuations; we’re busier than we’ve ever been, but a lot of people are dipping into the water very slowly and want to make sure they get their product into the market at the right time,” he notes.

Oelfke points to the abnormality of 10 Class A transactions sold to 10 different buyers, all in the second half of the year. “There was no supply out there, so many of these large institutional funds and REITs had raised substantial amounts of money and were feeling pressure to do some deals,” recalls Montague.

Cap rates ranged between 4.5 percent and 6 percent. (The 6 percent caps, he says, are deals that sold in early 2010, while the 4.5 percent caps were in the middle of the year.)

Last year, however, the low interest rates tended to drive cap rates down. “Today, [with] those same deals, you’re looking at 50 bps difference in financing—maybe even more,” says Montague. “It’s hard to buy a 5.25 cap property and then go put debt on it at 5.8 or 5.9. The real fear for the market is what’s going to happen with Treasuries and where will interest rates go, because if they start to creep up, that will affect valuations for all assets, but mainly the Class As that have been trading sub-6.”

Today, more local and small investors are looking at the value-add play in the A world, points out Montague, with some in the industry believing there isn’t much interest in the stabilized B and C assets, though he doesn’t necessarily agree.

“Traditional B-Class assets that are in strong to medium locations—I think those can command good returns as long as there’s a story. People would pay 7 to 7.5 caps on those if there’s not a lot of deferred maintenance or they can do certain upgrades to raise rents. The problem is we haven’t seen that many of those hit the markets, and when they do, they traditionally get scooped up quickly.”

Montague believes the greatest investment opportunities exist in development sites. “Everyone is looking for the irreplaceable location,” he notes. “Houston has had a long history of being very developer-friendly. We don’t have zoning, so if you’re in an area that’s not deed-restricted … you’re able to build what you want there.”

To comment, email Erika Schnitzer at [email protected].

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