Well, last week we looked at the health of the residential real estate market and where it might be headed in 2012. I thought this week we’d take a look at the apartment sector of commercial real estate.
First, let me define a few terms I’ll be using throughout this article.
Multi-family properties – Classified as multiple separate housing units for residential use. This can be one building or several buildings within a complex. These properties are commonly referred to as apartment buildings. The property must be over 5 units to be commercial.
Class (of property) – A subjective division of buildings by desirability among tenants and investors. Criteria include age, location, construction quality, attractiveness, style, level of maintenance, and so on. Marshall & Swift (we use their website in class) classifies buildings as A, B or C.
Class A: High quality – No more than 10 years old – attracts prestigious tenants
Class B: Useful space but no special attractions – typically 10-50 years old
Class C: Much older building without any amenities – attracts moderate to low income tenants
Effective rent – the actual cost of renting an apartment after all specials and discounts. The effective rent can be calculated on the annual basis or the preferred monthly basis.
So, now that we’re all on the same page with nomenclature, let’s look at how the apartment sector is doing.
There are many factors that have converged to benefit multi-family properties. For example, even though interest rates are low, credit remains tight; so many that would like to purchase homes are still renting. Another example is household formation. Jobs are being created and new households are forming, whereas in the last several years we’ve had household contraction. Fortunately, for the multi-family sector, the households that are formed aren’t moving into ownership, but into rentals.
The multi-family sector has outperformed other commercial property types over the past two years. Occupancies and rents have seen consistent improvement even though the economy has been slow. This sector bounced back with very impressive numbers. At the end of 2009, vacancies were at a 30-year high of 8 percent. By the third quarter of 2011, the national vacancies plummeted to 5.6 percent. They are expected to go even lower in 2012, possibly dropping to 5 percent.
Occupancy has improved; however, growth in rents has not reached projections. The national prediction was that effective rent growth would exceed 6 percent in 2011. According to Reis (a leader in commercial real estate performance information and analysis), actual growth was relatively modest, 1.8 percent year to date (through November 2011).
This was the average nationwide; there have been some markets that have risen by over 6 percent and others that have fallen by close to 2 percent. This can be seen most clearly in some REITs. Here is an example: Equity Residential (serves the Sand states and the East coast) has strong income growth and expects continued growth in 2012, whereas AMICO (serves Texas and the Northeast), had solid results, but notes that leasing traffic has slowed down since October 2011.
Many analysts see the root cause for the difference in performance is between the different classes of the properties, i.e., Class A versus Class B/C properties. The Class A properties’ rents and occupancy took a big hit in 2009. The Class B/C properties didn’t experience that kind of hit, in fact, some saw small increases in rents.
Even though Class A properties endured severe rent and occupancy declines in 2009, their quick recovery in 2010 and 2011 has been impressive, although not returning to 2009 peak levels, whereas Class B/C properties have posted decent gains over the last two years and have exceeded their 2008 highs. Class B/C properties are, however, closer to reaching the income constraints for tenants.
So, where do we see the future growth in multi-family properties and the REITs that hold them? It’s expected that both Class A and Class B/C apartments will post positive returns and continue to rise over the next 12 to 18 months. Once the vacancy rate is below 5 percent, we could see growth in effective rents. Class A will most likely grow at a faster pace and Class B/C will likely increase at the rate equal to inflation.
We know that for this sector to see a long-term increase in performance, there has to be economic growth and job creation. Isn’t that what we’re all waiting for?
Our next online Professional Real Estate Investor class has been scheduled for February. Hope to see you all there.
– Diana Hill email@example.com