Maturing markets have reduced returns, but consistent cash flows and stability of investments keep capital flowing.

While the multifamily industry has now moved further along the real estate cycle to a more mature position characterized by higher property values and new construction, most industry executives still view the industry and its major players as under control, despite the flood of capital that continues to chase deals.

"From what I have heard at several of the industry's major trade shows in recent months, the players are very realistic about the market and not overly exuberant," says Jonathan Kempner, president of the National Multi Housing Council (NMHC), Washington, D.C. "So, in general, people are not reaching to make deals."

Crown Court Apartments But that is not to say there are not some construction errors being made. "There is a feeling that, due to the abundance of capital, some deals on the margins that shouldn't be built, will be," says Kempner, but he adds this should be limited, and so far it hasn't affected the national picture.

"There are reports of overbuilding in some areas, but the national numbers don't show it," says Jack Goodman, vice president and chief economist with the NMHC. "Rents and vacancy don't indicate any softening in the market."

Nationally, apartment occupancy rose slightly during the fourth quarter of 1997 to 94.4%, according to statistics compiled by Dallas-based M/PF Research Inc. Rents rose 2.9% in both the second and third quarters of 1997 and 3.1% in both the fourth quarter of 1997 and the first quarter of this year. That was a three-tenths of a point improvement over first quarter 1997 figures.

So these key statistics remain strong in the face of some talk of potential overbuilding and, in fact, Goodman believes the discussions and concerns about overbuilding at this point to be a healthy sign, since they indicate the strong level of caution that remains in the minds of developers. Others agree.

"The fact we in the apartment industry talk about overbuilding so much makes me more comfortable," says John Oharenko, vice president in the Chicago office of Horsham, Pa.-based GMAC Commercial Mortgage Corp. "No one wants to get burned again."

On the other hand, many in the apartment industry see overbuilding as just another facet of the real estate cycle. But while they think it is inevitable, they don't foresee the calamity that resulted in the late 1980s.

"[Overbuilding] is going to happen, but the buffer we have now is that we are not leveraging the properties as much as in the past," says Frank McDowell, president and CEO of BRE Properties Inc., a San Francisco-based REIT that operates in the Western U.S. He adds that the trend in the industry is toward higher degrees of leverage.

"We don't have any wild overbuilding, and I don't think we will get back to the problems of the 1980s again," says Robert Sheehan, consulting economist for the National Apartment Association.

The statistics seem to support this stance.

Harvey Green, chief operating officer with Palo Alto, Calif.-based Marcus & Millichap, points out that the resurgence in new apartment construction began in 1994, however, since that time apartment vacancies have moved up only slightly to around 6% at the end of 1997.

"The market has generally absorbed the new product with only slight increases in vacancy in select local markets," states Marcus & Millichap's January 1998 apartment market report. "While short-term vacancies have risen in the Class-A, luxury category, job growth has remained above expectations."

"Absorption has been strong in Atlanta, Dallas, Denver and a few other markets, so there has been no runaway vacancy as yet," says Hessam Nadji, senior vice president of research with Marcus & Millichap.

"Most cities in the Southeast and Midwest were expected to see some decline due to new construction, but it hasn't happened and I credit that to the strong economy," says Douglas Crocker, president and CEO of Chicago-based Equity Residential Properties Trust.

While the economy is important many believe the real key to the continued prosperity of the apartment market to be the amount of new construction.

"I am less concerned about the economy than I am about new supply," says McDowell.

"The deciding factor for investment returns in these markets will be the degree of cutbacks in new construction," agrees Marcus & Millichap's 1998 national apartment market report.

Although new apartment starts were around 280,000 units in 1997, Green points out that figure is only 30% of the total during the last market peak in 1985. So certainly, in relation to the late 1980s, overbuilding does not appear to be an immediate concern.

In addition, while NMHC statistics indicated an eight-year high in new apartment starts during the fourth quarter of 1997, that number was down 13% during the first quarter of this year. "Currently, the level of multifamily building is in-line with long-term needs," Goodman says.

