RED Mortgage Capital: Intermountain Region Generates Strong Apartment Performance and Value Creation
West Coast markets garner more press clippings and public attention. But the Intermountain States — Arizona, Colorado, Idaho, Montana, Nevada, New Mexico, Utah and Wyoming — are posting impressive numbers that belie their station in the American consciousness.
Offering Americans the sunshine and outdoor recreational opportunities they crave and the lower operating costs businesses seek, the region is in the nation’s sweet spot and taking full advantage of its position. Population, income and employment growth lead the nation. Indeed, the region claims the four fastest growing states in America — Nevada, Idaho, Utah and Arizona — and its seventh, Colorado. Meanwhile, Nevada, Utah and Arizona recorded the fastest rates of payroll job creation last year, and Colorado and Idaho figured in the top six nationally.
Apartment rents increased accordingly. Late-cycle bloomers Las Vegas and Phoenix posted the fastest rent growth last year among larger markets and Salt Lake wasn’t far behind. Emerging markets like Boise, Bozeman and Reno were in the same league, chalking down high single-digit increases.
Investors competed fiercely for opportunities in the region. Apartment sales volume in the five Intermountain metros (the “Intermountain 5”) covered by RED Capital Research (“RCR”) — Colorado Springs, Denver, Las Vegas, Phoenix and Salt Lake — totaled about $15 billion in 2018. This represented 11 percent of total U.S. volume last year, a considerable achievement for markets that account for only 3.5 percent of the population.
Buyer appetite pushed prices higher and cap rates lower. Standard going-in yields for institutional quality Class B assets declined 5 to 20 basis points in each market in the second half of the year with the exception of Denver, in large part reflecting the popularity of value-add situations. Asset prices advanced 5 to 10 percent, generating another year of double-digit total investment returns.
As elsewhere, pending supply poses the principal threat to market equilibrium and investment returns. Total inventory in the Intermountain 5 will increase nearly 7 percent by the end of 2020, challenging the limits even of markets with the proven growth potential of these. Prospects vary from market to market. We examine the outlook for each below.
Viva Las Vegas: Strong Economic Fundamentals Drive Market-Leading Apartment Performance; Outlook Clouded by Supply, Economic Risks
The Las Vegas economy was in full sail in 2018, powered by a degree of American consumer swagger not seen since the dot.com era, strong demand for new homes and surging business investment in the professional, technical and healthcare service industries. For its part, the tourism and entertainment industry set new records for total visits and domestic and international air traveler arrivals, while gaming revenues stacked up to the highest pile of chips since 2007. Still, leisure service industries accounted for less than one in three new Las Vegas jobs, testifying to the healthy diversification of the contemporary Clark County labor market.
Population and job growth fueled strong housing demand. But increased competition from new and renovated single-family home supply blunted multifamily market share. Consequently, apartment absorption was nearly unchanged from 2017 on about 2,500 units (Reis), despite a 30 percent increase in deliveries to an 18-year high of nearly 4,000 units. Consequently, metro occupancy declined 80 basis points in 2018 to 96.0 percent (Reis), the lowest since 2015. Same-store performance, on the other hand, was considerably stronger. Stabilized asset occupancy increased about 60 basis points over the year and new property lease-up accelerated.
Rent trends were not indicative of a market under supply pressure. All property effective rent surged 8.1 percent year over year in fourth quarter 2018, representing the fastest gain observed in Vegas’ 29-year Reis data history. Same-store rents advanced 7.5 percent. Rent growth in the Spring Valley submarket, the epicenter of workforce housing renovation, stood out, rising more than 12 percent.
Rent growth of this magnitude attracted interest from property buyers. Investors closed on assets valued at more than $1 billion from October to March, nearly equaling the series record for this period set two years ago. Vintage garden properties built in the 1960s and ’70s were the favored target, with the highest concentration centered in Spring Valley. Assets of this stripe commanded unit prices ranging from $80,000 to $110,000, generating going-in yields in the low-5 percent area. Stabilized institutional-quality properties traded to mid- to high-4 percent yields at prices approaching $200,000 per unit for properties with standard amenities and $300,000 for Class A luxury complexes.
Class C properties offered the most attractive value-add opportunities. Rent increases of as much as 30 percent may be achieved by elevating Class C assets to Class B standard, creating the potential for material yield enhancement after a relatively modest investment per door.
Thunderbird Rising: Phoenix Arises From Housing Crash Ashes More Diversified and Resilient Than Ever
Few American markets suffered more than Phoenix during the housing crash. More than 200,000 payroll jobs were lost in less than three years, personal income plunged seven percent from pre-recession levels and home values fell by half.
What a difference a few years can make. This Phoenix is now fully emerged from the ashes. Metro employers created 255,000 jobs since 2015, and more Americans relocated to Maricopa County than any other last year.
Although growth may remain Phoenix’s top business, the economy now is considerably more diversified. In 2006, economic sectors associated with housing and population growth – construction, retail, finance and government – contributed 42 percent of metro payroll jobs. Last year, these sectors accounted for less than 38 percent, supplanted by more stable business and healthcare service sector employment.
