COVER STORY, SEPTEMBER 2012

MULTIFAMILY ROUNDTABLE
Houston multifamily experts praise city's 2012 performance.
John Nelson

It’s considered common knowledge that multifamily properties are a hot commodity and the darling of the commercial real estate world. Investors are interested in Class A and B properties, banks and other lending organizations are bullish on lending for apartment refinancing and acquisitions and tenants are filing into the developments. Positive absorption and minimal construction are expected to drive multifamily occupancy to highs not seen in years.

For the sixth quarter in a row, the U.S. multifamily industry has improved in market tightness, sales volume, equity financing and debt financing, according to National Multi Housing Council’s (NMHC) Quarterly Survey of Apartment Market Conditions.

Houston is standing at the forefront of the positive trend with an uptick in employment and a stable of industries, most notably oil and gas, that has fueled the sector’s growth in the city. From June 2011 to June 2012, Houston’s nonfarm employment rose 3.3 percent by adding approximately 85,000 jobs, according to the U.S. Bureau of Labor Statistics. The job growth outstripped the national increase of 1.3 percent and was the only MSA with job growth passing 3 percent.

Houston has also increased its annual effective rent growth by 1.7 percent from July 2011 to July 2012, which ranks Houston as the No. 9 MSA in the country in terms of annual effective rent growth, according to Axiometrics. Additionally, Houston currently has a 93.4 percent occupancy rate, up 180 basis points from last year.

Construction is slated to double in 2012 compared to 2011, but only 10,500 units are under construction and another 15,000 units have been planned, most of which are Class A properties, according to Marcus & Millichap. Vacancy should reach its lowest point since 2006 due to minimal new supply and a projected 9,000-unit absorption.

Investor interest in the Class A space has driven down cap rates, but as the inventory of apartment properties for sale wanes and falls short of demand, investors will move on to Class B+ products because of its upside and first-year returns.

To best gauge the ins and outs of Houston’s multifamily performance, Texas Real Estate Business picked the brains of four multifamily experts specializing in Houston: Brian Austin, director of development at Alliance Residential Co.; Greg Austin, managing director of Jones Lang LaSalle’s Houston office; Ed Cummins, senior vice president of investment services at Transwestern Houston; and David Wylie, principal at ARA’s Houston office.

B. Austin: One of the largest drivers for increased demand is the fact that fewer prospective renters are purchasing single-family homes. The reasons for this are two-fold. First, prospective renters are finding it difficult to purchase homes due to more onerous and stringent lending requirements. As a result, one of their only viable options is to rent. Second, we are seeing an increase in renters by choice, or people who avoid home ownership due to a preference for the flexibility of living in a multifamily community. For example, residents may desire the ability to move to another city or another part of town if they change jobs. Being this nimble is more difficult with home ownership.

On the investment side, investors recognize that demand has increased and supply will remain somewhat in balance. Clearly, there will be submarkets that will deal with oversupply issues, but sophisticated investors see that as a short-term problem for a long-term investment. Additionally, the historically low interest rates and readily available debt are driving demand for existing multifamily product. Investors are realizing that interest rates will ultimately increase over current levels, which will further increase the value of the investment.

G. Austin: Job growth, population growth and limited financing for new home buyers, which lowers home ownership and increases apartment tenancy, has driven demand for tenants occupying multifamily properties.

Cummins: Jobs, jobs, jobs and low interest rates are the main drivers.

Wylie: From a tenant’s perspective, jobs are the No. 1 driver and lack supply is the No. 2 driver. Lack of supply includes multifamily supply, but also lack of single family options. The lack of single family options is an interesting trend. We are hearing from owners and operators that tenants can’t afford to live in a single family home that allows for the same quality of life that their apartment provides. That might include the physical quality of the community, but also includes location and the school district. We also hear that when residents are qualifying for single family and giving notice to terminate their lease, the process is taking up to six months longer than it did in 2006 or 2007.

