It's a great time to be renting apartments from Summit Properties Inc. in Austin, Texas. With the city's technology bubble suddenly burst, occupancy rates at the company's two apartment complexes in Austin plummeted from 97% in third-quarter 2000 to 88% in third-quarter 2001. To entice renters to its 850 local apartment units, Summit is offering free rent along with big-screen televisions and DVD players. The company even has initiated a raffle with a free apartment for an entire year as the grand prize.
“The Austin marketplace will be fine in the long term, but it's going through some indigestion right now,” acknowledged Michael Schwarz, CFO of Charlotte, N.C.-based Summit, which owns and manages 20,000 apartment units in seven states. “Apartment vacancies in most cities are higher than they were a year ago,” he said. “It's a difficult operating environment today.”
The troubles that Summit is enduring in Austin are not an isolated phenomenon. In the third quarter of 2001, there was a nationwide vacancy rate of 4.5% in apartments, up from 3.2% in the same period a year earlier, according to Carrollton, Texas-based M/PF Research Inc. Also, rent growth registered -.1% in the third quarter of 2001 after a scant .3% increase in the second quarter, according to Dallas-based Axiometrics Inc. By contrast, rents increased 3.6% in the third quarter of 2000.
Cities such as Miami and New York and Los Angeles remain in relatively good shape, but others, such as San Jose, Calif., Atlanta and Phoenix, are now classified as “distressed” by Merrill Lynch & Co. analyst Steve Sakwa, who tracks 31 apartment markets around the U.S.
“Apartment markets nationwide are still in the down phase of the real estate cycle with no recovery in sight until mid-2002 at the earliest,” Sakwa said. “Weak markets outnumber healthy ones, and the imbalance is widening. Three months ago, 10 of the 31 markets were in good shape. This time around, there are just eight such markets.”
In the late 1990s, rent increases of 5% to 10% per year were the norm in many cities where demand routinely out-paced supply. Now, the balance of power has shifted from landlord to tenant with the onslaught of the recession, and landlords are finding that even price cuts aren't enough to fill up empty spaces. Apartment players know that they are simply in the midst of a down cycle and comfort themselves with the knowledge that another up cycle is out there somewhere on the horizon. It's just a question of when.
In the meantime, landlords are offering as much as two months of free rent in some places along with a host of other freebies, ranging from microwave ovens and parking to health club memberships. Also, more property owners have begun to offer rent-to-own programs, affording their residents a savings vehicle for a down payment on a single-family home. In sum, apartment owners who hate to see any unit sit idle for more than a month are scrambling for ways to keep a steady income stream flowing.
Concessions by the Bay
When looking for the sometimes dramatic impact of the economic slowdown on the apartment sector, one need look no further than the San Francisco Bay area. The three markets that make up the area — San Francisco, Oakland/East Bay and San Jose — are in the worst shape of all, according to Sakwa. He calculates that rents in northernhave fallen between 7% and 11% during the past year.
Approximately 67% of the apartments in San Francisco are now being rented with concessions attached, according to Axiometrics — a dramatic increase from the 10% figure of a year ago. Nationwide, 60% of all apartments were rented with concessions in the third quarter of 2001, according to Axiometrics, compared with 36% a year earlier.
The current climate is a sharp contrast to the heady days of the late 1990s. For instance, rental rates in San Francisco rose at least 10% every year between 1996 and 2000. Free-spending corporations rented apartments for interns and traveling employees, filling up one-fourth of the units in some complexes.
Lee Carlson, CEO of San Francisco-based BRE Properties Inc., which has 3,500 units in nine properties in the San Francisco area, recalls that vacancy rates at his company's properties were a razor-thin 2% in 1999. Turnover was just 55% annualized, far below the industry standard of 65%. Concessions were unheard of.
What a difference two years make. BRE's San Francisco rents plummeted 15% in 2001. Occupancies have slipped below 95%, and turnover is running at an 80% rate. “We never believed that rental rates would continue to go up like they did in the late '90s,” Carlson said. “But we've had more of a correction than we expected.”
In fact, rates have fallen so far at BRE properties that many customers are upgrading. “Families with two-bedroom units are finding that they can move up to three bedrooms now at a cheaper price,” Carlson said. “Renters today have a lot of choices. A year or two ago, they only had take-it-or-leave-it options.”
BRE was opposed to rent concessions for many years, but the company is relenting lately and experimenting with modest giveaways, including a $200 move-in allowance, free DVD players and raffles for prizes donated by local merchants. BRE asked a consulting firm to survey residents on their attitudes and found that rental rates merely ranked ninth on a list of reasons to stay in an apartment. More important to residents are such considerations as how building managers treat them and how quickly maintenance personnel respond to a service call.
