Despite recent reports of lackluster tenant demand and historically high vacancy in the US multifamily rental market, investor demand has proven surprisingly resilient.  Indeed, according to Reis's Third Quarter 2004 Transaction Monitor for US Apartments, investor competition has been pushing the national multifamily average cap rate lower for seven consecutive quarters.  How to reconcile the strong investor demand for multifamily apartments with mediocre fundamentals?  It seems today's low mortgage costs and high home prices have launched a rash of conversions--a trend that's bound to persist so long as rates remain low--allowing converters to reap major rewards. 

National Multifamily Supply and Demand Fundamentals

A recent survey of various real estate market analytic reports revealed the following observations about the current tepid state of the multifamily apartment market in the United States:

• Apartment fundamentals have stopped deteriorating, but improvement has been slow and modest. 
• Job growth has improved but not to the level forecast by most economists.
• Low mortgage rates have sapped demand for apartments and reduced the monthly cost of homeownership.
• Net absorption of apartment units was weak over the last three years, and while there has been modest improvement this year, net absorption remains well below historic norms.
• More apartments are showing up on lenders' watch lists, primarily because of weak tenant demand.
• Of the four major property types, fundamentals remain the weakest in the apartment market.
• The national apartment market vacancy rate has fallen slightly from its peak but remains high by historical standards, at 6.6% per third quarter according to Reis.
• Weak tenant demand stems from lackluster job growth.

Investment Observations

Contrast the observations above with recent commentary about the strong investor demand for multifamily properties around the country:

• Apartment cap rates continue to decline across all quality levels and geographic areas.
• The pace of condo and co-op transactions broke another record in the third quarter of 2004 (as cited by the National Association of Realtors).
• The booming housing market has driven up values for all things residential.

Indeed, Reis quantified this demand in its third quarter 2004 edition of the Reis Transaction Monitor-US Apartment Markets, reporting:

• Investor competition in the third quarter pushed the national multifamily average cap rate down to 6.6 percent, a 30-basis-point decline from 6.9 percent from the previous quarter and the largest quarterly drop in seven quarters (Q402 to Q304) of consistently falling rates, as capital continues to flow into apartment properties, which in turn lowers going-in-returns for investors.
• Investors' first-year yield expectations for their multifamily building buys are consistently lower than those for office properties (7.9 percent), and neighborhood and community shopping centers (8.5 percent). 
• Cap rate compression continues to be a fact of life throughout US markets.  Most of the metropolitan multifamily markets monitored by Reis recorded declining or stable cap rates during the third quarter: Of 66 markets, 36 cap rates (55 percent) fell in this quarter, 16 metro cap rates remained unchanged, and 14 experienced cap rate increases. 
• The dollar volume of US multifamily property transactions in the top 80 metropolitan markets tracked by Reis continued to increase during the third quarter, reaching a total of $9.05 billion, up 14.3 percent from $7.92 billion last quarter and 25.0 percent higher than one year ago.
• It appears that the acceleration of capital flows into the multifamily sector are pushing prices upward during 2004 at an annual rate of 16.2 percent, based upon a comparison of year-to-date activity during 2004 with the comparable period from one year ago.
• Based on data collected to date, 41 percent of the assets that traded during the third quarter were Class A properties; these trades accounted for 64 percent of the total dollar volume.  The average Class A unit sold for $117,000 while Class B/C units sold for $65,000.

How to reconcile the strong demand for multifamily apartments with mediocre fundamentals?

Condo Mania 

According to the National Association of Realtors (NAR), per second quarter 2004, condominiums accounted for 12.8 percent of the housing market--a 33.3 percent increase over the past ten years--and have appreciated in value at an unprecedented double-digit pace for the past four years.  This demand is being driven by first-time buyers, many of whom have been priced out of the current housing market boom, as well as increasingly wealthy empty nesters that are recouping huge appreciation windfalls and reinvesting in lower-maintenance condos or co-ops, often in downtown areas.  (Of course, in addition to apartment-to-condo conversions, new condo construction is also a current trend.)

Despite the local government reticence to see rentals--typically a source of affordable housing--taken off the market, municipalities are also benefiting from the current condo mania.  Many condo conversions are older rental buildings that have a significantly lower appraisal value and pay lower property taxes as a result.  Consequently, revamped properties that are repackaged and sold to a condominium buyer will often result in a higher property taxes, providing local governments with an additional source of revenue.

According to the NAR, third quarter 2004 sales of existing condos and co-ops set the second highest pace on record, with the South and West regions seeing the highest recent percentage increases nationwide.  According to David Lereah, NAR's chief economist, "We've seen an incredible pace of existing condo and co-op sales over the last six months, but we're also seeing some exceptional price appreciation."