From an investor’s perspective, Texas has outperformed every other market in the country. Supply has been held well below historic averages in every market, and as a result of job growth, absorption has remained strong. Rent growth has increased over historic averages in every market, and we have three-, six- and, in some cases, 12-month trends to prove it. Historically, the knock we hear from some investors on Texas multifamily is that there is no restraint on development, and that usually comes from someone who was burned on a deal 30 years ago. However, we see the market restraining itself today in the form of conservative capital markets. Yes, development is coming in some of the better submarkets across the state, but in every Texas market, the supply numbers are far below their historic averages. The market is restraining itself today in the form of available and or willing capital partners. It is harder to raise equity than it was in the last cycle.

La Maison at River Oaks in Houston sold for $208,000 per unit earlier this year.

La Maison at River Oaks in Houston sold for $208,000 per unit earlier this year. TREB: In what submarkets and for what types of multifamily properties are deals getting done? What are some of the largest (or most important) multifamily sales that have occurred this year in Houston?

B. Austin: The majority of new developments are occurring in infill or urban submarkets. Deals that are considered “Main and Main” locations are garnering more attention from equity sources. Any deals that are in lesser locations are more challenging to finance. Suburban deals continue to be difficult to finance, but it appears that equity is starting to look to these areas. However, in order for suburban development opportunities to attract equity, the location must have a compelling story. For example, being in close proximity to an expanding employment center or a location with high barriers to entry.

G. Austin: There are more than 25 new multifamily transactions being developed inside and around Loop 610 and the Galleria, Greenway Plaza. Sales in 2012 include LaMaison at River Oaks selling for $208,000 per unit, San Brisas in the West Houston energy corridor selling for $ 204,000 per unit, The Arcadian Kirby project in the Medical Center selling for $144,000 per unit, The Verona at the Reserve 30 miles from downtown selling for $118,000 per unit and Discovery at Shadow Creek in Pearland selling for $113,000 per unit.

Cummins: Deals are happening in all submarkets and in all classes from Class A to Class D. We sold a 1,038-unit non-performing Class C portfolio for about $20,000 per unit in a submarket where similar deals had been trading in the $12,000 to $13,000 per unit range. In my opinion, this was a significant transaction because it changed the “price of poker” for these types of assets.

Wylie: Multifamily transactions are occurring in every product type and in every market. The investor demand is as strong as we’ve ever seen it for distressed assets, because the supply has shut off. We are also seeing stable Class C sales with real cap rates and not just price per unit buys, which in most cases are the distressed deals from two years ago coming full circle. Additionally, we are seeing stable Class B assets trade, which we didn’t see any of two years ago.

The Class A value-add and Class A core asset transactions have remained strong. The market is deep with capital for all asset classes. They have all been important for different reasons. For example, the market needed to see the full circle distressed sales occur because it frees up short term opportunistic capital to be redeployed and it gives confidence to other investors as they see success stories. We didn’t see many true Class B trades for a few years, so it was important to see those deals start to happen to establish value benchmarks and to free up capital to redeploy. Odds are, if you held on to a Class B asset in the down years, you have made money, and hopefully that capital will end up back in the market.

The top of the food chain deals are always important because it gets the larger funds and institutions active, which in turn provides confidence and also sets benchmarks for the market. All of these transaction types were important for one common result — record high prices. The fundamentals have improved so much that these assets are trading at market cap rates, and we are breaking high water marks, which again, shows success stories and justifies additional investment.

TREB: How is multifamily construction/repurposing going in Houston? Has it increased, decreased or stayed the same compared to this time last year? For what reasons?

B. Austin: Houston, Austin and San Antonio have seen a dramatic increase in construction as compared to this time last year. These three markets saw virtually no new units under construction mid-year 2011, but are now seeing significant deals under construction and in the pipeline.

The strong demand for existing product has resulted in downward pressure on cap rates to the point that investors have turned to development opportunities. For example, cap rates for infill properties are between 4 percent and 5 percent. Investors will begin to consider development opportunities in a similar submarket with a projected yield of 6 percent to 7 percent. The spread of 200 basis points is considered acceptable for an investor to take the risk associated with a development opportunity.