There are other things a company like BRE can do to stimulate rentals, Carlson explains. The company has boosted its media promotions and displayed more banners and balloons on weekends to attract apartment shoppers, with the expectation of closing leases with at least one-third of the visitors who come through its doors. To motivate rental agents, the company offers extra commissions of $50 as a reward for filling hard-to-rent spaces.
Elsewhere on the West Coast, circumstances aren't quite so dire. Carlson reports that the luxury segment in Los Angeles is soft, but rents are either stable or rising in single digits. The company is in the process of delivering a new property called Pinnacle at Otay near San Diego, which will feature rents ranging from $1,200 to $1,800 per month. “Leasing is going very well there,” Carlson said. “We're actually above our pro forma expectations on price for the property. The entire Southern California market is still supply-constrained and healthy.”
Tough times elsewhere
The apartment sector's tough times aren't limited to the West Coast, as landlords in the rest of the country are struggling with the recession as well. Chicago-based RMK Management Corp. completed a 336-unit apartment complex in Aurora, Ill., last May. The company figured the property would be two-thirds full by now. Instead, the property is just 40% occupied.
To boost interest in the property, RMK is offering tenants free parking and a book of 10, $100 coupons that residents can use at any time toward their rent. “This gives the resident flexibility,” said Anthony Rossi, RMK's president. “They may choose to use five of the coupons in a month like January when they have a lot of Christmas bills to pay.” The company also is offering residents such amenities as kitchen TVs and microwave ovens to closewith wavering rental prospects.
In the Atlanta metro area, AMLI Residential Properties Trust of Chicago has delivered a new 200-unit property called Kedron Village just south of the city that has been slow to attract interest from renters, despite offers of free rent for a month. Robert Aisner, president of AMLI Management, estimates that 13,000 new apartment units were added to the Atlanta market in 2001 at a time when job growth had stalled.
“Generally when we open a new property like Kedron Village, we expect to be stabilized within a year,” Aisner said. “We obviously won't get leased up within that time now. Instead of being stabilized by the third or fourth quarter of 2002, we'll probably push that back a couple of quarters.” He added that AMLI has slowed new development starts.
“We began slowing down on the development side about 10 months ago,” Aisner explained. “We wanted to be in a position with very little exposure to new construction going forward.”
Atlanta landlords, in particular, must be careful when making concessions in order to lure residents, according to Kenneth R. McCullough, an attorney with the law firm of Seyfarth Shaw in Atlanta. In Georgia, renters have a broad right to early termination of leases — a provision meant to benefit military personnel apt to be transferred on short notice. When the economy was healthy, the provision wasn't a problem since landlords could routinely rent apartments as fast as they were handed back. No more, however. As a result, McCullough emphasized that landlords should only grant concessions that are designed to be amortized over the entire life of a lease.
“If you grant, say, a month of free rent and give it upfront, when the renter breaks the lease you have no way of recapturing that concession,” McCullough noted. “It's best to spread the concession out over a full 12 months if you can.”
Another concession problem has cropped up in Atlanta, which is sensitive to any preferential treatment on housing matters. What if a concession is granted to one renter, but not to another who never bothers to ask? McCullough advises his clients to carefully document any special deals. “If you're knocking $50 off the monthly rent for a customer, make it clear in your records you're doing so because that was the only way you could get the customer to sign with you,” McCullough said. “If you have good documentation, you're less likely to be accused of a Fair Housing violation.”
Conditions also are softening in markets such as Washington, D.C., and Boston that had been holding up well until recently, said Jeff Franzen, a partner in the Washington, D.C., office of Dallas-based Lincoln Property Co. Conditions could get much worse before they get better. In Washington, D.C., for instance, 40,000 new units are slated to be delivered over the next three years.
Lincoln has responded to the softening of these markets by offering such deals as the equivalent of one month of free rent spread over the first four months of a one-year lease. But Lincoln, like most other large landlords these days, employs sophisticated computer software to fine-tune the concession process.
“We may have a single apartment complex with 100 one-bedroom units, with 20 different price levels for those 100 units. We price according to what floor the apartment is on, whether it has a fireplace, etc.,” Franzen said. “Our concessions follow a similar rifle approach. Even in a soft economy, you can rent your best apartments at full price. The unpopular locations are the ones most likely to require concessions.”
Irving, Texas-based JPI also has responded to the recession by pro-rating free rent. For instance, in Austin, the company has noticed rival landlords of new properties offering as much as eight weeks of free rent. JPI has jumped into the concession fray to remain competitive and fill the four new complexes of its own that it has brought to the Austin market. However, JPI is careful to prorate its free rent over just the first three months of the lease.
