Philadelphia’s New Brand Identity in Commercial Real Estate
Interest in Philadelphia among commercial real estate investors has been on the rise for years. But the Eastern Pennsylvania market managed to maintain a relatively low profile in the public consciousness, overshadowed by its larger East Coast primary market rivals, each with its own clear brand identity.
But this is largely a thing of the past. Philadelphia has emerged lately as a leader in cutting-edge biotech and life science innovation. The city is a magnet for gene and cell-level therapy entrepreneurs, a status that is rapidly evolving into a distinct brand. Billions in venture capital and real estate investment have followed, elevating the Athens of America to the top rank of U.S. competitors for global investment cash.
The multifamily sector is a chief beneficiary of the trend. Fueled by strong demand for luxury space, builders ratcheted apartment development higher over the past 10 years, raising construction starts from about 4,000 units per year at mid-decade to 6,000 annually since 2017. Currently, there are about 8,000 multifamily units under construction, and the pace isn’t likely to slow much this year.
The magnitude of the supply surge is anticipated with a degree of trepidation in some quarters. Philadelphia renters have never absorbed more than about 4,500 units in a single year, while new supply is likely to approach 8,000 units in 2020, followed by delivery of about 4,000 units next year.
So far, renters have risen to the task. Tenants absorbed nearly 3,000 units last year, according to Yardi surveys, maintaining fourth quarter average market occupancy at 95.2 percent, unchanged from 2018. Indeed, the occupancy of a 1,084-property sample of stabilized same-store properties chalked a 10-basis-point increase to 95.6 percent over the same period, hardly the profile of an oversupplied market.
Performance in the most heavily supplied submarkets — Center City, Frankford/North and King of Prussia — was striking. Same-store occupancy increased in each over the year. Only City West, the epicenter of the life sciences boom, suffered a measurable decline.
Rent trends are following a similar trajectory. Metro same-store effective rents increased 4.2 percent year-on-year in fourth quarter 2019, the fastest growth recorded in the sample’s six-year series, and on a 4.0 percent annual pace in January. Heavily-supplied submarkets lagged the average but in each case recorded gains of 3.5 percent or faster.
RED Capital Research’s Reis-specified econometric rent and occupied stock growth models are optimistic that these favorable trends will persist. We expect tenants to absorb the equivalent of 90 percent of new supply in 2020 and 2021, holding occupancy above the 95 percent threshold, laying the groundwork for further rent increases in the 3.5 percent to 4.0 percent range.
Investors increased acquisitions accordingly. Buyers closed on over 13,000 units last year, a market record and increase of 25 percent over 2018. Total dollar volume decreased 14 percent, however, as buyers elected to steer clear of heavily supplied submarkets, focusing instead on less costly workforce and value-add opportunities outside the urban core. Cap rates for this product were fairly generous by East Coast standards, falling in the mid- to high-5 percent area, with potentially higher yields available for buyers willing to renovate older garden units to Class B+ finishes.
Funds and other institutional buyers gravitated toward recent construction, mid-rise elevations located outside of Center City. Cap rates for this product mostly fell in the mid-4 percent vicinity, with prices per unit universally topping $300,000.
Solid rent growth and moderate decreases in cap rates generated attractive total returns for investors in 2019, estimated at over 11 percent. Prospective returns are likely to moderate somewhat but RED Capital Research models foresee annual unlevered investment returns averaging 8.6 percent through 2024, second highest among the eight Northeast and Mid-Atlantic markets we model after Washington, D.C. While returns may be more volatile now than in the past, multifamily investors will find much to like in the City of Brotherly Love.
— By Daniel J. Hogan, ORIX Real Estate Capital’s Managing Director for Research. RED Mortgage Capital, a division of ORIX Real Estate Capital LLC, is a content partner of REBusinessOnline. The views expressed herein are those of the author and do not necessarily reflect the views for RED Capital Group or of the author’s colleagues at RED. For further analysis from RED Capital Group click here.