Sailing uncharted seas

Heading into 2008 on uncharted waters, most experts believe the multihousing industry will remain buoyant, although the high tide of 2006 may be ebbing. The course of the overall economy, however, is tougher to chart. Depending on who's talking, the U.S. is either heading into recession or set to hit a trough mid-year and bump along the bottom before entering a period of slow recovery in 2009.


The UCLA Anderson Forecast calls for a near-miss recession, nationally and in the nation’s top performing West Coast markets, driven to the brink by the ailing single-family housing market and anemic job growth, but saved, just barely, by a meager one-percent increase in the gross domestic product (GDP) over the next two quarters. Anderson, which has provided national economic forecasts for 50 years, defines a traditional recession as a two-quarter period or more of decline in GDP.

Fed Chairman Ben Bernanke assures the world the U.S. will avoid recession. But don’t exhale just yet. David Shulman, Anderson chief economist, explained, “When the economy slows to a one-percent pace, it runs the risk of falling into an actual recession, just as when an airplane’s velocity dips down to its stall speed and falls out of the sky.”

And, although he buys the near-miss scenario, Anderson economist Ryan Ratcliff adds a caveat, saying, “The outlook would change if there is a significant worsening of the real estate sector beyond what’s already been forecast or the emergence of another source of weakness.”

The Economist last month noted that, “Most economists aren’t forecasting a recession in America, but the profession’s pitiful record offers little comfort. Our latest assessment suggests that the U.S. may well be heading for a recession.”

Moody’s Chief Economist Mark Zandi thinks we are there already, arguing that “regionally, after accounting for lags and errors in the data used to judge these things, it is fair to say that California, Florida, Michigan, Ohio, Nevada and Wisconsin are now in recession. These economies account for well over one-quarter of the nation’s GDP.”

The prognosticators have erred before. Take those at Anderson. Last year, Orange County’s employment base increased by about 30,000 jobs.

At the beginning of this year, Anderson forecasters were predicting the county would add about 20,000 jobs in 2007 because they expected very little impact from subprime problems.

“But, by mid-year, that projection was down to 10,000 jobs and now they are calling it a break-even. By comparing the most recent forecasts by Chapman and UCLA’s Anderson, both groups call Orange County job growth a push, one calling for a nominal increase, the other calling for a nominal decrease,” said Mary Ann King, president of Moran & Company and a partner in the company’s Costa Mesa office, who attended the Anderson Forecast conference on the Orange County market last month. “It kind of makes you lose confidence in the forecasts,” she added.

Economic recessions historically are preceded by housing declines and a recession puts downward pressure on apartment owners’ ability to raise rents because renters have less money to spend. But, so far for the rental housing sector, the subprime issue has been a double-edged sword.

With the days of easy credit gone, “fewer people are leaving apartments to buy homes and those who lost their homes to foreclosure are being driven back to the rental market, increasing demand. On the other hand, people are renting out condos and single-family homes they can’t sell, creating more competition for apartments,” said King.

Multifamily owners and investors have several concerns in a weakening economy, said Sperry Van Ness President Jerry Anderson, who took the company’s reins in November and spearheaded the acquisition of Florida-based JBM Realty Advisors. “One is the availability of financing and the cost of that financing. Another is the ability to get and keep tenants and to be able to raise rents over a period of time, because that’s what increases the value of your property. In a weakening economy like we are in now, financing is going to be more expensive, job growth is down, disposable income is down and investors are nervous about this whole subprime mess and tenants’ ability to pay the rent,” he said.

West Coast markets hot and cool
Any macro view of the apartment industry splinters when viewed through the micro lens of location. Demand has quickened in some West Coast markets and slowed in others. And, markets are very important to renters, said King. “If you work at Google you’re probably going to rent an apartment in the Silicon Valley. And the biggest indicator for the demand for apartments is job growth, so you do have a differential performance by sub-market.

“The number one market on the West Coast is Seattle. Its economy is hitting on all cylinders. No longer a one-horse town with aerospace being its major industry, we refer to Seattle as a tripod economy, having three really important sectors, one being aerospace and the others being high-tech and biotech. All are doing extremely well. Seattle probably has the strongest job growth of almost any metro nationwide–in the four to five percent range–and the demand for apartments has been very strong. In fact, the supply of apartments has actually decreased. That’s very unusual, but that’s because we lost more apartments to condo conversions than we have gained through new construction,” she said.

