Multifamily W Minnesota

The suburban apartment market is stronger than you think

David Carlson

Many real estate experts predicted that the multifamily market would run out of steam three years ago, and some are now saying they expect to see apartments take a dive next year. They were wrong in 2013, then again in 2014 and again in 2015. And the weight of evidence is against them in 2016.

Guest post by David Carlson, Redwood Capital Group

Many real estate experts predicted that the multifamily market would run out of steam three years ago, and some are now saying they expect to see apartments take a dive next year.  They were wrong in 2013, then again in 2014 and again in 2015.   And the weight of evidence is against them in 2016.

The apartment market—and in particular, the suburban garden apartment market—will continue to perform well for years to come, short of another significant economic shock.  This is true throughout the Midwest and in nearly every major MSA nationwide.

We can expect to see rent growth decelerate, and vacancy rates will rise in certain submarkets.  But barring a major economic shock that affects all property types, the apartment market will continue to perform well for the next few years.

The doom-and-gloom crowd relies on two simplistic arguments.  One is that real estate markets turn down every eight years or so, and it’s been eight years since the last downturn.  But investors make money by analyzing supply and demand factors, not by simply looking at a calendar.

The other case against apartments is that new construction is at its fastest pace in a decade, and is therefore overheated.  The fault in that logic stems from the fact that multifamily starts were at a historical low point for several years while demand increased steadily.  In fact, the 283,000 units that came on line in 2015 fell short of the 49-year average of 341,000 units, according to Federal Reserve Economic data analyzed by Marquette University.

A report from Marcus & Millichap estimates that 1.3 million new households will be created in 2016, translating to net absorption of 300,000 apartment units in the 12 months ending in September. The national vacancy rate stands at 3.5 percent, the lowest since 2002. And first-time home buyers are in short supply due in part to stringent lending requirements and a lack of entry-level homes for sale, the report stated.

Demographic and cultural trends also favor the apartment market.  Millennials are renting longer than previous generations, as a lifestyle choice in some cases and by necessity in others.  In addition, many Baby Boomers are downsizing from homes to the maintenance-free lifestyle of apartments.  And some of the families who lost their homes during the recession continue to rent with no plans to return to homeownership.  The number of people over 55 years old in apartments has increased by 200,000 households in the past decade, while home ownership levels have steadily fallen.

As a result of these trends, apartment occupancy levels have risen and rents have increased.  Nationally, average rents have climbed by more than 21 percent since 2010, with the largest increase of 4.6 percent in 2015, according to the REIS Report.  The past 12 months have seen rent growth moderate, to about 2 percent nationally.

Urban versus suburban

As apartment rents have risen faster than household income, affordability has become an issue in many submarkets. Rents may flatten out, especially in urban submarkets that have experienced the most development and have commanded the highest rents in recent years.  The Marcus & Millichap report notes that most of the development in recent years has been concentrated in just 10 major metro areas, some of which have begun to offer concessions as leasing has grown more difficult.

When investment professionals suggest that the multifamily market is primed for a downturn, they’re typically focused on these concentrations of urban high-rise properties, which conceivably could run into problems.  If STEM (science, technology, engineering and mathematics)-related industries hit a bump, however, the impact on suburban apartment properties would likely be positive rather than negative.

In 2015, 75 percent of all large new apartment properties across the country were high-end luxury buildings, the vast majority of them concentrated in urban work-live-play neighborhoods.  In the Midwest, 73 percent of apartments were high-end luxury units, according to an analysis of Yardi Matrix data compiled by RentCafe, which went on to observe that this tilt is continuing in 2016. Some Midwestern cities—Kansas City and Milwaukee among them—gained no new apartments outside the urban core.

In other markets like Chicago and Minneapolis, suburban development has been very limited. A Colliers report on Minneapolis/St. Paul  includes a breakdown of development by submarket, which reveals that the vast majority of new projects in the past four years have been confined to downtown Minneapolis and the Uptown/St. Louis Park submarket.   Most suburban submarkets have added fewer than 1,000 units in that time.

As affordability becomes an issue, the high-end luxury segment is first in line to feel the heat.  In Chicago, the average monthly rent for a luxury apartment is $2,417, compared to $1,323 for non-luxury units.  When renters in high-end luxury units can no longer afford to pay most of their income for rent, many of them will turn to the next-best thing:  suburban apartments with many of the amenities they’re accustomed to enjoying.

Luxury Amenities for the Mid-Market

New urban luxury apartments in recent years have attracted upscale renters with a range of amenities that rival resort properties:  rooftop terraces with poolside bars, social gathering areas with food and drink options, fully equipped business centers, concierge services, and so on.  Now, suburban renters can enjoy many of the same on-site amenities, albeit on a more modest scale.

Redwood Capital Group’s investment strategy is to buy well-located suburban apartment properties in need of cosmetic upgrades, and bring them up to near-luxury status with new interior finishes and amenity packages rarely seen in garden apartment communities.  For example, after acquiring The Reserve at Hoffman Estates, a 642-unit property in Chicago’s northwest suburbs, we upgraded interiors with maple or espresso cabinetry, black appliances and other features common in luxury units but rarely seen in mid-market properties.  The 30-year-old property already had two outdoor pools, and we added a hot tub, sundeck and barbeque grills to pool areas.  Other new amenities include a cyber café, dog park and upgraded fitness center.  The Reserve’s amenities certainly aren’t as impressive as those in many Fulton District high-rises in downtown Chicago, but at less than half the cost in rent, it’s a highly attractive alternative.

As suburban apartment investors, Redwood’s executives have found many such value-add opportunities in the Midwest and across the country.  Compared to urban luxury properties, there are fewer institutional investment competitors, so going-in cap rates are moderately more attractive, and in many cases, there are supply constraining barriers to entry such as zoning restrictions and public resistance.  This is in contrast to many urban markets where development has essentially been encouraged by cash strapped cities.   And in many instances, in the suburbs there is limited other nearby properties with the same level of amenities and unit features post renovation.  This is in contrast to urban properties where a renter can simply walk down the street to the next one in line.

Best of all, suburban properties are likely to withstand an economic downturn as well as, or better than, other commercial property investments.    The apartment market isn’t likely to turn sour any time soon—but if and when it does, quality suburban apartments are positioned to benefit from the losses of the urban luxury segment.

David Carlson is managing director and founder of Redwood Capital Group, a multifamily property investment firm based in Chicago.  Redwood currently owns and operates about 35 apartment properties, totaling nearly 11,000 units valued at more than $1.08 billion.