“By the fourth month we like to get our residents back to a regular rent level,” said Jo Ann Blaylock, an executive vice president of JPI. “If you prorate free rent over an entire 12-month period, people get used to what they perceive as a lower rent level. Once the lease expires, you'll then have more trouble getting them to return to paying regular street rent. They'll view that as a huge increase.”
Rent to own
Instead of new tenant concessions, Chicago-based Equity Residential Properties Trust, which is generally reluctant to offer free rent, is hoping that one of its well-established programs will help it get through the economic downturn. Since 1995, the company has offered the “Rent With Equity” program, which allows its residents to set aside a portion of their monthly rent for the purchase of a single-family home.
The policy doesn't cost Equity anything, as partner homebuilders offer the discount and fund it themselves. In Atlanta, where Equity has about 11,000 apartment units, some 70 single-family homes were built under the program in 2000.
What's in it for the homebuilders that partner with Equity? “We essentially are feeding customers to them, which allows them to save on marketing costs,” said Gerry Wiatrowski, senior vice president of marketing at Equity.
Is the company shooting itself in the foot by helping residents save for a new home? “If people are going to leave for a new home, they're going to leave,” Wiatrowski said. “With our program, the longer they stay, the more credit they can earn toward that home. We find people are remaining with us for an extra year so they can earn another $2,000 toward their dream house. It actually can help retention.”
Waiting for the up cycle
Taking into account the recent negative trends, Merrill Lynch's Sakwa has scrambled to lower his earnings estimates for the 11 apartment REITs he covers. He still thinks the entire group will enjoy an average annual growth in earnings of 6.2% between 2001 and 2005, but he has pared back short-term “Buy” recommendations on such stocks as Equity Residential, Englewood, Colo.-based Archstone-Smith and Summit. Sakwa predicts that the average occupancy rate for the group will fall 1.5% over the next 18 months, signaling that the market has not yet hit bottom.
The current apartment market is actually being squeezed from two angles, according to Mark Yura, a real estate lawyer and partner with the law firm of Piper Marbury Rudnick & Wolfe in Chicago. “Low mortgage interest rates have enabled many renters to escape apartment living for home ownership,” Yura said. “At the same time, the loss of jobs and growing unemployment have forced some tenants out of rental living. They're doubling up with roommates or moving back home with mom and dad.”
And yet the low interest rates carry a silver lining for apartment owners as well. Yura has been busy assisting clients in refinancing their rental properties. “Companies are fixing their long-term debt at very low levels right now,” he said. “Their cost of ownership has been reduced. As a result, even with vacancies rising, most apartment owners are not in any real distress. They'll get through this.”
In the meantime, some companies are using the down cycle to hunt for acquisitions. For example, Chicago-based Jupiter Realty Corp. recently purchased a 440-unit apartment complex in Houston for an undisclosed price.
“We felt we bought at just the right time in Houston,” said Donald A. Smith, chairman and CEO of Jupiter Realty. “The market was overbuilt. But now construction has slowed and the additional inventory is being absorbed.”
Jupiter Realty is seeking properties that feature occupancies below 90% and heavy rent concessions, and that have the potential for a turnaround once new management is in place and renovations are completed. “We don't expect to get bargains like you could in the early '90s, when you could get apartments for 70% of their replacement costs,” Smith said. “But we think we can find assets for 80% to 90% of replacement value.”
Like many other apartment industry players, Schwarz of Summit is not discouraged about the long term. Most apartment companies are heartened by predictions that the current economic downturn may prove to be a relatively short one. The general consensus is that rental rates will remain soft through the first two quarters of 2002, then begin to escalate again, albeit modestly.
“Beginning in 2003 the demographics will begin working in our favor. That's when the Echo Boom — the children of the Baby Boom generation — enter their prime rental years,” Schwarz said. “We're ratcheting back our development during the next year, but beyond then we see good opportunities in certain markets.”
It appears that concessions will remain an annoying necessity for landlords for a while. But renters signing 12-month leases now may find that the freebies won't be offered again next year.
H. Lee Murphy is a Chicago-based writer.
A SOFTER APARTMENT MARKET
During the recession, the multifamily sector has seen vacancy rates increase, which has resulted in more rental concessions. The chart below lists the apartment occupancy rates in some major metropolitan areas for third-quarter 2001 and the percentage change compared to third-quarter 2000.
|Third-quarter 2001 |
|% change from |
|— Source: M/PF Research|