Daniel Hogan
Director of Research,
RED Capital Group
As the real estate cycle enters the late innings, multifamily investors increasingly are seeking alternatives to high-cost coastal metros but remain unwilling to sacrifice the property market liquidity found in the primary markets. Many are finding the right balance of opportunity and liquidity in the Mid-Atlantic States, where cap rates are often higher than in the “favored five” markets and value-add opportunities in strategically located Class B properties abound.
RED Capital Research (RCR) performance models suggest that the Mid-Atlantic’s season in the sun has longer to run.
Philadelphia Apartment Market Ranks Second Among the Top 50 U.S Markets for Risk-Adjusted Returns
Sales of Philadelphia apartments topped $2 billion during the 12-month period ending in June, a 125 percent increase over the year-earlier period. Fund and trust buyers dominated trade, concentrating on urban mid-rise and suburban garden value-add plays at mid-5 percent to low-6 percent cap rates. Investors penciled IRRs in the mid-6 percent range for Class A assets, and the low-7 percent area for value-adds.
The metro economy has performed well since 2015 — and posted accelerating gains in the spring and summer. RED Research models forecast further above-trend payroll job creation through 2019, before higher interest rates curb growth.
Developers also are ratcheting up activity, and supply has eroded occupancy. About 4,000 multifamily units were delivered in the year ending in June, of which 30 percent remain vacant, pulling average occupancy down 90 basis points, year over year, to 95.7 percent, according to Reis — the lowest in seven years. RCR models suggest occupancy will bottom over the winter and rebound to 96.3 percent by year-end 2019.
Rent roll and street rents advanced at 3.5 percent and 2.3 percent annual rates, respectively, in the second quarter 2018, up moderately from 2017. RCR models forecast stable growth through 2019, slowing later.
Model-estimated expected and risk-adjusted returns in Philly are among the highest in the country. RCR currently ranks the metro 16th for IRR in its 50 metro peer group and second in respect to risk-adjusted returns.
Baltimore’s Multifamily Sector is Number 1 for Risk-Adjusted Returns
Investors are finding much more to like in Baltimore than crab cakes. Multifamily sales approached $3 billion last year, a 45 percent increase over 2016. While sales will moderate this year demand for Class B infill elevator buildings and suburban luxury and Class B/B- garden complexes remains robust. Cap rates are on par with Philadelphia and often are higher for workforce-oriented value-adds. Buyers project 5.5 percent to 6.5 percent IRRs in most cases, which RCR considers conservative.
After a lackluster 2017, metro area job growth rebounded in the spring and summer, accelerating past Baltimore’s large seaboard peers. Vigorous hiring in the business and healthcare professions powered the growth spurt — trends likely to spur gains in consumer-driven sectors next year. RCR models anticipate further above-average job creation in 2019, setting the table for constructive absorption and rent trends.
Supply levels also are on the rise here and occupancy rates declined accordingly. Delivery of nearly 3,000 units by mid-year saw occupancy fall 30 basis points to 95.8 percent, according to Reis — the lowest in four years. With nearly 4,000 units under construction, further occupancy attrition is possible, but absorption of new space is vigorous and we expect metro occupancy rates to be back on the upswing in the second half of 2018 and into 2019.
Rent growth was deliberate in 2017, but gained traction this year. Street rent growth trends remain tepid but renewal rent increases appear to be on the rise, boosting average rent roll growth to nearly 3 percent year over year in the second quarter, according to Reis. RCR rent models are very optimistic, foreseeing 3 percent or faster annual gains persisting through year-end 2019.
Expected five-year total returns on Class B investments fall in the low 7 percent area, slightly above those in Philadelphia. Moreover, Baltimore’s return volatility is exceptionally low, elevating risk-adjusted returns to the top rank in our RED 50 peer group, perhaps making this metro an ideal option for investors with recession concerns, particularly those seeking workforce and Class B repositioning situations.
Metro Washington, D.C., Submarkets Remain a Favorite but Investors Should Watch Multifamily Supply
Metro DC remains a favored market among global investors seeking long-term stable returns. Investment sales volume exceeded $6 billion last year and is on track to reach $7 billion in 2018. Cap rates currently gravitate to the low- to mid-4 percent area for Class A assets, and the 5- to 5.5-percent range for Class B’s. Total return expectations are lower accordingly: investors target 5 percent IRRs for Class A assets and mid-5 percent returns for B’s, among the lowest of any market east of the Rocky Mountains.
Buyers have Northern Virginia value-add plays in their sights, particularly Arlington and West Alexandria brick masonry buildings that can be readily repositioned to compete as Class A’s. Investor interest also is focused on 20- to 50-year-old garden projects in the Dulles area, where absorption and rent trends have been constructive and could pop if Amazon chooses the area for its HQ2, an increasing likelihood.
Value-add buyers have invested nearly $500 million year-to-date in South Prince George’s County, almost entirely in Class C garden-style properties built before 1980. Cap rates were universally above 5.75 percent and most exceeded 6 percent, generating IRR potential above 7 percent.
Institutions and funds accumulated recent construction trophies in emerging neighborhoods near metro stations in the District, Bethesda and Alexandria. Caps were in the mid-4s and five-year expected returns hover in the 5.0 percent to 5.5 percent area.
Supply concerns weigh heavily on these markets. Nearly 20,000 units are under construction currently and as many as 10,000 will be delivered in 2019. RCR demand models project that District occupancy is likely to fall about 50 basis points by year-end 2019, but overall Capital Area levels should hold firm near the mid-year 2018 94.5 percent Reis baseline as suburban occupancy is positioned to rise slightly so long as the U.S. economy stays on course.
Rent trends, by contrast, are sluggish, constrained by record concession levels. Current same-store street rents are up less than 1.5 percent year over year, while rent rolls are advancing at roughly 2.5 percent. RCR rent models project moderate rent roll acceleration approaching 3 percent in the second half of 2018, but foresee a return to the 2.5 percent neighborhood next year.
Investment return will be similarly modest. Average property NOI is expected to rise at a 2.5 percent annual rate in the suburbs and 3.0 percent in the District. Because cap rates are likely to rise 25 to 50 basis points in sync with Treasury yields, investors should temper total returns expectations as IRRs above 6 percent seem unlikely in all but a few select value-add situations.
— This article was contributed by Dan Hogan, Managing Director of Research with RED Capital Group, which is a content partner of REBusinessOnline.com. 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.