Green adds that the decline in starts is a reflection of a slowdown in apartment absorption. Marcus & Millichap reports that during 1997 the percentage of units absorbed during the first three months after completion fell below 73%. This figure has declined from a high of 81% in 1994.

But statistics can be read in various ways, and some see the decline in apartment starts during the first quarter as just a temporary slowdown as developers in some of the major development markets such as Atlanta, Dallas and Phoenix stop to digest what they have already built.

"What is causing [the decline in apartment starts] is that developers in the high-growth markets are pulling back because the market is telling them 'It's not going to happen,'" says Nadji.

Strong and getting stronger Despite a few negatives, most industry watchers see the apartment industry as strong and getting stronger at least in the short term because it has been making headway upstream to this point.

"The apartment industry is doing well, especially considering the things it has been combating," says Crocker, This includes low interest rates and the impact that has in encouraging current renters to buy homes.

Rose says the high prices on single-family homes in most parts of the country will keep people flocking to apartments.

However, some statistics appear to disagree, at least to this point. Green of Marcus & Millichap says the rise in home ownership has slowed apartment demand. The firm's apartment market report published in January cited a rise in home ownership in the U.S. from 63.5% (an all-time low) in 1985 to 66% at year-end 1997.

"This trend has developed despite an increase of 32% [since 1990] in the nation's median single family price to $126,000," states the report. It goes on to credit record-low interest rates, high consumer confidence and a 7.9% increase in personal income as reasons for the trend. However, first-time renter figures should remain strong since the group's average earnings are 20% under the estimated minimum needed to purchase a starter home, points out Green, adding that the lost renter base has primarily affected the higher-end apartment market.

"It is a good sign that the apartment industry has improved even without the benefit of a strong demographic base," says Sheehan. "There are fewer renters today than three years ago." But ultimately, he says, the number of renters will begin to grow again.

Investor interest remains The apartment industry was the first out of the recession in the early 1990s and, while other real estate properties were at low points, investors gorged themselves on apartment transactions.

"Apartments were the best performers at that time," says Nadji.

But since then the market has matured and the great acquisition opportunities have disappeared along with the double digit returns. Property values rose and the apartment market entered the construction phase of the real estate cycle.

"Prices are now pretty much at replacement costs," says McDowell. "There are basically no areas where you can buy for less."

Nadji says the major increases in property values in most of the country took place from 1993-96, but on the West Coast, which exited the depression later, values have moved about 20% in the last two years.

"Cap rates are 7.0 or sub 7.0 while two years ago they were 8.0 to 8.25," says Geoffrey Stack, managing director with Irvine, Calif.-based Sares*Regis Group. "Most buyers think there will be significant rent increases, so they are willing to pay more,"

The fact new units are now being built is also a concern. "Now there is a threat to multifamily investors from new construction," says Nadji. As this new product comes on line it erodes vacancy numbers and rent increases. Competition and overbuilding have diluted potential earnings.

In addition to new construction, the hotel and office markets reached the recovery and have become more attractive as investments. Today, adds Nadji, these properties are offering investors 8% appreciation compared with only a 3% or 4% return on most apartment properties.

REITs reflect decline

Part of this decline is reflected in the REIT industry. Apartment REITs that have reigned in the early days of the recovery now lag behind REITs focused on other property types. Statistics from the National Association of Real Estate Investment Trusts (NAREIT) show that during 1997 the total return on apartment REITs was 16.04%, below the average return of 18.86% for all REITs.

"Apartment REITs have not been in the leadership group since 1994," says Lou Taylor, senior real estate analyst with Prudential Securities, New York. "In addition to the office, industrial and hotel sectors improving, many of the apartment markets are now at equilibrium, so rental growth is minimal and cash flow growth isn't particularly strong for many of these trusts."

However, although apartment properties don't offer the returns they once did, this does not mean they are not attractive investments.

"Whether a market is perceived as healthy really is relative to the investors' expectations," says Gary Kachadurian, principal of the RREEF Funds, a San Francisco-based pension fund advisor. "The bottom of apartment values was reached in the third quarter of 1992. For opportunists that were willing to take the risks of investing at that time, the returns have been terrific."

