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December 13, 2012
At more than $500,000 per apartment unit, the recent record-setting sale price on the Aspira apartment tower in downtown Seattle speaks volumes about the state of the apartment market. Exactly what is says depends on how you interpret trends in the market.
Multifamily asset pricing, capital markets, demographic trends, and the for-sale housing market will all impact the long-term success of today’s decisions to buy or sell.
Through the third quarter of 2012, King County apartment transaction volume was on track to exceed any level over the last five years, with 64 (20-plus units) apartment sales closed year-to-date with aggregate pricing of approximately $1.2 billion. Many other sales are under contract and expected to close prior to year-end, making 2012 likely to be one of the most active apartment transaction years ever.
The high level of activity suggests that owners and investors are divided on the issue of whether this is a time to load up the portfolio with new acquisitions, or take chips off the table and sell.
Sellers quote that values on certain assets are at all-time highs and cap rates are at historic lows. Newly constructed, well-located properties particularly appealing to institutional investors have reached remarkable pricing levels; well in excess of new replacement cost and at cap rates below 4 percent.
Recent sales of Aspira and Circa Greenlake, both purchased by affiliates of TIAA-CREF, illustrate institutional buyers’ willingness to accept very low yields in exchange for quality real estate in premier locations.
Certainly, these sales represent the leading edge of pricing for apartment investments in the metro area, but other assets have traded at very low cap rates relative to long-term averages. In a broader context, these transactions illustrate the current shortage of investment opportunities that generate a compelling risk-adjusted yield.
While cap rates are low relative to historic averages, as buyers are keenly aware, so too are interest rates on available debt. Fannie Mae, Freddie Mac, life insurance companies and other players are lending to multifamily owners on seven or 10-year terms at rates less than 3.5 percent. And full-term loan rates are in the low 4 percent range.
At the end of the last apartment cycle in 2006-07, many multifamily properties were bought with so-called “negative leverage,” where cap rates were less than the borrowing costs. Today, such trades are rare, as rock-bottom interest rates are providing positive leverage on even the lowest cap rate investments. Further, investors gain comfort from longer loan terms and in many cases, interest-only periods on the front end of the loan term.
With such compelling interest rates on debt, today’s buyers are able to acquire fully occupied, performing apartment assets with projected double-digit rates of return with conservative underwriting of income, expenses and exit pricing.
Supply shock anxiety
Owner anxiety about a supply shock in the Seattle area also plays into sale decisions. A recent CBRE study estimated that approximately 18,500 new apartment units will be delivered to the Seattle area over the next three years. The near-term supply averaging more than 6,000 units per year for the next three years is roughly twice the long-term average for the Seattle market.
Though market occupancy rates are still stable at around 94 percent, some market observers expect some softening of rents with this new supply.
While near-term supply in the Seattle market remains an open question, buyers regularly cite favorable demographic trends as support for apartment rental demand for the longer term. A large percentage of the typical renter population is between 18 and 35 years old, which happens to line up with the Echo Boom. The U.S. Census Bureau projects that group will grow, on average, by 400,000 people every year for the next 10 years.
While the near-term supply issues create some uncertainty, the longer-term outlook for apartment demand appears well supported by the age composition of the demographic. Further, as Seattle performs well relative to other U.S. cities as a creator of new-economy jobs, there is a strong argument that it will capture more than its share of young workers, many of whom will occupy apartments.
As rents in the Seattle area have generally risen between 10 percent and 20 percent over the last three years, and mortgage interest rates continue to be at historic lows, the prospect of a home purchase has become increasingly compelling for many renters. Many current renters recognize that relatively low pricing on homes and historically low interest rates are tipping the balance between whether it is cheaper to buy than rent.
No long-term pessimism
Depending on the assumptions used, many areas of the Seattle metro area are less expensive to buy than rent. Attrition of apartment residents to homeownership had a materially negative impact on apartment occupancy in the heat of the market years, 2004-06, and sellers today see a recurrence of that trend as a distinct possibility.
Apartment optimists cite several countering factors that mitigate the risk of mass movement of renters to owned single-family homes or condominiums. First, many among the Echo Boom generation have come into their financial maturity watching older peers get hurt financially through home ownership. Pricing news continues to be unclear, with seemingly conflicting reports on price changes and foreclosure activity.
Coupling the risk of homeownership (real or perceived) with a current propensity to “de-leverage” and the ever-increasing value workers place on labor mobility suggests that the housing recovery will be slow and steady and less likely to be materially disruptive to apartment operations.
Further, the apartment optimists cite the possibility of tax reform impacting the deductibility of mortgage interest, which effectively increases the cost of home ownership and, all else being equal, creates additional financial incentive to rent.
Finally, the apartment optimist can always counter with the argument that Seattle has permanently become a global gateway market with stable new-economy job creators that will support apartment demand as well as multiple barriers to supply, both geographic and political.
Though sellers may currently have concerns over asset prices, near-term supply and the dynamics of the housing market, it is difficult to project a long-term pessimism about the Seattle apartment market.
Tim Overland is COO with Security Properties, a national multifamily owner and operator that has acquired or developed more than 66,000 residential units in 450 properties over its 40-year history.