Wednesday, March 30, 2011

Mixed Signals Point to a Market Bottom

Morgan Walsh - Multi-Family Specialist

Posted by: Morgan Walsh Multi-Family Specialist 775 336 4646

Morgan Walsh is a commercial broker with 20 years experience in investment sales, multifamily and specialty sales, representing buyers and sellers, institutional and private developers in market rate apartment sales, mixed-use residential devepment and the development of affordable housing projects.

Owners, buyers and investors are carefully watching the spring lease-up in Reno for signs that the apartment market bottom has been reached. Market bottoms show a very characteristic pattern-- low sales activity, high bid/ask spreads, negative sentiment widely shared, little new construction, slow absorption, flat rents and little investor interest. Market turns, however, occur unpredictably because they begin when conditions look a lot like the past six months. The period 2008-2010 saw falling occupancy, then falling rents, followed by flat rents and another dip in occupancy, and another dip in rents. Job loss, double-up of tenants, tenants leaving the region, and the rapid expansion of the single-family rental market are critical factors in apartment demand, and the large property owners have reacted by adjusting rents to demand, qualification criteria to the recession tenant, and marketing to a labor force which must reduce housing cost.

In 2011, Class A and B properties have achieved normal occupancy (with some exceptions of distressed property or owners unprepared to adjust). In many cases, utilities have been passed through to tenants in whole or part, and major, new construction has stopped. This spring, those owners will begin raising rents. If successful, the value and attractiveness of their properties as investments will sharply diverge from the rental market segment still struggling with occupancy, declining rents and values.

The Class C apartment market is suffering a dramatic loss of value from three sources—sharply reduced demand for property in location or condition deemed difficult to rent, finance, manage and maintain; falling rents with 7-8% of additional rent reductions required to achieve stabilized occupancy above 85%; and occupancy by tenants most vulnerable to further declines in income and job loss. To the extent these property have been over-leveraged, with debt service levels predicated on high occupancy and rising rents, the risk of distress and default is high and properties have been liquidated at a fraction of their stabilized value.

Meanwhile, the shadow market for single-family rentals continues to grow (10% per year and likely to continue for 3-5 years) but the median landlord for such property is increasingly a savvy investor, not a distressed small investor, so the tenant selection, leasing, property management and maintenance of this housing stock is increasingly sophisticated and able, pushing the housing cost to rent a home up, especially in attractive submarkets. The net effect for rental tenants is a small gap between the high-end apartment and the attractive house, so the tenant seeking convenience will lean toward the well-managed apartment property. Finally, the net cost for move-in is now clearly in favor of the apartment property and will likely continue to grow.

2011 will bring two interesting effects. First, the Class A and B markets will strengthen profitability and gain market share in rental housing. Class C properties will find the rent level needed to maintain normal occupancy, de-leverage as quickly as possible or re-leverage at a lower value under a new owner, but no appreciable increase in Class C property value will occur until jobs return. Many low-end properties will change hands this year, as occurs at the bottom of every recession, with a new owner group bringing capital and expertise to exploit the property’s full potential. Traditionally, Reno’s opportunistic owners have bought and held. This time, we may see a significant fraction who stabilize the property and then exit for a new opportunity.

Financing remains exceptionally affordable, although underwriting has never been more demanding for borrowers and their collateral. We expect favorable financing to remain in place through the end of 2011. Apartment expense levels are highly manageable, with a soft market in property coverage, competitive vendors and owner’s high attentive to cost reduction. Fuel remains the wild card and could ripple into a major headache for apartment owners, as added expenses and reduced demand for tenants whose commute becomes too expensive. Further job loss is likely to affect the Class C market early and hard, and remains the most likely probable negative factor affecting apartment operations in 2011.

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