US Apartment Operating and Financial Conditions Continue to Improve

On Thursday July 15, Merrill Lynch/Bank of America sponsored a conference call to review operating and financing conditions and in the US Apartment market. The call provided even more color and confirmation of firming conditions, as reported earlier in these columns.

On the Operating side, participants around the country all reported firming conditions. Markets showing strength were New York, San Francisco, Chicago, Washington DC, and Seattle, all reporting occupancies greater than 95% and rents on new leases rising at 3-7%. The rate of lease renewal was strong, as one participant in Chicago noted that 65%-75% of expiring leases were renewing, up from 50% in the prior year. That was reducing the available inventory of apartments for rent, enabling new lease increases.

Even markets such as Austin, Houston , Dallas, and Atlanta, which had been weaker were now showing strength, and new leases were be written at rents above the prior year. Even markets such as Miami, Ft. Lauderdale, and West Palm Beach were experiencing sequential rent growth of 7% in the second quarter of 2010. Only Phoenix and Las Vegas seemed to be in a continued decline. What this was translating into was overall P&L revenues that were expected to show year over year increases in the late 3rd and 4th quarters of 2010.

The speed of the occupancy and rent snap back was a surprise even to the market participants. At the same time, there seemed to be a bit of a drop off in June, which was giving these apartment managers some pause. Consequently, they were continuing to offer flat lease renewals and maintain an overall defensive, “cautiously optimistic” stance.

Supply continues to remain quite muted. Historic annual supply additions in the 250,000-300,000 unit range (about 1% of the capital stock) are now down to 70,000 units, of which half are Low-Income Tax Credit deals which restrict residents to the lower half of area median income.

Although there is some talk to reviving development capabilities, only the REITs with direct access to the capital markets, are in any position to come up with the necessary capital to pull new construction off, as the commercial banking sector which supplies the debt capital, is only slowly re-entering the market.

On the investment side, there was a general mood that capital markets conditions continued to improve, and that institutional investors, both debt and equity, made a big move to re-enter the transaction environment in January, which when combined with little available properties for sale, was resulting in a “reflating of the bubble”. Mortgage terms from the GSEs (Fannie and Freddie) for 1st position debt are now 70-75% Loan to Value, 1.25 Debt Service Coverage at 5.0%-5.25% for 10 year terms, with 7 yr terms at 4.7%. City markets that Fannie and Freddie have placed on “pre-review” are South Florida, Atlanta, Houston, Phoenix, Las Vegas, Indiana , Ohio, and Michigan.

Cap rates have compressed 50 basis points in the last quarter and now are: Class A Assets 5.0 - 5.75%, Class B 6-7%, and Class C 7.25-8.0%. (Note: Class A is usually determined as assets less than 10 years old and with rents >1.25X the metro area median rent. Class B- 10-25 years old, with rents from 1.25 to .9X metro median rent, with Class C below that). Transaction volume is expected to return the levels of 2002-2004 by the 4th Qtr of 2010, which is considered a “normalized” level, before the CMBS induced price bubble.

So, the US Apartment recovery continues more strongly than the office, retail, and industrial sectors. While participants were happy to see the recovery both in operating and asset prices, and were positioning themselves to take full advantage of it, continued concern about the trajectory of job growth infused caution for the future.

In a new twist, Life Insurance companies are offering rates between 4% and 4.5% ,with earn-outs for mortgages with 5-7 year terms for Class A product and partially stabilized newly constructed product. The rates are less than the GSEs and for a product type that the GSEs will not underwrite.

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