December 14, 2006
Tri-county apartment market is hot
By TIM UFKES
Hendricks & Partners
In the last few years investors have turned to the Seattle multifamily market. In that time, we never saw the pent-up demand that we are experiencing today. Many of the largest institutional buyers are clamoring for large, 1980s-vintage buildings and are willing to pay prices between a 4.0 percent to a 4.5 percent capitalization rate the ratio of net income to cost of capital on the seller’s trailing numbers.
The average price per unit is up an astounding 15 percent from last year to nearly $110,000 per unit. Most, if not all investors in these types of properties are planning extensive improvements that involve a $3,000 to $12,000 investment per unit in renovation costs. To recoup the cost of renovation, investors plan on increasing rents $100 to $200 per month.
The investors’ plan is to complete the renovations within the first year of ownership and recapture the entire cost of the renovation in increased rents within three years. Based on an unscientific sampling of these investors, most are planning to exit the market within a three-year window.
Sales near records
Sales volumes for the tri-county market have steadily increased since the crash of the market following Sept. 11, 2001, with a peak in 2005 of more than $2.6 billion. Investment in 2006 won’t be far behind and is expected to be approximately $2 billion. We are likely to see this trend continue as long as population and job growth continue to add demand for housing.
While some of the investment in the for-sale housing market has been speculative, the increased demand has increased housing prices in the Kennewick-Richland-Pasco MSA by 6.0 percent in the year-ended in the third quarter of 2006.
In most residential markets, there is a premium to own when compared to renting. For example, in Southern California a market that is known for having unaffordable housing costs on average the mortgage-to-rent ratio is roughly 2.00. This means if you own, you are paying twice the cost of renting. In the Tri-Cities, the ratio is 1.25, but it has been steadily increasing as more people move into the area and consume the available housing.
As the spread continues to grow, renters are less likely to financially be able to move from the rental market to the for-sale market.
A market driver
It is estimated that downtown Seattle will see its population more than double by 2013. About 9,000 condominiums are being built downtown. I think of the old adage, “build it and they will come.” There are an additional 4,500 units being built in downtown Bellevue and approximately 2,000 in downtown Tacoma.
Demand for land by condo developers has put most urban sites out of reach of apartment developers. There are slightly less than 2,600 new apartment units planned in 2007 and approximately 5,700 units in 2008, which will not come close to meeting estimated population growth.
This all spells higher rents in the near future, with estimates of more than 130,000 new jobs being created and population growth at 7 percent to 9 percent for the next three years, while vacancies continue to drop below 4 percent for most of the Puget Sound region. As vacancies drop, operators will offer fewer concessions and thus less credit loss. Some apartment building owners could see a swing of more than 8 percent to 10 percent in increased income because of higher rents, fewer concessions and lower bad debt.
Flat interest rates
Even with interest rates elevated from a low point in mid-2004 of below 5 percent, capitalization rates have continued to dip even lower. Interest rates have slumped recently from their three-year highs of nearly 6.5 percent to approximately 5.75 percent for long-term fixed debt. At the time of writing this piece, the market is predicting that the Federal Reserve will continue to hold rates at roughly 5.25 percent through the first quarter of 2007.
For existing owners, this represents a huge profit with prices doubling and even tripling since the early 1990s. Many owners recognize that we are likely scratching the top of the market right now. With higher interest rates likely in the near future and capitalization rates surely to follow, this is the optimum time to sell and capture prices that this market has never seen before.
For the buyers in this market, they are betting interest rates will not climb substantially above current levels and they will have time to complete their renovations, stabilize at higher rents and sell these assets at substantially higher prices than we are seeing today.
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