Annual effective rent growth for Class A properties continues to slow. Construction starts for identified apartment properties declines. Rising construction costs render new apartment projects uneconomic.
As 2Q 2013 began, national effective rent growth softened to its slowest pace in the past 32 months. The growth rate had held fairly steady between 3.53% and 3.84% from June 2012 to February 2013, slowed to 3.22% in March 2013, and declined to a low of 3.11% in April 2013. While effective rent growth was weaker than in prior periods, the occupancy rate continued to strengthen, with a national average of 94.60% in April and with 44 of the top 88 Metropolitan Statistical Areas (MSAs) generating an average rate above 95.0%.
Class A properties continue to be a drag on national rent growth. Annual effective rent growth for these properties slowed to 2.8% in April though occupancy increased from 95.0% in March to 95.12% in April. There was very little separation between Class A occupancy (95.13%) and Class B occupancy (94.96%) in April. However, Class B properties increased effective rents at a slightly better pace–3.2%–than Class A properties over the past year, but fell behind Class C properties, which produced a growth rate of 4.0%. Class C properties also have the best absorption rates, and this trend will likely continue as the occupancy rate still averages just 93.2%.
One of the questions we are constantly asked is whether the market will get oversupplied. Our forecast is for supply to begin to slow over the next couple years, which we outline in the Pipeline section of this newsletter. The primary drivers for this are increased construction costs, declining Class A rental rates, and oversupply in core submarkets. .
This month’s newsletter features an article from our research partner, Dr. Sam Chandan. Dr. Chandan is President and Chief Economist of Chandan Economics (www.chandan.com) and an adjunct professor at The Wharton School, University of Pennsylvania. Sam works closely with our advisory clients to help test and refine their goals and strategies (click here for more information).
Apartment Mortgage Cap Rate and Interest Rate Spread
Exceptional inflows of capital to the apartment sector showed no signs of letting up in the first quarter, reflecting investors’ bullish outlook even as rent growth displayed signs of coming off its peak. National average cap rates were practically unchanged at 6.1%. However, cap rate spreads over Treasuries narrowed as the risk-free benchmark inched up. For properties valued above $10 million, the average cap rate was just 5.5%. Institutional trades pushed cap rates in major markets below 5% with increasing regularity
In support of small- and mid-cap investment, underwriting standards eased in response to competition between agency lenders and banks. Debt yields on multifamily mortgages originated during Q1 2013 registered a new low, falling below an average of 9.0% for the first time on record. The prevalence of interest only and partial interest only loans also increased. Working with banks, life companies, agency lenders, and conduit lenders, borrowers raised $11.26 for every dollar in net operating income during the first quarter, up from $11.15 during Q4 2012.
Investors in Manhattan apartment buildings had the best access to financing of any primary market or submarket. Manhattan was followed by Seattle, Los Angeles, Boston, and San Francisco. Measured in terms of loan structure and pricing, Miami rounded out the first quarter’s list of top 10 most liquid markets. Interest rate and maturity credit risks are on the rise, most observably in Washington DC. For now, those considerations are dominated by investor enthusiasm about the apartment sector’s long-term prospects.
Effective Rent Growth
Nationally, annual effective rent growth has been moderating since July 2011. Effective rent growth has declined from 3.22% in March to 3.11% in April. The annual growth rate was 4.14% a year ago. The peak annual growth rate at the national level was 5.32% in July 2011.
Fourteen of the top 88 MSAs had an annual growth rate greater than 5.0%, including Oakland (8.16%), Denver (6.46%), San Jose (5.99%), and Houston (5.84%). Only four MSAs had a negative annual growth rate: Tucson (-0.51%), Albuquerque (-0.53%), Mobile (-1.03) and Little Rock (-1.06). More details on top and bottom performing MSAs can be found at the end of this newsletter.
Asking Rents and Concessions
Nationally, annual asking rent growth declined from 2.24% in March to 2.17% in April. The annual growth rate was 2.56% a year ago. While Axiometrics tracks asking rent growth, effective rent growth is our main focus because it matches closest with actual revenue growth.
Concession values lowered the asking rent 1.56% at the national level in April, which is the equivalent of 5.7 days of free rent on a 12-month lease. For comparison, the concession value lowered asking rents 2.54% last year and 3.94% two years ago. The peak for concession value was in December 2009 when asking rents were lowered 7.47% by the use of concessions.
Nationally, the occupancy rate increased 16 bps from 94.44% in March to 94.60% in April. This rate is up 28 bps from April 2012 and 70 bps from April 2011. Seasonally, there is a fairly rapid increase in occupancy rate the first two quarters of the year. The national occupancy rate is already hitting the 2012 peak of 94.6%, set in September 2012.
Currently, 44 of the top 88 MSAs have an average occupancy rate greater than 95.0%.
Asset Class Performance
At the national level, Class C properties continued to post the best annual effective rent and occupancy growth rates in April 2013. Annual effective rent growth for Class A properties declined from 4.7% in April 2012 to 2.8% in April 2013. While Class A and C properties have been on opposite growth paths the past year, Class B properties have been very stable.
Class A properties continue to maintain the highest occupancy rate of all three asset classes. While Class A properties have had flat or negative occupancy growth since April 2012, Class C properties have experienced the most significant improvements in occupancy rate of the three asset classes, though their occupancy rate started at a much lower base.
Class B properties have had flat to slightly positive occupancy growth since April 2012 and are beginning to close the gap in occupancy rate with Class A properties.
Top and Bottom Performing MSAs
The following table lists the top 11 ranked MSAs across the country for annual effective rent growth. Houston, Denver, Oakland and San Jose continue to rank in the top tier for revenue growth. Washington, DC, which was one of the strongest MSAs early in the cycle, is now one of the weakest MSAs nationally.
Some additional MSAs:
The Axiometrics Pipeline team is in the process of surveying our developer clients about increases in construction costs. What has been reported so far is that increasing construction costs are making it difficult to pencil out new projects, particularly in the suburbs. The cost increases are making the pro forma rents too high for the market. Additionally, developers are abandoning phase two projects of very successful phase one projects that started in 2010.
Depending on the situation and location, we have heard that construction costs are up 10% in as little time as the last 90 days. Generally, we have heard about 10% – 20% increases in construction costs over the last year. However, one client indicated that in Denver they have seen close to a 40% jump over a 14-month span. This is based upon a comparison of a deal contracted in January 2012 to a bid recently received from four local general contractors on a very similar project. Demand for labor is high while the supply of labor, especially framers, has contracted. The situation is exacerbated when the new project is located in the suburbs and competes more directly with the labor working on single-family housing.
Shown below is the trend in construction starts according to the Axiometrics pipeline data or what we call identified supply. The identified supply is based upon conventional apartment properties that are located in over 350 markets. The identified supply is not based upon any Census data but is from actual projects identified by the Axiometrics Pipeline Team. Rather than using monthly starts, Axiometrics uses a sum of the previous three months in order to remove volatility. This approach also allows the overall trends to be recognized faster than does an annual look at the data.
Significantly, as shown below, starts are leveling off at the national level. For starts to stay at this level, or increase from this point, there will have to be more starts in the suburbs. In order to confirm this as a trend, the starts need to continue to fall into the summer months. It will be more difficult to start new projects with (i) oversupply occurring in key submarkets; (ii) Class A rent growth declining, (iii) and construction costs increasing
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