Condo & Co-Op Sale Surge Ahead of Home Sales

Recent Condo Conversion Transactions

Publicly-traded real estate investment trust (REIT) AvalonBay Communities, Inc. recently announced the sale of a 144-unit multifamily project in San Jose, California on December 14, 2004, and the pending sale of a 454-unit multifamily project in Arlington, Virginia by year-end 2004 at a combined first-year capitalization rate of 4.3 percent.  An analysis of the latter sale is especially instructive as the prospective purchaser is a condominium converter.  The $120.5 million purchase price equates to about $265,000 per unit, which compares extremely favorably to AvalonBay's 1997 acquisition price of about $103,000 per unit ($46.7 million).  Incidentally, according to the company's press release, its unleveraged internal rate of return, or IRR, on the two-property transaction was in excess of 20 percent.  (Shane Cochran, a local housing official, recently estimated that a household would have to earn nearly $91,500 per year to be able to afford the average home or condominium in the city of Alexandria.)  The capitalization rates and per unit pricing illustrated above can only be rationalized by significant upside and condominium conversion potential.  Indeed, apartment owners are giddy about not only selling their properties to converters at cap rates as low as 3 to 4 percent but also relish the ability to nearly double their cash flow by trading into other rental projects at cap rates of 5 to 6 percent, giving them twice as much cash flow.

Also on the West Coast, ColRich Residential LLC, a newly formed joint venture of San Diego-based ColRich Group and Resmark Equity Partners that invests on behalf of the California Public Employees' Retirement System, pursues condominium conversions in the western United States.  ColRich just successfully completed the conversion of the Bernardo Pines apartment complex in Rancho Bernardo, California, selling all of its 200 units within one year.  According to Danny Gabriel, chief investment officer and co-president of ColRich, "With the growing lack of affordability in many regions, we believe conversions are no longer a cyclical play" but "a consistent play in meeting housing needs."

Flush with success, ColRich then tackled the 400-unit Haverhill at Highland Reserve in Roseville, California, near Sacramento, renaming it The Villages at the Galleria.  Indicative of the lure of a large pot of gold at the end of the condo conversion rainbow, ColRich capitalized on the recent change to a local ordinance that prohibited the conversion of apartments from rentals to condominiums for eight years after the first unit was rented.  Originally designed to stem rampant conversions in an overheated housing market during the late 1990s, the law was changed to allow a limited supply of 1,400 rental units to be converted to condominiums.  According to Reis, the property, which was 13 percent vacant at the time of sale, was acquired for a per-unit sale price of approximately $125,000. (ColRich Investments was advised on the acquisition financing for its purchase of Haverhill at Highland Reserve by Buchanan Street Partners, which structured a $55 million bridge loan, funded by PB Capital, that featured a $41 million funding at close of escrow and enabled another $14 million to fund future conversion costs.)

In Tucson, Arizona, the 120-unit Tierra Catalina project recently sold for a local record-breaking price of $123,000 per unit.  Despite its 95 percent occupancy as a rental, conversion to condominiums represents a higher and better use.

Moreover, according to recent reports, some oversupplied office markets are seeing projects once targeted for office development replaced with residential condos.  Recent events in the Irvine submarket of Orange County, California, where the average office vacancy rate is over 14.5 percent, include Legacy Partners' $16.4 million acquisition and subsequent razing of the two office buildings located at 2801 and 2811 Main Street in order to build the 294-unit Legacy at Main & Jamboree apartment project on the site.  "Mid- and high-rise multifamily developments have started to dominate the infill land opportunities in the John Wayne Airport area submarket," noted an executive with Voit Commercial Brokerage, which represented the seller, RD Olson Development, in a recent GlobeSt.com article.  "The land in this marketplace has traditionally been zoned for commercial use, but residential developers are entering the market to acquire the land and have it rezoned for housing."

While many trends may start in California, it doesn't take long for some of them to reach the East Coast. A perusal of Reis's data base reveals that The Gallery at Virginia Square, a 19-story, 231-unit, 2002-vintage multifamily apartment building in Alexandria--proximate to restaurants, cafes, nightclubs, boutiques and bookstores, as well as major employment areas, and a Metro stop providing easy access to Washington, DC--recently sold to Archstone-Smith for $60 million, or  $260,000 per unit (nearly identical to the high AvalonBay purchase price mentioned previously), funded by the buyer's tax-deferred exchange proceeds from dispositions of non-core assets.  Such a per-unit pricing once again can be more easily rationalized by significant upside and condominium conversion potential. 

The conversion and construction of residential condominiums in New York City is something that all real estate professionals are familiar with, despite the uniqueness and complexity of the city's housing laws compared to the rest of the country. 

According to the New York City Rent Guidelines Board's "Housing Supply Report," as of late 2002, there were almost 3,209,000 housing units citywide, of which approximately 2,085,000, or two-thirds, were rental units.  During 2003, an additional 15,000 units were completed, bringing the total to approximately 3,224,000.  Additionally, in 2002 the number of permits for new dwelling units rose 14.7 percent to more than 21,000, the largest number since 1973. 

