After years of historic increases, 2017 was the year that the central business districts (CBDs) of the nation’s major cities lost some of their luster. Multifamily rent growth slowed in cities like San Francisco and San Jose, Calif. Landlords in some submarkets, such as San Francisco’s South of Market (SoMa) district, actually lowered rents and offered concessions to new tenants during the early part of the year.
These West Coast cities were not alone. Rents in New York, Chicago and Miami grew only slightly, while rents in Washington, D.C., actually contracted.
Sluggish rental growth in markets like these is one reason for a significant change in the results of Capital One’s Multifamily Survey. When asked where they expected to see the greatest increase in value in 2018, 43 percent of multifamily respondents named secondary and tertiary markets, while another 35 percent selected suburban markets. Only 17 percent chose urban markets.
This contrasts markedly with the results from the previous year’s survey. At that time, 47 percent of respondents selected urban markets, 27 percent chose suburban, and 19 percent named secondary and tertiary.
Urban Markets on Pause
There are a number of reasons why urban markets have fallen from grace. One is simply an overabundance of supply. There were 380,000 multifamily units completed in 2017, up from 320,000 units the year before, Marcus & Millichap estimates.
Exacerbating the effects of this increase was a developer focus on high-end apartments in CBDs. Nearly a quarter of all units delivered in 2017 were in urban cores as developers targeted the millennial market with amenity-laden properties. Unfortunately, developers are finding that the rents they must charge to justify their investment in expensive CBD real estate are pricing out all but the most well-heeled millennials. As a result, Marcus & Millichap believes Class A vacancy rates will rise from 6.3 to 6.8 percent in 2018.
From City Centers to Suburban Cities
Investors are following renters, and both are on the hunt for better values. Many renters are abandoning the CBDs in favor of smaller, less expensive cities like Oakland, Calif. Downtown Oakland has a vibrant cultural scene and is home to tech firms like music-streaming service Pandora. It is also a short commute by BART to jobs in San Francisco. Oakland rents increased 6.2 percent in 2017 as prices exceeded $240,000 per unit, reflecting an emphasis on Class B transactions as new Class A assets leased up.
The dichotomy between Seattle and Tacoma, Wash., is not quite as stark. With a tech sector anchored by Microsoft and Amazon and soaring home prices that have made rentals an attractive option, this metropolitan area has turned in impressive rent growth over the past three years — but even here, suburban Tacoma has the edge for investors.
Seattle has averaged 6.3 percent annual effective rent growth since 2015, with occupancy exceeding 95 percent, according to Axiometrics. Annual rent growth over the same period in Tacoma was 8.3 percent, and occupancy averaged an equally impressive 96.4 percent. The decisive reason: differences in inventory growth. Seattle’s inventory has averaged 2.8 percent growth over the past five years; Tacoma’s only 0.8 percent. Put these facts together, and it is no wonder that properties in desirable areas of Tacoma were trading for upward of $300,000 per unit at year-end 2017, according to Marcus & Millichap.
Reconsidering Secondary and Tertiary Markets
But as Tacoma prices suggest, some suburban markets have become pricey and some investors are looking farther afield. Respondents to Capital One’s Multifamily Survey predict 2018 will be a breakout year for secondary and tertiary markets. The performance of California markets like Sacramento and the Inland Empire confirms this contention.
Anchored by state government, Sacramento was never ravaged by the recession the way the Inland Empire was. Steady, diversified job creation in recent years has also driven demand for apartments. For their part, developers have kept pace with demand, and their projects were distributed fairly evenly throughout the city. This has led the metro’s average unit sales price to surpass its 2007 peak. Even so, at roughly $130,000 per unit, Sacramento remains attractive to investors seeking an affordable alternative.
Although the Inland Empire suffered during the recession, its location in the midst of one of the greatest transportation corridors in the nation meant it would ultimately recover — and recover it has. Hiring is robust but, as is the case with Sacramento, many workers are still not ready to pay a premium for home ownership. With a modest number of deliveries in the pipeline, rent growth is expected to remain at 6 percent with vacancies under 4 percent. Ontario and Rancho Cucamonga are expected to see values exceeding $200,000 per unit.
Investors Recalibrate Their Approach
Although the consensus is that rising values in 2018 will be found in suburban, secondary and tertiary markets, most investors are sticking to established strategies. Some investors with institutional money behind them may venture into secondary markets like Sacramento, but tertiary markets are still a no-go zone for many of them. Others are sticking to the core, adjusting their investment horizons and staying in familiar markets.
On the other hand, value-added investors have become more adventurous. Much of the value-added potential in primary markets has already been realized, and these investors are expanding their criteria to include suburban locations and properties in secondary or tertiary markets.
The multifamily market is finally beginning to settle down now that it has recovered most, if not all the ground lost during the recession. This is evidenced by the shift in increasing values away from the urban cores. We may see more activity as the gap between bid and ask becomes more reasonable and sellers and buyers finally settle upon the same page.
— By Kristen Croxton, Senior Vice President, Originations, Capital One Multifamily Finance. This article originally appeared in the Finance Insight e-newsletter, a special publication by REBusinessOnline, offering insight on the lending market leading up to and following MBA CREF 2018.