"But, today values are up, and for pension funds such as our clients that seek fewer risks and lower leverage the market is very healthy. However, I can see that for opportunistic buyers the market must seem overpriced."

Loan performance is bearing out this reduced risk. The American Council of Life Insurance has measured the delinquency rate of apartment mortgages at just 0.5%, while the overall delinquency rate for commercial mortgages is 1.3%, says Green.

So apartments are still profitable investments, and statistics indicate that they are safer long-term than other property types.

In addition, most investors have found that, over the long term, apartments have performed better than most other property types, Kachadurian points out.

"One of the main reasons is that apartments require fewer capital expenditures than other property types," he explains.

One major area of savings is that apartments don't require large expenditures for tenant improvements when the space turns over, as office properties usually do. Also, no large brokerage commissions need to be paid every time a new tenant is brought in. And apartment properties can pass rental increases along to tenants more frequently due to the shorter lease terms. "There is more opportunity for market corrections in the rent," explains Oharenko.

Multifamily needs fewer upgrades "Another of the nice things about multifamily is that there is less functional obsolescence of the buildings than in other property types," says McDowell. The structures do not need upgrades as often as office buildings.

"For multifamily properties, only about 5% to 7% of net operating income (NOI) is spent on capital improvements," stresses Kachadurian, "while for an office property, often 30%, 40%, even 50% of NOI has to go back into the building."

"Theoretically, investors know that returns in apartments are not as great as in hotel, office and industrial properties, but they still like apartments because they are viewed as safer investments for a number of reasons," says Nadji.

While the cost of apartment projects are high, so are the occupancy figures, and the cash flows from these projects are substantial. "For a variety of reasons, apartment are very stable investments," says Nadji, who points out that losing one tenant in an office or industrial project can be very detrimental to investors' interests, but with apartments no single loss of a tenant is going to have much of an impact.

Another factor in the investors' preference for apartments is that "housing is fundamental," says McDowell. "People always need a place to live regardless of the economy. A bad economy may impact the rents you can get, but people still need housing."

And, of course, consumer demand could grow.

"We will continue to have at least 15% of the population in apartments," says Goodman, who adds that recent changes in the capital gains tax could result in as much as a 10% rise in the number of apartment dwellers in the next decade.

Changes in the traditional idea of the American Dream are also having an impact on apartment living. "A lot of younger people are opting to invest in stocks and bonds rather than home ownership," says Hal Rose, executive vice president in charge of production with Calabasas Hills, Calif.-based ARCS Commercial Mortgage Co., L.P. "They say, 'I am going to invest money to create a nest egg, not buy a house.'"

The stability of apartment investments is also growing as the number of REITs in the industry increases.

The number of REITs in the National Multi Housing Council's (NMHC) list of the 50 largest apartment owners, published in National Real Estate Investor in March, rose from 12 to 14 during 1997 and, for the first time in its nine-year history, a REIT was the largest owner. In addition, the number of apartment units owned by REITs nearly doubled last year to 632,051, giving the 14 REITs in the NMHC 50 a 4% share of the nation's rental apartments.

Several acquisitions and consolidations among these REITs has since increased those figures.

"Having REITs in the industry is definitely a positive," says Oharenko. "The fact they are public companies make more information about particular markets available and lessens the likelihood that less knowledgeable developers will begin unadvised projects.

"Plus, analysts are constantly policing the actions of the REITs and if there is a problem the brakes go on rather quickly," he adds. "If one of the REITs doesn't do its homework on some projects they will be quickly punished."

Money being "thrown" at apts. The advantages of apartment investment apparently are known to just about everyone, since so much capital is available for the acquisition, refinancing and construction of multifamily projects.

The amount of capital available continues to increase. "It is literally being thrown at the industry," says Sheehan.

"Borrowers are without a doubt in the best market since the 1960s," says Oharenko. "The amount of capital is at record levels and the prices haven't been this low in a long time."

Spreads on capital have dipped below 100 basis point above Treasuries in some cases and routinely run in the 150 to 200 basis point range.