If Seattle is the hottest market on the West Coast, Sacramento just might be among the coolest. “In the early 2000s, cap rate spreads evaporated between primary and secondary markets and a lot of people decided they could make a lot of money by building in Sacramento. The market got very overbuilt,” said King.

BRE, the only apartment REIT with product in Sacramento, began marketing several of those assets for sale in Q2, sold one in the third quarter and expects to close the sale of another by year-end.

Owners of apartments in several perennially strong Southern California markets began to feel the effects of the subprime issue last fall. BRE Properties lowered the top end of its guidance in Q3 and adjusted the mid-point based on what the company refers to as a headwind in Southern California, where the REIT owns 6,800 units.

BRE has core markets from San Diego to Seattle and east to Arizona, where the REIT’s apartments are owned in partnership with JPMorgan Asset Management. “We divide our markets into two categories: those impacted by subprime related job loss and/or have an abundance of single-family housing supply that competes with apartment stock, like Orange County, the Inland Empire, Sacramento and Phoenix, and markets where economic growth and a lack of supply have maintained a wider rent-versus-own gap, and avoided subprime job loss,” said BRE COO Ed Lange, adding that San Francisco and Seattle fall into the latter category. “Rents are up 10.5 percent year-over-year in Seattle and more than seven percent in San Francisco with revenue growth above long-term trend lines running between eight to 11 percent, NOI growth 12 to 15 percent and occupancies hovering between 95 and 96 percent in those markets,” he said, but added that he expects to see a pause at some point after a period of such phenomenal growth.

Sign of the times
Orange County, which last year claimed the number one position in Marcus & Millichap’s National Apartment Index (NAI), suffered job losses in the mortgage and financial sectors this year.

The condo conversion train slowed but didn’t really stop in Orange County and condo development flourished, particularly high-rises, which are more expensive to build than mid-rise podiums or garden– style apartments and the most difficult to flip to rental. A number of the county’s condo mid-rises and gardens have either sold to apartment players or were flipped to rental projects by their developers as the for-sale housing market crumbled. And, in what King calls a sign of the times, several large condo developments in Orange County have been mothballed.

Miami-based Lennar Corp., one of the most prolific condo builders in the county, suspended sales at two of its high-rise master planned projects–Central Park West in Irvine and A-Town Metro and A-Town Stadium just west of Angel Stadium, in what is the linchpin of Anaheim’s Platinum Triangle.

Wildfires may have ravaged the Southland, but Lennar CIO Emile Haddad said the company isn’t planning a fire sale. Rather than offer discounts, Lennar and its investors are willing to be patient and wait for the market to improve. The builder could flip A-Town Stadium to apartments.

Meanwhile, Lennar, in partnership with Canada’s Intergulf Development Corp., continues to build the 240-unit Astoria, which consists of two 14-story condo towers and a 574-space parking garage at Central Park West.

Sub-market breakdown
Performance differs even within individual markets and regions. Growth in the long-time leading market of Southern California, for instance, is moderating, but “at distinctly different rates depending on the submarket,” Guericke said in Q3. “New supply and/or jobs- related issues are the key differentiating factors in these results. For example, Ventura and North West Los Angeles County are affected by lease-ups of competing apartment property, as well as job cuts announced at Countrywide Financial in Calabasas and Amgen in Thousand Oaks. Orange County had similar issues,” he said. Essex made the decision to exit the Portland area recently with the $97.5 million sale of four communities with a total of 875 units, two in Hillsboro, Ore., and two in Vancouver, Wash., due to a greater risk of increased supply of for-sale and rental housing compared to its other core markets. The sales proceeds were used in a tax-free reverse exchange for the two-year-old, 400-unit Mill Creek at Windemere in San Ramon, Calif, which the REIT purchased in September for $100.5 million.

BRE discovered that even firm markets have soft spots. The REIT’s two communities located south of Seattle-Tacoma International Airport aren’t performing as well as its properties in the northern part of the Seattle metro. They were listed for sale in the second quarter.

