Multifamily investment activity in Connecticut is expected to gain some additional momentum this year after a reasonably strong 2008. Last year, investors’ fears of the added risks associated with lower-tier assets limited transactions to mostly Class A and B+ properties in the state’s urban areas. While reduced investor demand for properties in secondary and tertiary locations will continue, buyers are expected to target Class B/C apartments in stable CBD markets. Buyers will likely target lower-tier properties in the New Haven and Hartford core, Hamden and the Fairfield/Bridgeport/Trumbull Triangle, where students drive demand for properties. Fewer Class A transactions and the presence of low-leverage opportunistic buyer funds will likely result in a shift in pricing trends, causing cap rates to increase to the mid-7 to 9 percent range.
Apartment properties are trading and being financed in the region, thanks largely to agency lenders and still-active local and regional commercial banks. With the fall of the CMBS market, a financing void has emerged in the local and national markets. In 2006 and 2007 CMBS originations nationwide totaled more than $400 billion. Our research suggests that more than $80 billion in CMBS loans will come due in 2009-2010 and recapitalizing those loans will be a key to restoring financial stability in the markets.
In Connecticut, apartment owners are generally not facing added competition from shadow inventory; unsold condominiums and foreclosed or unsold single-family homes and as a result will remain net beneficiaries of the housing downturn due to the expanding renter pool. However, vacancies are expected to escalate in 2009 due to job losses. In addition to greater apartment renter retention generated by more stringent mortgage requirements, owners will also benefit from the return of many homeowners to apartments as ARMs reset at substantially higher rates. Average per-unit sales value through fourth quarter of 2008 in Connecticut was $137,163, which compared favorably to $142,782 per unit for year-ending 2007.
The current apartment transaction climate, defined by various degrees of price declines, should be distinguished from the sector’s long-term intrinsic value. Properties that must be sold in today’s environment clearly require discounting from previous years’ values in order to clear the market. Nationwide property values are expected to drop by an average of 21 percent but we fully anticipate that Connecticut assets will fare much better. While opportunistic buyers in the market will be looking for high-octane returns, well-managed and well-maintained Connecticut properties will still command reasonable prices although pricing on IRR and cap rate will yield to purchasing on cash-on-cash returns based on 12-month trailing data.
The challenge in predicting an exit strategy and terminal cap rate suggest that active investors in the market are looking for cash returns on investment in the first year of 8 to 10 percent. For an owner contemplating a sale in the foreseeable future (within 2 to 4 years), this is the best time to sell as we only expect yield criterion to continue trending upward. More than ever, a fresh look at each property’s hold, refinance or sell strategy is warranted, given the recent market volatility.
Commercial mortgage delinquency rates have increased, although they remain close to historical lows, with the overall average below 1 percent. The number of distressed commercial real estate assets in Connecticut will rise over the next year as fundamentals weaken and institutions and major investors continue to de-leverage their portfolios. Additionally, some development deals will likely stall due to financing issues and many properties purchased with adjustable-rate mortgages will reset in 2009 and 2010.
Investors must differentiate distressed properties from the rest of the marketplace, which remains extremely healthy compared to historical standards and other major property sectors. There is greater delinquency risk in the years ahead; however, with a significant number of large, floating-rate loans due to mature between 2010 and 2012. Connecticut multi-family owners with reasonable leverage and relatively healthy operations are expected to comprise the majority of the marketplace in 2009. These investors will continue to ride out the downturn and will be rewarded by several key factors that point to long-term value. The significant decline in new construction, combined with renter demographics similar in scope to the baby boom wave as they entered peak renting years, will be the main drivers of value creation.
Transaction volume in Fairfield County, Connecticut’s “Gold Coast,” decreased by 37 percent from the previous year, when condo conversions were still considered viable. Average per-unit value also decreased from $566,315 to $533,631. Tolland and Windham counties saw nominal trades for 2008, accounting for only 0.25 percent of the statewide sales. Middlesex County had a healthy year, accounting for 12 percent of total units traded in Connecticut for more than $76 million.
Hartford County transactions decreased by 54 percent from the previous year, but average per-unit value increased by 17 percent to $85,464. Hartford, known as “New England’s Rising Star,” will be on many buyer’s radar screens this year as there will be a number of opportunities to invest in what is perceived as a growth market. In both the cities of New Haven and Hartford, people working in downtown are now also living in newly constructed or adaptive re-use properties in the CBD. The convenience and access to shops, restaurants and theaters has become highly attractive to urban renters and we expect this pattern to continue. Sales volume in New Haven County doubled from the previous year: $115,708,000 in 2007 to $230,156,000 in 2008 and per-unit value increased by 26 percent, jumping from $81,657 to $102,657.
Professionally managed units typically outperform privately owned properties by roughly 10 percent. This gap was more evident in 2008 as institutionally owned properties comprised the bulk of the units traded. Additionally, many of the properties sold in 2008 offered a value-add component, which nominally increased intrinsic property value. It remains a good time to sell and based upon actual underwriting, an excellent time to buy.
With nominal construction starts, excellent base industries, historically high occupancy and healthy rental growth, Connecticut remains at the top of many buyers’ lists of preferred markets for multifamily investing. With changing demographics, more echo boomers entering the rental market and baby boomers rethinking housing alternatives, the market is expected to quickly return to historically strong occupancy levels and solid rental growth for those property owners intuitive enough to competitively maintain their regional apartment communities.
While we expect 2009 to continue to be a tough year for the commercial real estate market, multi-family is the preferred product type for both institutional and private investors because it delivers stable, solid returns, particularly in the supply-constrained New England markets.
— Steve Witten is the first vice president and senior director of the National Multi Housing Group at Marcus & Millichap Real Estate Investment Services.