Who would have ever thought that higher interest rates could be a blessing? But for apartment owners, such a turnabout couldn't come soon enough. Record-low interest rates over the past few years have led many apartment tenants to vacate their units in favor of homeownership and the American dream.

But apartment owners may have to wait a bit longer before a bump in interest rates stimulates rental activity. While the interest rate on a 30-year home mortgage climbed to 6.34% in mid-May, up from 5.38% in March, that's still incredibly low on a historical basis. The Federal Reserve Board is slated to meet later this month to consider raising interest rates to curb inflationary pressures. Any increase in the Fed Funds Rate would likely have a ripple effect on the automobile and housing industries.

Linwood Thompson, managing director for Marcus & Millichap's national multifamily group, contends that the home-buying frenzy will continue either until mortgage rates rise to at least 7% and lenders tighten underwriting standards, or home prices escalate to the point that fewer families can qualify for a loan despite the low interest rates. In Southern California, for example, home prices jumped 29% over the last year.

An interest rate hike would benefit investors in secondary markets, says Tom Thompson, executive vice president of investments at Coldwell Banker Commercial Real Estate Partners in Newport Beach, Calif. His firm owns apartments in Austin and San Antonio, Texas, as well as Richmond, Va. “When interest rates go up, we're going to make so much money that we won't know what to do,” says Thompson.

Apartment investors, especially institutions operating without leveraged capital, will heave a sigh of relief, too, as competitors — especially condominium developers — begin dropping out of the picture. Kevin Chin, senior advisor in San Francisco for Irvine, Calif.-based brokerage Sperry Van Ness, says higher interest rates will temper private investor activity in the hottest markets where cap rates have plummeted to 6% over the last two years.

Rising interest rates help strike a balance between values and cap rates, notes Christopher Grey, principal with Los Angeles-based investment banking firm Haverford Capital Advisors Inc. But David Sonneblick, principal with Los Angeles-based investment banking firm Sonneblick-Eichner, warns that although cap rates will follow rising interest rates, “there will be a lag before this happens, and capital will move from real estate to other asset classes.”

With the help of industry experts, NREI set out to take the temperature of the apartment investment climate. What follows is a regional snapshot.

California: Hot

A hike in interest rates is unlikely to impact investor activity in Southern California, where demand for apartments far exceeds supply. The region leads the nation in both market strength and investor appeal. The reason? Apartment vacancies are less than 4% locally compared with more than 7% nationally, according to Encino, Calif.-based brokerage Marcus & Millichap. In addition, rents are rising at a healthy 4% to 5% annually.

There is no end in sight for rent growth and absorption of new product. Only about one-quarter of the families living in Southern California are able to afford a single-family home. What's more, population is expected to swell from 16.5 million in 2000 to 22.6 million over the next 20 years, according to the Southern California Association of Governments.

Such positive fundamentals have investors salivating, and there's a plethora of both private and institutional capital chasing too few available properties. Property values have escalated more than 15% over the last year in Los Angeles — triple that in San Diego — and cap rates are below 6%, says Kitty Wallace, senior vice president for Sperry Van Ness.

Wallace notes that sales were flat at the end of 2003, but “just when I thought maybe the market was slowing down, the first quarter (of 2004) ended with an increase in sales volume.”

Up the California coast, the apartment market in the San Francisco Bay Area continues to grapple with fallout from the tech wreck, which has been exacerbated by an increase in apartment dwellers moving to condominiums, says developer Will Thompson, principal at San Francisco-based Thompson/Dorfman Partners LLC.

Rents have declined 18% in the East Bay, and up to 35% in the Silicon Valley over the last couple of years, notes Chin of Sperry Van Ness, but investor demand has remained strong due to barriers to entry and a shortage of new product. A lot of capital, mostly from private investors, has flowed into the market, causing the average unit price to rise to $171,000 and cap rates to fall from more than 7% to about 6% by the end of 2003. Less than 1,000 units will be delivered this year.

Northwest: Warming Up

The Pacific Northwest apartment market also has struggled with job losses, many of which can be attributed to the crash of the tech sector. Rents in Portland, Ore., dropped less than 1% in 2003, but the region's high unemployment rate — which hit 9.5% in mid-2003 — affected investor confidence, notes Bill Younce, senior advisor in Portland for Sperry Van Ness.

Property values, however, climbed about 6% over the last two years, Younce says. He adds that a land-use ordinance that sets boundaries for new development created artificially high barriers to entry, which caused property values to rise. As a result, “there are a lot of investors looking in Portland because there's not a lot of available property,” Younce explains.

Likewise, Seattle's apartment market is recovering along with its improving economy, which will add an estimated 21,000 jobs this year. “Investors are targeting recovery markets, and Seattle is a good recovery market,” says Mary Ann King, president of Chicago-based apartment brokerage Moran & Co.

While property values declined about 6% over the last couple of years, only 1,300 units — about half as many as last year — will be delivered in 2004, which is expected to stabilize the market and boost rents about 1%, reports Marcus & Millichap.

Northeast: Blazing On

With market fundamentals similar to California, multifamily units in the cities of the Northeast and the Mid-Atlantic are in high demand among investors. The District of Columbia, which at 3% has the lowest unemployment rate of the nation's largest metro areas, is perceived as recession-proof. High investor demand caused the region's median price per unit to nearly double from $43,000 to $82,000 during 2003. But don't expect the values to continue to climb — 5,650 units will be added this year on top of the 6,800 units delivered in 2003, Marcus & Millichap reports.

Jim Hinton, senior vice president of real estate investments for Camden Property Trust, notes that the D.C. market softened following 9/11, but “rent concessions are burning off, so there's a big opportunity for rent growth.”