The multifamily market prospered during the initial stages of Phoenix’s return to form as rental apartment options appealed to households chastened by memories of the housing crisis. Metro apartment occupancy rebounded 750 basis points from recession lows, touching an all-time high 95.8 percent in 2017, propelled by the greatest one-year space demand since 2000.
Recently, homeownership has regained popularity, restrained only by limited inventory of homes for sale, rising prices and diminishing affordability. Intensifying competition from the single-family market and rising apartment supply trimmed metro occupancy in 2018 to 95.0 percent, and threatens to make further inroads this year. Builders are poised to deliver 20,000 or more new homes and another 7,000 apartments in 2019, which will test the depth of even this mighty market.
RCR absorption models are optimistic in the short run, but occupancy levels surely will come under pressure after mid-year, especially should economic growth decelerate and home affordability improve. Expect occupancy to test 94 percent by next winter.
By contrast, rent growth shows no sign of fatigue. Average unit rent increased 8.4 percent last year (Reis), first among the 50 large markets we model econometrically (the “RED 50”) and the fastest growth recorded here in 24 years. Rent trends of 8 percent or faster were sustained in January and February (Yardi) and are likely to persist above 7 percent through mid-year, according to RCR equations. The models suggest that growth will return to earth later in 2019, but the medium-term outlook is favorable, elevating Phoenix to the RED 50 first decile.
Capital poured into the market last year. Investment sales volume approached $7 billion, exceeded only by New York, Los Angeles and Atlanta. Trade covered the full gamut of metro offerings, ranging from 1970s era value-adds to recent construction mid-rise trophies. Class B workforce housing was the most popular item on the menu, accounting for about half of recent sales. Chandler, Gilbert, Tempe and Mesa were the preferred locales, where Class B gardens with value-add potential traded for prices near $200,000 per unit to going-in yields in the high-4 percent to low-5 percent range. Mid-rise trophies commanded prices near the $300,000 per unit mark, generating sub-5 percent pro forma yields.
Fast out of Gate after the Recession, Denver Now Leads the Region into a More Moderate Growth Phase
Denver’s youth-friendly outdoor ethos and Rocky Mountain pedigree made it the first market in the region to catch the eye of the rising Millennial Generation. Metro vacancy rates as high as 9.4 percent in 2009 plummeted to the mid-5 percent area in just two years as newly employed tenants in their 20s arrived by the thousands.
But adhering to the first-in-first-out rule Denver now is leading the regional shift from the cycle’s hyper-growth phase into a more moderate post-boom era. In terms of economic growth, Denver payroll job creation peaked near 4 percent in 2014, at least one year before its regional rivals. By the same token, job creation has decelerated earlier, too, downshifting to the low 2 percent area in 2017 and 2018, and further to an eight-year low of 1.8 percent year on year pace over the winter even as Las Vegas and Phoenix power ahead at 3 percent growth rates or faster.
Employment growth near 2 percent is no grounds for apology but it may not serve Denver’s apartment market well. Metro apartment construction has grown steadily since 2014, and is poised to reach a crescendo in 2019. Inventory is expected to rise more than 10,000 units (5 percent) this year, and 4,000 units in 2020, more product than Denver could digest even in the best of economic circumstances.
Moreover, Denver apartment owners may experience increased tenant losses to homeownership this year. After several years as one of the county’s most competitive housing markets, for-sale inventories have increased significantly and home prices have begun to soften, even decline in some counties. Households previously priced out of the housing market can expect to have another bite at the apple in 2019, with negative implications for multifamily demand.
RCR models project that apartment occupancy is likely to decline further in 2019 (following last year’s steep 120-basis-point plunge to 94.0 percent), perhaps to as low as 93 percent. Occupancy losses could be greater should the positive linear relationship between unit completions and absorption diminish as supply growth approaches upward historic bounds or should tenants migrate to homeownership in greater numbers than the past.
As in Phoenix, robust rent trends persisted, regardless of rising competitive pressures. Metro average unit effective rents increased 7.0 percent year over year in fourth quarter 2018 (Reis), ranking fourth among the RED 50 behind Phoenix, Las Vegas and Atlanta. Expressed on a same-store basis, rents advanced 3.6 percent in fourth quarter 2018, and a healthy 4.2 percent in February.
Our models suggest that Denver rent trends are likely to decelerate this year as competitive pressures mount. Our rent model expects Reis-specified trends to fall to about 5 percent by mid-year and to the low-3 percent region by year end. The intermediate term outlook remains encouraging, however, with projected rent growth expected to average more than 3 percent during the 5-year forecast interval, positioning Denver in the RED 50’s second decile.
Supply concerns led to more cautious investment behavior after mid-year 2018, contributing to a modest decrease in property market activity. Although sales exceeded $5 billion for the third consecutive year, volume decreased more than $1 billion from 2017, and $1.5 billion from 2016’s record tally.