"If spreads get any lower, it is going to be difficult for lenders to make a profit," says Rose. "So why would they go lower?"

But the competition to place money in the industry may provide that answer.

GMAC, which placed approximately $6 billion in total loans last year, expects to increase that total by at least 20% in 1998, and the same should go for its apartment loan totals, says Oharenko.

Rose projects that ARCS Commercial Mortgage, which currently services $2.4 billion in apartment loans, will service between $6 billion and $8 billion by the end of the decade.

And, of course, apartment REITs had a market capitalization of more than $24.6 billion in 1997, according to NAREIT statistics.

The steady cash flows and lower risk investment are part of the reasons for the continued strong investment interest in multifamily. But the commercial mortgage-backed securities market is also playing a part.

Conduits and other developers of these loan pools are seeking to add more apartment loans to make the pools more attractive to investors. "The most stable real estate properties are apartments, and there is currently a great demand to finance them and put them in these pools to add to their stability," says Rose.

Pension funds that historically have dealt only with Class-A properties have even begun buying Class-B and -C properties in order to place more money in the industry.

But too much of a good thing - even money - can present problems.

Too much money chasing too few deals always spells trouble for the real estate markets," says Nadji.

"There is more capital than deals," agrees Stack. "And that is resulting in some of the overbuilding that is occurring."

With this in mind many apartment firms are looking to locate in markets that have some barriers to entry - such as availability of land, topographical restrictions or perhaps stringent zoning. "This reduces the risk of overbuilding and cuts down on competition," says Scot Sellers, president of Security Capital Pacific Trust, Englewood, Colo.

Some apartment firms have been focusing on secondary markets for some of the same reasons. "We look very favorably on loans for properties in secondary markets," says Oharenko. "We feel there is less chance of overbuilding because there is not as much momentum for new construction."

Bigger is better Consolidation of apartment companies will be a continuing trend in the industry as more and more companies strive to take advantage of the economies of scale they can create through mergers, as well as diversifying geographically.

"You can't take advantage of the efficiencies unless you get bigger," says Crocker. "It is just a matter of a lower cost of doing business."

"Consolidation among the REITs is almost a necessity," says Nadji. "The pressure on them to buy and develop more property makes consolidation a natural fit for them."

Nadji adds that the reduction in competitors can only help in the bidding wars for properties. "Two firms merging to add to their portfolios is better than four or five companies bidding up prices," he points out.

This pressure to grow is also showing up in the number of REITs that have gone into the development business.

San Francisco-based BRE Properties Inc., the nation's sixth largest multifamily REIT, has joined the growing ranks of multifamily REITs turned developers. The firm is investing $200 million for the development of 2,445 units in five major markets in the western U.S. and plans to double that development investment by the end of the year.

"I think almost all apartment REITs have a development arm and a strategy," says McDowell, whose firm acquired its development capabilities from Trammell Crow late last year.

But as always the moves are determined by investment returns. "Acquisition yields are relatively unattractive, in our opinion," says Sellers. "Right now the development yields are the best way to go."

But consolidation will not be restricted to apartment owners, the number of capital sources should decline as well. "I definitely see a consolidation in our industry as well," says Rose.

The competition to offer lower priced capital will require lenders to take advantage of all the efficiencies they can muster to be competitive.

The wild West

A few years ago, most real estate executives didn't want to admit there was such a place as Southern California, but today the region and, in fact, the entire West Coast is booming as the markets have reached the point the rest of the country occupied a few years ago.

The apartment industry is driven by job growth, and Southern California is now thriving with new industry. "The region did lag coming out of the depression and it now has finally replaced the defense jobs that were lost in the late 1980s," says Sellers.

"The entertainment, bio-tech and tourism industries are all flourishing around Los Angeles," says Stack. He reports that Orange County has been adding 40,000 new jobs a year recently, while up the coast the Bay Area has added 70,000 new jobs.

"The high tech industry is really thriving there," adds Sellers.

But some say things were never as bleak as they appeared. "As recently as 1995 California was perceived as being depressed, but things have probably improved so quickly because they were never as bad others thought."