Furthermore, investors recognize that renter demand has far outpaced deliveries during the past two and a half years. Austin has seen absorption outpace deliveries 292 percent, San Antonio by 139 percent and Houston by 342 percent. During the last 10 years, these three markets did not see demand outpace supply by such a wide margin.

G. Austin: Construction has picked up tremendously during 2011 due to Houston’s continuation of leading the nation in job growth. The city has a pipeline of supply for new units in excess of 10,000 units. There was a quarter of that number in 2011.

Cummins: New construction is on the rise. In Houston, we have about 4,700 units in lease-up in 22 properties, 11,500 units under construction in 46 properties and more than 17,000 units in the planning stages. Assuming the units will be developed, the total only represents approximately 60 percent of the new supply delivered between 2007 and 2009.

Wylie: Multifamily development is up in the urban core and in the best of the suburban submarkets. Development has increased from this time last year because of demand. Most of the urban core markets and better suburban markets — where development is coming — have seen double digit rent growth during the last 12 to 18 months. The numbers work and justify new development.

Repurposing has increased in the urban core because there is not much available raw land.

TREB: What types of lenders are active in the marketplace? What are they most bullish on? Describe the challenges, or lack thereof, of securing financing for new development or acquisitions.

B. Austin: Generally speaking, all the banks are making multifamily construction loans. The banks are focusing on underwriting and want to make sure that developers are realistic on their rent projections. Furthermore, banks are focusing on sponsorship. Those development companies with a proven track record and a strong balance sheet are able to secure financing.

G. Austin: Primarily institutional investors are in the market today, but there is a lot of private equity placed into new developments. They are very bullish on core locations and being in the middle of the job hubs. The challenges are that lenders are requiring 25-40 percent equity in these developments and construction costs are starting to go up by 10-20 percent compared to 2010/2011 costs.

Cummins: We are working with local, regional and national banks, the GSEs, life insurance companies and conduit lenders. As investments sales advisors, we look closely at the sponsorship of the buying entity. If the sponsor has a good track record and liquidity, we feel comfortable about the financing options.

Wylie: The government agencies, including Fannie Mae and Freddie Mac, continue to capture the majority of market share for multifamily lending. Five-year rates are as low as 3-3.25 percent with seven-year rates ranging from 3.5 to 3.75 percent and 10 year rates between 3.75 to 4 percent. The fact that they will lend up to 80 percent loan-to-value at these rates makes them tough to compete with relative to other financing sources.

Life companies continue to look for well-located, institutional quality product and are able to offer more prepayment flexibility than the agencies, as well as ability to lock rate at application. However, they are usually capped at 65 to 70 percent loan-to-value. Additionally, the recent drop in interest rates has caused life companies to institute floors which have made them less competitive than the agencies even on lower leverage transaction. We are seeing some CMBS lending on Class B and C deals where the agencies and life companies are not as active.

Lenders, similar to equity investors, are most bullish on the macro fundamentals of the multifamily industry such as declining home ownership rates, a supply pipeline well below historical norms and job creation leading to demand for new households.

Acquisition financing is readily available for well-qualified sponsors who have ownership experience and financial strength. Development financing is harder to come by as regional banks have been hit hard in recent years with overexposure to residential and commercial loans. Leverage levels are lower than in the last cycle and recourse is more stringently enforced. Only qualified sponsors are able to source construction financing easily; though this market continues to thaw as banks balance sheets improve and the economy improves.

TREB: What types of properties and markets are still struggling? For what reasons?

B. Austin: Properties that have significant deferred maintenance or are in inferior locations are not performing well.

G. Austin: Mid-level Class C properties are still a challenge. That segment classification makes up about 35 to 40 percent of our market and there is a lot of ownership transition right now. They are in average to below average condition and these owners, for the most part, are not very deep pocketed. Therefore, they are not putting a lot of capital back into the properties and that is what is needed to happen before they turn the corner. The Alief, Northwest Hosuton, Northeast Houston, Champions East, Sharpstown and Fondren Southwest are the submarkets that are struggling the most right now.

