The unprecedented job and population growth that Dallas-Fort Worth (DFW) has experienced during this cycle has brought a plethora of new buyers to the Class B multifamily space, and the simple economics of high demand and low supply are re-shaping the landscape of the investment market.
According to CoStar Group, the average price per unit in the Class B space has increased by 4.3 percent year-to-date, and deal volume on sales of Class B assets is down from 2017. These trends attest to the strong impact price escalation has had on the market. A more crowded buyer pool is also breeding competition and pushing prices upward.
The metroplex’s growth cycle dates back to the beginning of the expansion. Data from the U.S. Census Bureau shows that between 2010 and 2018, the metroplex added about 1.1 million people, or 122,000 per year. Earlier this year, Cushman & Wakefield released a report stating that DFW added approximately 754,000 jobs between 2009 and 2018, or 75,000 per year.
This convergence has significantly boosted apartment demand in the metroplex, ushering in waves of competition for older multifamily assets, many of which are positioned for value-add investment and subsequent rent bumps. Price escalation caused by heightened competition is Econ 101, but the increasingly diverse composition of the buyer pool paints a more compelling picture of just how much this market has flourished during this cycle.
“The Class B space has just exploded over the past few years,” says Al Silva, senior managing director of investments at Marcus & Millichap’s Dallas office. “The buyer pool is as sophisticated and diverse as we’ve ever seen it. You’ve got all sorts of private capital as you normally would, but also syndicators, high-net-worth individuals, foreign capital — we’ve done deals with Japanese, Mexican and Israeli equity groups in the last year alone.”
Other sources concur with this notion.
“Our office gets calls and emails every day from new buyers, many of whom are syndicators with a fresh education from an apartment investor mentoring program and looking to make their mark,” says Jon Krebbs, managing partner at Dallas-based brokerage firm The Multifamily Group (TMG). “We’ve also seen a lot of private investors coming in from New York and New Jersey.”
A More Efficient Market
The growth in the buyer pool has generated more efficiency in the market, Silva adds, enabling the forces of supply and demand to set price levels accurately. Big data has leveled the informational playing field, and buyers often know as much as brokers do about marketplace trends.
“Data on the rental market is on-demand and takes a minute to access,” he says. “That’s at the heart of the sophistication of the buyer pool, and it should continue to evolve. Pricing is partially a reflection of this efficiency, which has been a big contributor to the amount of growth and appreciation in this space in recent years.”
DFW’s Class B multifamily market has undoubtedly become more balanced and transparent on the demand side of the equation. But there are supply-side issues that threaten the market’s long-term efficiency.
Ever-rising land and construction costs ensure that all new product coming out of the ground must command Class A rents. As such, supply of Class B product is firmly capped, which aggravates the price escalation and makes it harder for investors to win deals.
“There are definitely concerns about low supply and pressures on pricing, but that’s been the case for several years now,” says Cliff Booth, founder and CEO of Dallas-based investment firm Westmount Realty Capital. “The difference is that now there’s so much competition that we lose most deals we work on.”
Booth notes that with returns on Class B multifamily investments tightening in DFW, his company has had to get creative in this market by targeting less sought-after deals. Such opportunities include deals for properties that require a heavier construction commitment or which trade off-market due to an unusual motivation from the seller. Assets with loan assumptions are more cumbersome and therefore pose greater risk and draw less appetite from investors.
Some investors that have been active in the space during this cycle are beginning to target opportunities in other markets or asset classes, sources concur.
For example, Westmount acquired two older multifamily assets this year in San Antonio, another Texas market with strong job and population growth but which has not yet seen such a massive influx of capital. The firm acquired the 300-unit Pointe at Ramsgate (built in 1975) and the 200-unit Place at Houston Street (built in 2003) with plans to execute value-add programs at both properties.
Pricing, Liquidity
Elevated prices have of course translated to lower cap rates and returns on investment. Rob Key, managing director of JLL’s Dallas office, says that average cap rates on Class B, value-add deals have compressed by more than 50 basis points between 2015 and 2018. Cap rate compression continues to prevail in 2019, somewhat to Key’s surprise.
“At the end of last year, I would’ve said that we won’t continue to see cap rate compression in the Class B space, but we have,” he says. “A lot of that is due to the attractive interest rate environment. Fannie Mae and Freddie Mac have pulled back a little bit, but we’ve seen debt funds and banks get very aggressive in the value-add space and bridge the liquidity gap.”
The average range for internal rates of return (IRR) on value-add deals has shrunk over the last several years as prices have soared upward, says Krebbs of TMG. Though every deal is different, several years ago investors could reasonably expect an IRR of 18 to 20 percent on a value-add deal, whereas today that range is closer to 14 to 16 percent.