Many in this growing base of workers in Southern California are looking for apartments and the occupancy rate, already around 96%, is expected to climb another percentage point or two in the near future, says Stack, adding that San Francisco's vacancy rate is currently about 1%.

"Southern California is behind the rest of the country in the cycle, so good acquisition opportunities still exist," he says, adding that Orange and San Diego counties are both experiencing significant rental increases.

Property values have also moved significantly. "Almost every property that has sold has done so at a price greater than the asking price," says Stack.

Nadji says, in addition to Los Angeles and San Francisco, San Diego and Seattle are also very healthy apartment markets.

Tax change may boost demand for apartments With the supply of new multifamily units on the increase in most areas of the country and vacancies beginning to tick up in some markets, apartment owners, developers, lenders and potential investors are putting even more emphasis on gauging the future demand for apartment living.

With the economy booming, job formation is boosting demand in many areas, but the industry is expected to get another boost to demand from an unlikely source - the tax laws.

A provision in the Taxpayer Relief Act, signed into law by President Clinton last August, basically eliminated capital gains taxes on the sale of owner-occupied housing.

Jack Goodman, vice president and chief economist with the National Multi Housing Council, Washington, D.C., describes what the change means to homeowner this way: "Under previous law, homesellers were liable for the gains tax unless they bought another house of equal or greater value within two years of the sale. Sellers aged 55 and over could claim an exemption from the tax, but only once and for no more than $125,000 of gain."

"Under the new law, the first $500,000 of capital gains on a home sold by joint-filers is exempt from the tax. For single filers, the cap is $250,000," Goodman explains. Another new advantage is that the claim on the maximum gain is allowable every two years, with the only condition being that the home must be the sellers' principle residence. Under these guidelines, few homeowners would be liable for the tax.

The advantage for the apartment industry is that these former homeowners no longer have to buy a new home to avoid the capital gains tax. Apartments are now an option. And for older executives looking to simplify their housing or veterans of numerous transfers, looking for less permanent ties to a location, apartments are an obvious solution.

"The tax change removes an obstacle for homeowners in cashing out equity in their homes," says Hessam Nadji, senior vice president of research with Palo Alto, Calif.-based Marcus & Millichap. "It opens things up for a lot of people."

"It will definitely get more residents to consider rental alternatives," Goodman says. He points out that of the approximately 1 million homeowners moving interstate each year, currently only 50% choose to rent and only half of those choose apartments. Furthermore, he adds, the new law eliminated the time factor in a buying decision and should at least extend the amount of time the residents remain renters.

But the real question many in the industry are asking is, "To what extent will this tax change and the residents affected impact the apartment market?"

"It is definitely uncharted territory," says Goodman, however, he believes the impact could be substantial, possibly increasing the number of new apartment households by as much as 10% in the next decade.

Since the homeowners that benefit from this tax change are on the high end of the income spectrum, most feel the luxury apartment market would benefit most, and Goodman says this sector could see as much as a 15% demand over the next five years.

Others in the industry are less optimistic about the impact of the tax change. Some see the change as a positive but are unsure of the extent it will drive demand, particularly for mid-range apartment units.

"It will help on the high-end apartment sector, but I don't think it will have a major impact on the bread and butter apartment industry," says Douglas Crocker, president and CEO of Chicago-based Equity Residential Properties Trust.

"I don't think the tax change is going to cause the market to be flooded with renters," agrees Nadji. "It is not going to be an overnight shock-wave to the apartment industry."

Whatever its final impact, the change in the capital gains tax is a positive for both homeowners and apartment owners. *

Other are taking a wait-and-see approach, but so far without results. "Every time there is a tax law change it has an impact of some kind," says Frank McDowell, president and CEO of San Francisco-based BRE Properties Inc. "But, to date, I haven't seen any discernible change in the market."

But Goodman stresses that any change will take some time, and he underscores the fact that "the switch from owning to renting does not have to be permanent to boost apartment demand substantially. Demand increases both when more people switch to renting and when the average renter remains a renter longer."