Of the rental units citywide, only about one-third are unregulated or "free market" half are rent stabilized (apartments vacated after June 30, 1971); about 3 percent are rent controlled (most buildings built before World War II with tenants in possession as of June 30, 1971); and the remaining 17 percent are part of various other types of regulated apartment units.  With more than two-thirds of its housing stock regulated, it's difficult to definitively estimate overall market rents.  However, studio apartments in Manhattan doorman buildings typically rent for about $2,000 per month, one-bedrooms go for about $2,700, two-bedrooms command about $4,000 monthly, and three-bedroom units often go for $6,000 to $6,500 per month. 

High rents have not deterred tenants.  Vacancy rates have hovered at around 3.0 percent for as long as anyone can remember.  Just finding an available apartment for rent in New York City is difficult at best.  An examination of Manhattan vacancy rates reveals that the rental market, even during times of crisis, has continually exhibited overall vacancy rates below 5.0 percent.  Even following the events of September 11, 2001, the overall New York apartment vacancy rate remained relatively steady, with quarterly rates fluctuating between 3.4 percent and 4.0 percent through 2003, according to Reis; this year, levels have begun to decline again, falling to a third quarter low of 3.2 percent. 

The average New York monthly rental rate remains among the highest in the nation, at $2,252 per third quarter, according to Reis's coverage of the top 80 metros in the country.  Indeed, the average household income level in New York City is also high, estimated at $113,950 by Economy.com, in part reflecting the strong influence of the securities industry.  Excerpting from an April 2004 report entitled "The Impact of Wall Street on Jobs and Tax Revenues" by the New York State Comptroller's Office:

"The importance of the securities industry to the New York State and City economies is demonstrated by examining the recent bull and bear markets.  During the five-year bull market that ended in 2000, employment in the securities industry grew by 33,800 jobs.  The growth accounted not only for 8.8 percent of all the jobs created in the city, but also for 35.8 percent of the growth in wages because of the industry's lucrative salaries." 

Average compensation (primarily bonuses) fluctuates with the stock market.  Thus, securities industry average salaries were $242,000 in 2000 and $227,000 in 2002, while average salaries in non-securities industries were $47,000 in 2000 and $49,000 in 2002.

The combination of high rents, high incomes, and a dearth of available apartments has led to the construction of condominium apartments targeted to those that want to keep their primary residence in the city and have a country house in the Hamptons.  Here too, the lack of available land on the island of Manhattan has also contributed to the high price of condominium apartments.  (Though this is not to suggest that condo development does not occur.  Indeed, according to Reis, this year is expected to see the completion of over 2,200 condo units, with the Upper West Side, and West Village/Downtown, along with the Kings County submarket, seeing a substantial portion of this development activity.)

Lastly, condos have been a good investment.  According to the widely-watched Douglas Elliman's Manhattan Market Report, the average price of a Manhattan condominium apartment has risen from about $350,000, or $300 psf, in 1994 to nearly $1,250,000, or about $850 psf (reflecting not only appreciation, but also bigger unit sizes) in 2004. 

From a developer's perspective, it's hard to come up with an alternative scenario where an entire building can be sold for an average price of $850 psf.  Development becomes even more compelling when the alternative is to create rental housing, unless your time horizon is far into the future. 

Looking Forward 

There has always been talk of a housing bubble, or worse, a bust.  However, according to the May 2004 Homeownership Alliance report written by five economists with ties to the housing industry, America's Home Forecast: The Next Decade (2004-2013) for Housing and Mortgage Finance, household growth rates are expected to continue to support this sector.  As excerpted, this report states the following:

• Household growth along with replacement requirements, second home demand and changes in vacancies will require the average production of 1.85 to 2.17 million new housing units per year.  Even the lower end of this range is above the production levels of recent decades.
• Total home sales will average about 8.5 million per year.
• The national homeownership rate will rise above today's record level and will most likely exceed 70 percent by 2013.
• Home price appreciation should average around five percent a year from 2004-2013 but could be above 6 percent if supply constraints continue to tighten.
• Mortgage originations are projected to average nearly $3 trillion per year, and residential mortgage debt is projected to grow close to an 8.25 percent annualized rate. 
• Although the national homeownership rate has surpassed 68 percent, there are sizable differences in ownership rates across income levels, among racial and ethnic groups and among different regions of the country.  A rising homeownership rate will translate into at least 10 million additional homeowners by 2013, with roughly one-half of the gain accruing to minority households.

Generally not covered, however, are counter-arguments detailing that higher house prices and comparatively lower rental rates overall have simply made renting a more viable alternative than owning.  But not to worry.  There's always that latest new thing: condominium hotels.  In addition to literally selling rooms to investors, developers claim these units can command a 15 to 40 percent price premium over "regular" condominiums because of the additional level of services offered, ranging from housekeeping to room service. 

Condominium conversions and now hotel condo conversions, too.  What's next?