This is the first in a three-part series on the state of multifamily development and lending across the U.S. as credit quality concerns mount.
Amid concerns of a peaking multifamily market, publicly traded U.S. real estate investment trusts in 2016 were net sellers of multifamily properties for the first time since 2009.
In total, REITs sold $13.0 billion more multifamily properties than they bought. In the past 10 years, the only previous time REITS off-loaded more multifamily assets than they bought by such a large amount was in 2007, when sales dwarfed purchases by $21.11 billion.
REITs' caution around making new property investments follows a long and steady escalation in apartment values, which have more than doubled since 2010, according to a national index from Moody's/Real Capital Analytics. In recent months, a flood of new construction has depressed rents in coastal markets. New York and San Francisco, both key markets for the largest multifamily REITs, Equity Residential and AvalonBay Communities Inc., saw rent growth flatline in 2016.
Other markets, including Los Angeles, Denver and Seattle, have also faced supply concerns — though in Seattle, strong technology-sector job growth has kept rent growth rising. However, some industry observers say concerns about peaking values spread beyond major cities.
"Multifamily has just been overbuilt throughout the United States," said Jay Rollins, co-founder and managing principal at JCR Capital Investment Corp., which invests in properties valued at $50 million or less. "Everywhere. And it will decline everywhere."
Slim returns in some markets
Rising interest rates further complicate the investment picture. As investment rates go up, capitalization rates — a ratio of rental income to purchase price that moves inversely to price — might be expected to increase as well. In theory, property buyers dealing with higher capital costs stemming from rising rates should reduce the amounts they are willing to pay in order to achieve a more attractive yield.
Still, sales data does not show property prices declining in response. According to data firm Real Capital Analytics, cap rates dipped to 3.9% for mid- and high-rise apartments nationwide in the 2016 third quarter. In San Francisco, the average cap rate stood at just 2.7%, barely above the 10-year Treasury rate, but with considerably more risk.
Such low yields make it difficult for buyers to reach their target returns on coastal market purchases, even for buyers like private equity firms that can deploy higher leverage than REITs can, Drew Babin, an analyst at Robert W. Baird & Co. Inc., said, adding, "You're not going to see urban properties become appealing until there's visible [rent] growth re-acceleration."
Broadly, observers say, property buyers seeking near-term yield are avoiding coastal cities, leaving them to long-term investors like sovereign wealth funds and high-net-worth individuals. But whereas REITs have cooled on acquisitions nationwide, some prominent private equity firms have still pursued deals in the middle of the country, where "the math can still work," Babin said.
Private equity and REITs' differing outlooks after multifamily's long rise reflects REITs' relative risk-aversion and their inability to take on high levels of debt to squeeze returns out of low-yielding properties, observers say. Private equity firms typically use higher leverage — 60% to 70% versus less than 40% for public REITs — and can weather potential market underperformance with less shareholder scrutiny than REITs.
Opportunity in the eye of the beholder
Most notably, Starwood Capital Group kicked off 2016 by buying 72 properties from Equity Residential for $5.37 billion, and said Jan. 19 that it will acquire Milestone Apartments Real Estate Investment Trust, a Canadian REIT that owns U.S. Sun Belt properties, for $2.85 billion.
Those deals followed Brookfield Asset Management Inc.'s acquisition of Associated Estates Realty Corp. and Lone Star Funds' takeout of Home Properties Inc., both in late 2015. Each REIT largely owned properties away from the coasts — in the Midwest and Sun Belt, respectively. In 2016, Camden Property Trust sold a 15-property Las Vegas portfolio for $630 million. The company did not dispute a report that the buyers were Bascom Group and Oaktree Capital Management LP.
Equity Residential, whose chairman, Sam Zell, famously sold another REIT, Equity Office Properties, at the peak of the last cycle, has spent years selling properties in small and midsize markets to focus its portfolio on the coastal cities' strong demographic trends. Starwood and its private equity peers, meanwhile, see the current opportunity in the apartment market in smaller markets, where buildings cost less relative to the amount of rental income they generate.
Both Camden and Equity Residential declared special dividends with their sales' proceeds rather than invest them back into property.
Historically, apartments have been a relatively safe bet. Apartment buildings are one of the more stable real estate asset classes over time, Babin said — in part because they have the backstop of funding from Freddie Mac and Fannie Mae. Even for top-of-the-market buyers, patience can be valuable. Apartment prices rose 62% over the decade beginning in November 2006, despite two years of sharp price declines that began in 2008, according to the Moody's/RCA index.
"Properties only declined in the face of the fear," said Mitch Clarfield, senior managing director for Berkeley Point Capital LLC. "Those that had the capability to hold the assets through the downturn really didn't suffer that badly at all. Sometimes, they fared extremely well."