Currently the growth rate for apartment occupancy is about 1% annually. Goodman says that if the 10% increase in apartment households is realized over a five-year period, the annual would be tripled.

Whatever its final impact, the change in the capital gains tax is a positive for both homeowners and apartment owners.

Institutions learning their property ABCs The desire for multifamily properties has been great since the early 1990s, but as the market has matured and moved along the recovery cycle the number of good acquisition properties disappeared rapidly. And the competition for the remaining properties continued to increase.

This is especially true for Class-A properties, which traditionally have been the domain of real estate investment trusts and pension funds. "It is a fact that the Class-A inventory is not as great as it use to be," says Hessam Nadji, senior vice president of research with Palo Alto, Calif.-based Marcus & Millichap.

But as these trophy properties vanished from the market, the desire of REITs and pension funds to acquire apartment properties did not.

This is particularly true of REITs. "Wall Street is a stern taskmaster," says Robert Sheehan, consulting economist with the National Apartment Association. "It requires that you keep acquiring properties." REITs have even gone into the development business to gain new product for their portfolios.

But they have widened there criteria for acquisition as well. This change in acquisition strategy for these institutional owners has taken the form of lowering their sites by focusing on Class-B, and even Class-C, properties with upside potential.

"They are buying many of these properties at good prices, because their values have not risen as much as the upper-end product, and then spending additional money to upgrade them to A properties," says Jonathan Kempner, president of the National Multi Housing Council, Washington, D.C.

"REITs are very comfortable buying Class-B properties," says Hal Rose, executive vice president in charge of production with Calabasas Hills, Calif.-based ARCS Commercial Mortgage Co., L.P. "Besides, the difference between Class-A and Class-B properties is often just a matter of semantics." He adds that 95% of his company's loans are for Class-B properties.And many Class-B properties are sound acquisitions regardless of any potential for upgrading. "Good Class-B product is a good investment for cash flow alone," says Nadji.

"Apartment s in good locations are never going to be vacant," adds Gary Kachadurian, principal with The RREEF Funds, in the Chicago office of the San Francisco-based pension fund advisor, and 1998 chairman of the National Multi Housing Council.

By stepping down to Class-B and -C properties, the institutions have discovered another advantage. "In addition to the lower entry price, they are finding that there is often less competition for the mid-range market segment in their location," explains Nadji. "Ninety percent of the new product being built is of the higher end variety. So there is not a lot of competition from new product for that tenant base."

>From the pension fund perspective, the stepping down in property class may just be a matter of the institutions learning more about the apartment industry.

Kachadurian says institutional money only began coming into the apartment market in 1988 because, prior to that, the current tax advantages did not exist. But although the incentive to invest in apartments was added, each investor had to develop its own market expertise,

"When they know nothing about an investment product, investors tend to get what is newer, cleaner and which has less history," explains Kachadurian. "This usually will mean less problems."

But, he adds, over the years the pension funds have gained a better understanding of the multifamily market and now know how Class-B and -C properties can fit into their investment strategy.

So institutional investor interest in Class-B and -C properties isn't a trend in the apartment industry that is likely to end. But rather, it is a sign that they have passed another important point on the management learning curve.

"It is a very smart strategy," Kachadurian says. *

"Today, when the decision is either buy Class-A properties in less favorable locations (which usually means further from the city center), or C+ or B- properties in good established locations, pension funds are choosing the well-located property."

However, he points out that these properties require both renovation and repositioning to be able to drive rents. "It is a very smart strategy," Kachadurian says.

But it is not a strategy for every company.

"Many institutions will look at a variety of property classes, but the question is, do they have the management expertise to reposition the properties successfully?," says John Oharenko, vice president in the Chicago office of Horsham, Pa.-based GMAC Commercial Mortgage Corp.

"The buyer must have the expertise with an eye for renovating a property. But consider this a barrier to entry that eliminates some of the competition," says Kachadurian.

So institutional investors interest in Class-B and -C properties isn't a trend in the apartment industry that is likely to end. But rather, it is a sign that they have passed another important point on the management learning curve.