San Diego is another market where some of its sub-markets are experiencing competition from condo rentals. “Rental sub-markets impacted negatively by grey market rentals include Mission Valley and Downtown,” said King, adding that the jury is still out on the Inland Empire, where a high percentage of the mortgage loans made with no down payments have resulted in a relatively high rate of delinquency and foreclosure. BRE already is seeing decelerating fundamentals there that could result in lower than expected revenue growth for the REIT over the next nine months.

The Inland Empire, where Essex has only 276 same-store units, has a combination of commute problems, loss of jobs in the construction industry and very affordable single-family homes, many of which are being converted to rentals. “At the other end of the spectrum, our results in the remainder of Southern California are quite good, as reflected in the results in Los Angeles County, which generated 5.4 percent revenue growth,” he said.

Who wants yesterday’s cap rate?
Most pundits agree that assets in high-barrier-to-entry markets, as well as Class A institutional grade assets nationwide, will feel the pinch from the subprime fallout less than the B and C assets.

Sperry Van Ness began to focus on the institutional investor recently when Anderson was named president. “Historically, Sperry Van Ness has targeted the high-net-worth individual. That’s where we made our mark as an investment brokerage company. The reason our strategy is expanding and we bought JBM Realty Advisors is that top quality product preferred by institutions is less affected by a weakening economy. The institutions are happy to see some of these high-net-worth individuals and highly-leveraged buyers fall by the way side,” said Anderson.

“We see less impact on the core properties because there continues to be a lot of capital that needs to be placed and that capital is focusing on only the best sub-markets on both coasts. Deals that are in the center of the bulls-eye in Southern California, say in Pasadena and Irvine, are still hotly contested. Buyers know that. They know they don’t have the leverage to re-trade. If you are in the market trying to buy a deal that does not appeal to the pension fund market and it appeals only to private buyers, your cap rate has changed much more dramatically. That’s where you’re going to see more of the roller coaster in the delta between what it was worth yesterday and what it is worth today,” King said.

Nineteen bidders competed for the six-year-old, 280-unit Meridian Town & Country in Orange, Calif., that Moran & Company marketed and sold for Black Rock. “We had more bidders for the Meridian property than we have ever had for any core piece of real estate. Typically, I would expect a core offering like this to have only about a dozen bidders,” said King. The sale, which closed on August 30, experienced no impact from the credit crunch. King believes the bidders all saw tremendous opportunity to add value to the community. The buyer was Boston-based GID, a relative newcomer to the California market, which, according to CoStar Group, Inc., paid $101.75 million for the property.

Although there is plenty of institutional capital searching for core apartment transactions, deal flow is waning a bit as the year ends. “Many investors have chosen to sit out because they sense the market is changing” said King. She believes that many owners who don’t have to sell are holding back their offerings until the first quarter of 2008, expecting the CDO market will clear and liquidity will return to the debt markets. “They hope that with the return of liquidity to the debt markets, cap rates will stabilize and more investors will return to the market.”

Apartment REITs report seeing cap rates increase for West Coast apartment deals. BRE’s sale of the 208-unit Hazel Ranch in Sacramento for $24 million at a 5.8 percent cap rate based on in-place third quarter NOI, represented what the REIT estimates is a 25 basis point increase from original expectations. The buyer used Fannie Mae debt to purchase the community that BRE acquired in 1996.

Essex is seeing similar cap rate moves across all its markets. Meanwhile, the REIT is cautiously optimistic the recent turmoil in the for-sale markets may lead to an over-reaction on land values in the near term and present buying opportunities.

Prices may never return to where they were last spring, said King. “Instead of every deal, regardless of quality and location, trading between four and 4.5 percent, I think they’ll be trading between four and five in California and other coastal markets and between five and six for the rest of the world,” she said.

Sperry’s Anderson doesn’t think transactions are necessarily slowing. “What is happening is that the buyers are doing much more due diligence. Two years ago a buyer might have walked the property once, and said, ‘Lets get this thing closed.’ Now, instead of just looking at the surface, not only are they doing an X-ray, they’re doing an MRI, looking deep into the property to make sure it’s going to perform. Today, we have to have real sellers who understand the market and real buyers who know how to do their due diligence. And those real buyers better have real money because they aren’t going to get the low-interest-rate, highly leveraged loan they could before,”
he said.