Buyers mitigated risk by focusing on recent construction yield plays rather than value-adds. Newer construction trophies traded at cap rates in the mid-4 percent to low-5 percent range, representing 25- to 50-basis-point discounts to comparable West Coast properties. Likewise, institutional quality gardens were available in the mid-5 percent region, levels that offered attractive relative value to alternatives on both coasts.
The Salt Lake and Colorado Springs Markets Made Big Noise in 2018, and Investors Were All Ears
Salt Lake is fast becoming the go to escape hatch for financial services firms seeking a solution to prohibitive coastal operating costs and a fertile breeding ground for Fin-tech and Med-tech startups. Aggressive expansion at tech and finance shops propelled metro job and personal income growth to fresh heights last spring and summer.
Although job creation eased over the winter, Salt Lake entered 2019 with powerful forward momentum. RCR economic models forecast that metro personal income growth will be the fastest among the Intermountain 5 this year and that SLC will run neck and neck with Phoenix for employment growth laurels.
Apartment demand is likely to increase accordingly. The Wasatch Front housing market has been the hottest in the region and our models project that it won’t cool off much in 2019. Contrary to the U.S. norm, rising prices historically discourage homeownership in Salt Lake City and that relationship is likely to remain intact this year. Job creation and falling home affordability may increase absorption as much as 25 percent this year, possibly reversing 2018’s 70-basis-point occupancy decline to 94.4 percent (Reis), the lowest in seven years.
Rent trends were among the fastest in the U.S. in 2016 and 2017, but the supply surge and fall economic lull hindered revenue growth last year. Annual trends slid to 3.5 percent in fourth quarter 2018, the slowest in three years. RCR models anticipate further declines over the winter but a return to form in spring. Five percent growth no longer is in the cards but consistent 3 percent annual gains are within reason.
Institutional investors are becoming increasingly active in the SLC market regardless of its relatively small size. Multifamily property sales volume in the second half of 2018 was nearly double 2017, largely due to acquisitions by investment fiduciaries of several recent construction mid-rise trophies. The largest was purchased by a Southern California-based asset manager, priced to a sub-3 percent cap rate with a pro forma yield only in the mid-4s.
But the SLC bread and butter trade remained pre-2000 construction Class B suburban garden product. Central Salt Lake 1970s construction assets were priced from $150,000 to $175,000 per unit to going-in yields around 5.25 percent. Vintage Class B+ complexes constructed in the 1990s sold at prices near $200,000 per unit and cap rates near 5 percent.
Progress in Colorado Springs is tied inexorably to the fortunes of its southerly neighbor, Denver. When Denver sneezes the Springs catch a cold.
As it was, Colorado Springs mimicked Denver’s gradual economic and rent growth slowdown and its supply- and homeownership-driven occupancy rate decline. Rent growth fell from over 7 percent at mid-year 2017 to 3.5 percent in fourth quarter 2018, while occupancy drifted down 110 basis points to 95.6 percent.
RCR’s Colorado Springs rent model is less optimistic than Denver’s, hindered by the metro’s slower historic rent performance and consequent lower equation constant. But in other relevant parameters — income and job growth, occupancy and home price appreciation — Colorado Spring’s outlook surpasses Denver by a considerable margin. Apartment returns, therefore, may surprise on the high side.
Colorado Springs investors didn’t exhibit the growing caution observed in Denver but neither did they dive headlong into the multifamily property pool. Volume last year was roughly unchanged for the third consecutive year at $600 million. Trade was concentrated in ’60s- and ’70s-era value-adds located east of Downtown. Prices averaged about $90,000 per unit, generating yields in the mid- to high-5 percent region, roughly 50 basis points behind similar Denver assets. Buyers targeted post-renovation yields near 6 percent, a realistic goal as Class B properties in this market command 10 percent higher rents than Class C+ assets.
Relative Value in the Intermountain Space
Investors aren’t likely to go far wrong in any of the Intermountain 5. Each is well-positioned to outperform the nation economically and demographically, and the probability that for-sale housing will pose a meaningful competitive challenge to apartment tenancy is low.
But two markets stand out as attractive investment options. The first is Denver, which is distinguished by its highly diversified and comparatively less volatile economy, capacity for above-average rent growth and meaningful cap rate discounts for quality stabilized properties. Currently, we calculate that a fourth quarter 2018 buyer of an investment-quality Denver asset would expect to earn an unlevered annual return of 8.2 percent over five years, seventh highest among the RED 50. Although historic Denver NOI volatility is high, downside risks are not greater than other Intermountain alternatives.
The second is Phoenix. Although its historical volatility is among the highest in our large market peer group, it seems to have found the right growth market formula. A favorable economic balance has been struck between internal (construction, consumer services, government) and external (manufacturing, business services and tech) markets, reducing downside economic risks. At the same time, recent rent growth has rewritten the rules that apply to commodity growth markets and this momentum will not dissipate quickly. We calculate that expected investment returns now lie at about 7.9 percent, an attractive figure for a property market with Phoenix’s enviable liquidity.
— 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.