The healthy volume of capital in the marketplace, from both debt and equity standpoints, has also played a
significant role in cap rate compression, says Key.
Spreads between cap rates on Class B and C assets are also tightening, according to Silva of Marcus & Millichap. For owners and sellers, that means it’s a good time to dispose of older, less desirable assets and potentially elevate their portfolios.
“In the current cap rate environment, owners can sell lower-quality assets and get comparable yield on
higher-quality assets that they’re comfortable holding through the next cycle,” says Silva. “The fact that it’s a good time to upgrade portfolios with higher-quality product in better locations is a big driver of sales right now.”
Silva also cited two additional factors as contributing forces behind the burgeoning demand for Class B multifamily assets in DFW: the decline in the 10-year Treasury yield (which stood at 1.53 percent at the time of this writing, down nearly 120 basis points from the beginning of the year) and continued strength in fundamentals.
The consensus among most investors in this space is that a falling rate of homeownership in the metroplex, combined with continued job and population growth, will support even more demand for class B rental units in the years ahead.
DFW isn’t the only market fielding strong investment demand for Class B, value-add product. Fogelman Partners and DRA Advisors recently acquired Retreat at Steeplechase, a 390-unit community in Houston that was built in 1998.
A low yield on the 10-year Treasury pushes investors to alternative vehicles, such as real estate. Meanwhile, the robust population growth DFW has enjoyed throughout the cycle has caused single-family prices to rise at rates above the national average, effectively pushing some households away from owning and into renting.
Rent Gap
According to Key of JLL, part of the reason that investment in DFW’s Class B multifamily market has grown so explosively is that the space enjoys a “captive audience.” The population of Class B renters is in some cases bound by hard income ceilings, but stronger renewal rates across the market are also contributing to growing demand and income streams of Class B properties.
“Annual turnover is much lower than where it used to be,” he says. “Class B renters want a nice place to live but don’t want to pay new construction prices. In DFW, there’s still a sizable gap between Class A and
post-renovation Class B rents. If that gap shrinks, we should see some constraints on Class B, value-add deals, but we’re not there yet.”
According to CoStar, the average market rent for Class A properties in DFW is on pace to finish 2019 at $1.53 per square foot. Rents for Class B assets are projected to close the year at an average rate of $1.23 per square foot.
CoStar also notes that the metroplex has added more than 20,000 new apartments in each of the last three years. One might think that such a heavy building boom would cause Class A rents to moderate, but again, the metroplex’s remarkable growth of renters with strong incomes has kept absorption on pace with new deliveries.
In addition, sources say that despite the surging growth in both asset classes, landlords have generally maintained the same income standards with regard to leasing. Landlords typically expect a tenant to spend about 25 to 30 percent of his or her income on rent, which has kept rent growth fairly in line with wage growth in the metroplex and enabled new supply to experience a healthy rate of absorption.
Where Value Is Added
No two value-add projects are exactly the same, but the concept of value-add has breathed life and relevance into older properties. Buyers in the value-add space have piggybacked on each other’s successes, and as a result, the scope and breadth of these deals is expanding.
In addition, the value-add market is displaying signs of longevity. In just a few years, value-add buyers have become sellers to new value-add buyers that want to build on the existing capital improvements.
“We’ve sold a lot of assets recently that owners purchased in 2014 or 2015 and did low-level renovations — maybe $3,000 per unit on appliances, flooring, lighting or hardware,” says Key of JLL. “But in the new buyer’s eyes, there’s still a lot of meat left on the bone. Maybe it’s new cabinets or tile backsplashes, but we see a lot of deals where new owners are coming in to finish what the previous one started.”
Key also says that value-add buyers are finding new, creative ways to achieve rent premiums, such as adding private patios or backyards. Many older apartments in DFW lack washers and dryers, and furnishing them can justify some added rent.
Ultimately, however, the success of a value-add program is a function of the extent to which the added features or amenities with renters. Booth of Westmount notes that value-add programs are particularly dynamic because each one is curated with the submarket demographics and property limitations in mind.
“If it’s the upper end of the Class B spectrum, granite countertops in kitchens and bathrooms seem to resonate with renters, as do hardwood floors versus carpet, which gives the unit a cleaner look and feel,” he says. “We’re doing package locker systems at most of our communities, and we’re big on resort-style pools with new landscaping and furniture.”
Krebbs of TMG agrees that select features carry more weight than others, and that value-add investors are being forced to dig deeper to capture those extra fractions of points on their returns.
“Investors that may have been undercapitalized on their first deal are realizing that they need to do more, so we actually see budgets increasing for value-add deals,” he says. “Security cameras, covered parking, vinyl flooring, exterior amenities — returns are lower, so owners have to get more creative.”
— By Taylor Williams. This article first appeared in the October 2019 issue of Texas Real Estate Business magazine.