Strong renter demand for affordable apartments in affluent suburbs easily outstrips the available inventory of such properties. This supply and demand imbalance creates a big gap in the market that renovated older buildings can fill. These undervalued multifamily buildings also provide a healthy investment opportunity.
Cranes dot the skylines of many American cities today, and much of the development is new luxury multifamily communities. For the last 10 years, the majority of the new apartments built have been high-end apartments, often in downtown areas.
Underlying reasons
Two main factors are driving developers’ preference for luxury urban apartments. First, developers are turning to urban areas because many suburbs are using zoning density restrictions to prevent multifamily construction.
Kevin Finkel, Resource Real Estate
Developers may want to build in the suburbs, but suburban communities want to maintain the relatively small class sizes in their schools and the low crime rates associated with low-density areas, so they are not granting permits for new construction.
Cities, on the other hand, are eager to welcome new residents to grow their tax bases, so they’re quick to provide permits for new multifamily construction.
The second factor is rising construction costs. Excluding land costs, construction costs have risen 23 percent since 2010, mostly because of a lack of skilled labor.
Land costs have also risen sharply. For example, between 2011 and 2016, the Lincoln Institute of Land Policy’s index of nominal residential land prices rose over 80 percent. This index tracks residential land, which is mostly used for single-family homes, but still gives a sense of how fast land prices are rising.
Given these rising construction costs, developers need to charge high rents in order to be profitable. For developers, the result is that luxury apartments are the only type of apartment development that makes financial sense.
These luxury apartments are serving demand from wealthy renters who want to live in downtown areas. However, the majority of renters don’t fall into this wealthy category. They have to look at more affordable apartments. For the most part, these units are in poor shape given their 30- to 40-year-old age and a lack of capital investment.
Historical perspective
The last big apartment building boom in America occurred in the 1970s and 1980s before zoning restrictions became tighter. Much of that construction took place in prime locations in great suburbs. The apartment units constructed during that building boom are affordable, but they haven’t received much capital investment over the years.
This situation creates an opportunity for real estate firms that have experience renovating apartments and access to capital. Firms can buy these older apartment communities in thriving suburbs of growing cities. They can invest in these older apartments, renovate them and rent the units to the millions of workforce renters that need affordable, updated apartments.
Once older apartments have been renovated to look and feel new, the new landlords can charge higher rents. However, because an apartment renovation is less expensive than ground-up development, they’re less expensive overall for the firm that buys and remodels them.
Makeovers in Midwest
In 2014, Resource Real Estate Opportunity REIT I, a real estate investment trust sponsored by Resource Real Estate, purchased Meridian Pointe, a 339-unit community in Burnsville, Minn., located 15 miles south of downtown Minneapolis.
Unemployment in the Twin Cities area was just 3.6 percent in August, the fifth lowest rate in a major metropolitan area in the United States. Burnsville boasts a number of high-quality schools, as well as plenty of retail space and a low crime rate.
Meridian Pointe was built in 1988. After Opportunity REIT I bought the property, the apartment interiors, exteriors and amenities in the community were renovated and upgraded.
When Opportunity REIT I bought Meridian Pointe, apartments in the community were renting for an average of $920 per month. Today, rents average $1,115 monthly, an increase of $195, or 21 percent.
However, Meridian Pointe rents are still much lower than luxury downtown apartments in Minneapolis-St. Paul, which can exceed $1,700 a month. These apartments are a great choice for people who work in Minneapolis-St. Paul but want an affordable apartment in a safe, pleasant neighborhood.
In Illinois, Resource Real Estate Opportunity REIT II, another REIT sponsored by Resource Real Estate, bought Grand Reserve, a 319-unit apartment community located in Naperville, about 30 miles west of downtown Chicago.
The area is known for its top school districts, strong job growth and high quality of life. Grand Reserve is just 10 minutes south of the I-88 Illinois Technology and Research Corridor, home to over 275,000 jobs with companies like Microsoft, Alcatel-Lucent, BP and MetLife.
Grand Reserve was built in 1997. After Opportunity REIT II bought it, there were extensive renovations of the apartment interiors and exteriors, making them a great option for people who want to enjoy a quality community in a great neighborhood.
When Opportunity REIT II bought Grand Reserve, apartments in the community were renting for an average of $1,446 per month. Today, rents average $1,724 monthly, an increase of $278 a month, or 19 percent.
The big takeaway
Apartment construction today is primarily aimed at the well-served luxury market. It can be difficult for renters to find quality, affordable options in favorable suburban locations. By buying and renovating older buildings in great locations, real estate firms can create apartments that suit the needs of today’s workforce renters.
Supported by strong renter demand, landlords of these renovated properties can raise rents and potentially sell these buildings at a healthy profit.
Kevin Finkel is the executive vice president of Resource Real Estate (RRE), a Philadelphia-based value-add real estate investment firm that buys, remodels and sells distressed buildings. Finkel is also the president and COO of Resource Real Estate Opportunity REIT and Resource Real Estate Opportunity REIT II.