Cummins: Any over-leveraged asset is struggling, but in particular Class C properties with deferred maintenance can really doom an asset’s fate.

Wylie: We haven’t seen any submarkets that are struggling as a whole. Where we still see problems are where the owner is under-capitalized and as a result, not spending capital improvement dollars.

TREB: What are some of the different trends you’re seeing for condos and apartments in Houston?

B. Austin: Developers are focusing on upgrading interior amenities. China has opened the door to high-quality products at affordable prices. As a result, developers are able to upgrade interiors at reasonable costs. For example, granite was considered a significant upgrade a few years ago — today it is standard for high-end communities. The same is true for solid-wood flooring. Under-counter mount sinks are also now relatively common in new properties, and the majority of new high-density projects provide air-conditioned interior corridors. The next wave of apartment upgrades will relate to home automation and control, allowing residents to control air conditioning and lighting remotely.

G. Austin: Very little trending in the condo market, as we see very few successful apartment to condo conversions in Houston. For new apartments, the trend is still towards making the unit sizes smaller, higher-end finishes and the amenity packages more attractive.

Cummins: Operationally, we are finally seeing improving fundamentals in workforce housing. Class A properties were the first beneficiaries of significant job growth in the second quarter of 2010 and we are just now seeing improvement in the lower-end properties. On the investment side, we are seeing more yield driven buyers with a long-term hold strategy and are less concerned with price per unit.

Wylie: School district means everything. Well-located condos in good school districts are renting and or selling ‘sight unseen’ in some cases. Otherwise, the condo market mirrors the single family market in Texas. We have a healthy supply of townhomes that compete with the condo market and provide a good dense housing option in good locations.

Trends for apartments are the same as mentioned above, dramatically increasing rents, fully occupied properties with waiting lists — especially in strong school districts. A client told us a story last week about a family that came in to rent a two-bedroom in a 2010 built asset in Katy. Our client had no two or three bedroom availability and the market has no two-or-three bedroom units. So, our client leased this family two different one-bedroom units, next door to each other.

TREB: What’s on the horizon for multifamily activity in Houston? What do you expect will be the big story in the next six months?

B. Austin: I believe that we will continue to see strong absorption and rent growth in Austin, Houston and San Antonio during the next six months — new supply will be readily absorbed and concerns related to oversupply in these markets will be unfounded. Furthermore, Investor demand will continue to be strong for new, quality product and I expect to see record-setting prices paid for high-end properties.

G. Austin: We still think that acquisitions of existing product will continue to rise because of the need for the investor to still deploy capital. As interest rates remain low, this will spur more sales and refinances and keep the pilot lit on new development, so more proposed new construction. There should be some nominal boost in single family housing too. With the expected job growth and population increases that Houston is experiencing (and should continue to as population flocks to the coastal regions), we should see rental growth and occupancy improvement. Our big story will continue to be the relocation and new development growth of ExxonMobil just south of The Woodlands, which is in full swing and should be somewhat complete by 2015, bringing 10,000 immediate direct new jobs and up to 50,000 indirect supporting job positions.

Cummins: I expect transaction and development activity to remain strong. The big story will be the lease-up of the new units being delivered. A majority of these deals are high-end Class A in-fill projects.

Wylie: The big story will be whether or not we can maintain this pace. All of Texas is in unchartered territory with the fundamental performance of the market. There is some speculation as to whether or not we can maintain this level of performance and “How high can rents go?” is the question buyers and developers are asking as they underwrite deals.

The other big story is equity for new development. Currently, there is some equity in the market doing deals, but not much. Because of the strong fundamentals and competitive acquisition market, pricing is increasing. As the news of successful transactions spreads through the market, will development equity remain conservative or get aggressive again? This will impact the entire market, and beyond, including land prices, commodity prices, labor prices, rents, lenders, transaction professionals, developers and their partners.

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