Boston and New York are experiencing similar market dynamics. “Boston and Manhattan are very supply-constrained markets,” says Marcus & Millichap's Thompson. “There's the belief that property values have to rise because there's a shortage, and [these cities] are on the wish list of most institutional buyers.” With only 2,600 units in the pipeline and a vacancy rate of about 5%, capitalization rates in Boston are at 6% and below.

Last year, the 5,000 new units added in Manhattan were slow to absorb, so vacancy is expected to rise from 3.9% to 4.3% by year's end, according to Marcus & Millichap. Still, the price per unit rose from $100,000 in 2002 to $109,000 in 2003. Investor interest shifted to the Harlem-Morningside Heights area, an improving neighborhood with the most affordable apartments on the island.

Midwest: CBDs Lead the Recovery

Apartment markets in the Midwest are struggling, but property values in urban cores are rising due to high demand for condominiums, which has condo developers and apartment buyers competing for the few for-sale properties that become available.

Indianapolis, which boasts a 3.4% unemployment rate, is experiencing an apartment vacancy rate of 10% because single-family homes are so affordable, says Dave Martin, senior advisor in Indianapolis for Sperry Van Ness. The market's median home price is $111,000.

Property values are expected to rise more than 4% this year in prime locations such as the central business district (CBD) and neighborhoods near downtown, as professionals associated with a growing bio-medical cluster look for housing, according to Marcus & Millichap.

Chicago's apartment market is soft as apartment dwellers opt to own rather than rent. Although the apartment vacancy rate is nearly 7.5% in metro Chicago, owners' concern over occupancy rates is mitigated by the soaring appreciation of their properties, says Dan Martin, senior advisor in Chicago for Sperry Van Ness. High barriers to entry and demand for condominiums are causing property values to skyrocket.

Tom Moran, chairman of Moran & Co., predicts that values will continue to rise due to a shortage of available for-sale properties. Only 1,200 units will be delivered in 2004, reports Marcus & Millichap, the lowest level of new construction in more than a decade. In 2003, overall property values rose 14% to $66,547 per unit, and nearly 25% in the West and South Loop areas. Cap rates declined to 5.5% in the same period.

Though rental income has declined about 25% over the last couple of years due to increased vacancy and concessions, Moran points out that there are multiple offers on the few properties that become available, because prices are at or below replacement cost. “People are optimistic that the market will stabilize at 93% to 95% occupancy, and at that level there is no reason to give concessions.”

Southeast: Better Days Ahead?

The bellwether markets of the Southeast are a mixed bag. In Atlanta, the multifamily sector has spiraled downward for a couple of years as unemployment increased, peaking at 7.9% in 2003, and overbuilding continued during a time when many would-be renters have been able to buy homes. The region's 11% vacancy rate should remain flat — despite the addition of 3,750 more units this year — as a result of an improving economy that will add an estimated 35,000 to 40,000 new jobs, notes Marcus & Millichap's Thompson.

The North Gwinnett County and Roswell-Alpharetta submarkets have already rebounded due to employment gains associated with increased spending in the technology and information sectors, which boosted occupancy to 93% and allowed apartment owners to raise rents and eliminate concessions in these submarkets. Although values are not expected to rise in 2004, investor activity is expected to pick up.

The Atlanta market is on the radar screen of some out-of-state investors, Thompson says. “People anticipate that Atlanta will tighten up with job growth. This is a more cyclical market than Boston and New York, and investors believe that it's a good time to get in.”

South Florida's sales activity has remained in high gear, although apartment vacancy hit 7% in 2003, notes Bob Welbon, senior advisor in Miami for Sperry Van Ness. Demand for condominiums and an infusion of capital from U.S. and foreign investors are driving property values up and cap rates under 4%, he says.

Meanwhile, Miami's urban core is seeing a flurry of infill development because demand for urban residential product is growing as more young professionals and empty-nesters discover the benefits of living in an urban environment.

Welbon notes that 40% of properties sold are going to condominium developers hoping to flip units before they're completed. “The question is how long the bubble will last,” says Welbon. “What's going to happen as (interest) rates go up?” Although the market has a high level of construction — 6,000 apartments and about 47,000 condominiums are in the pipeline — South Florida is expecting 60,000 new residents in 2004.

Southwest: High Risk Factors

Similar to Atlanta, the apartment sector in the Southwest is experiencing difficulties due to overbuilding and the movement of renters to homeownership. About 8,000 units will be delivered this year in the Dallas-Fort Worth market, up from 6,700 in 2003. Meanwhile, the Houston pipeline has dropped from 9,300 units in 2003 to 5,600 units in 2004, reports Marcus & Millichap. Both markets are expected to continue to experience high overall vacancy through 2004, with Dallas holding steady at 10.9% and Houston escalating 80 basis points to 9.8%.

While there are plenty of potential buyers in Fort Worth, “finding product that makes sense is tough when vacancy is 12% and up,” says Robyn Jackson, senior advisor in Fort Worth for Sperry Van Ness. Even so, private investors are bringing a lot of money to the table in submarkets, such as Fort Worth's CBD, where condominiums are popular. “We're seeing a lot of new condos going up. Investors are buying old office and warehouse buildings, anything that fits location for the condo guys.”

The CBDs in both Dallas and Houston are experiencing revitalization, notes Leslie Cox, senior advisor in Dallas for Sperry Van Ness. Historical and industrial buildings are being converted to residential uses and new infill projects are cropping up, he says. “Condo conversion is very hot right now, and any property with an upside that doesn't have a lot of bugs is hot.”

Houston has 2,500 residential units available, under construction or proposed downtown, including the conversion of 23 historical buildings to residential and retail space. Marcus & Millichap says both markets likely will experience an influx of investors seeking properties with upside potential.

Patricia Kirk is a Dallas-based writer.