When Equity Residential Properties Trust sold a 27,115-unit Ohio apartment portfolio for $1.09 billion last June, the nation's second largest apartment owner was in good company. Like many other large apartment REITs, Chicago-based Equity Residential (NYSE: EQR) had lost patience due to years of lackluster rental growth in most Midwestern markets, with the Windy City serving as a notable exception.

“You certainly might have less risk, but there's also less upside volatility,” says Alan George, executive vice president and CIO at Equity Residential, referring to the Midwest's relatively weak employment outlook and flat population growth. Instead, George has increasingly led Equity Residential into higher-growth markets like Atlanta, New York City and Washington, D.C. during the past several years.

Over a five-year period beginning in 2002, the five largest sellers of Midwestern apartment units by dollar volume were all REITs. At the same time, however, private buyers were quietly snapping up assets in select markets such as Kansas City, Minneapolis, Chicago and favorable submarkets across the region.

From 2002 through 2006, private buyers acquired more than $3.5 billion worth of Midwestern apartment properties. Private investors also accounted for roughly 75% of all apartment acquisitions during that period. What do private buyers see in these Midwest markets, from which virtually every large apartment REIT has seemingly fled? The answer, quite simply, is higher yields.

Immediate returns

“You can either overpay on the coast or get a deal in the Midwest,” says Dan Fasulo, director of market analysis at Manhattan-based research firm Real Capital Analytics. “It's also incredibly hard to generate solid income in places like New York City where acquisition costs are so steep,” he says.

The average capitalization rate — or initial yield based on the cash flow and purchase price — of an apartment property in the Midwest was 7.2% vs. 5.2% for the largest cities in the Northeast in 2006. Cap rates for West Coast apartment properties averaged 5.3%, according to Real Capital Analytics.

That gap explains why the Midwest is on the radar screens of many private buyers, reports Real Capital Analytics, which tracks national apartment sales of $5 million and above. The research firm analyzes apartment sales in the 14 largest Midwestern cities.

The relatively higher yields earned by apartment investors on their Midwest purchases is precisely why The Village Green Cos., headquartered in Farmington Hills, Mich., is so bullish on select Midwest markets.

Ranked No. 36 on the National Multi-Housing Council's list of the top 50 largest apartment managers, Village Green owns and manages more than 31,000 apartment units in 135 buildings scattered between Cincinnati, Chicago, Detroit, Minneapolis and St. Louis.

CEO Jonathan Holtzman, a third-generation developer and owner, recalls that the company built its first Detroit apartment project in 1968 when the automobile business was thriving.

“If you look at the U.S. population, there are 65 million people living in the Midwest,” observes Holtzman, who races cars in his spare time. Roughly half of those 65 million people reside within a 1,000-mile radius of the Windy City, which is the dominant Midwestern apartment market.

Unlike a public company that must account for its quarterly performance, Holtzman has the luxury of taking alonger-term view of the market. Village Green rarely buys or builds a Midwestern apartment property with any clearly defined timeline or exit strategy. As Holtzman notes, the company plans to hold assets indefinitely.

He recognizes that every large metropolitan area presents unique risks and rewards. But he says that unpredictable business cycles don't faze him because he's not a speculator.

“How can you predict a business cycle? The answer is you can't. So, holding long term is the safest approach to take,” says Holtzman, whose Minneapolis portfolio was just 4% vacant at the end of March. The private company doesn't disclose earnings, but Holtzman says that his investors have consistently achieved strong returns in recent years.

Last fall, Village Green began developing its fourth apartment project in downtown Minneapolis, the $20 million Eitel Building City Apartments. The 213-unit, Class-A project should be completed next winter. Holtzman expects to boost rents by 3% during the property's first few years of operation.

Growth hubs

It helps that Minneapolis boasts one of the youngest populations of any U.S. city, boosting the potential number of renters among the coveted 18 to 34 age group. The median age in the Minneapolis market was 34.2 years in 2006, according to Boston-based real estate consulting firm Property & Portfolio Research (PPR), fully one year younger than the national median. Minneapolis also is a college town, which supplies the area with a steady stream of young renters.

The metropolitan area boasts 18 Fortune 500 companies, including Target, UnitedHealth Group and 3M. These large companies, many of which are hiring, helped the city boost its local population in 2006 by 0.9% compared with the national average of 0.6%, reports PPR.

Minneapolis apartment landlords have directly benefited from these trends. The metropolitan area's apartment vacancy rate fell from 6.4% to 4.9% during a two-year stretch ending in the fourth quarter of 2006. The vacancy rate is expected to bottom out at 4.7% by the end of 2010.

Shrinking vacancies have given landlords added pricing power, too. Average rents were $958 per unit in the fourth quarter of 2006, up 3.2% from a year ago. Rental growth over each of the next five years is projected to average 2.9%, slightly higher than the estimated growth of 2.8% among the nation's top 54 apartment markets, according to PPR.

Apparently word is spreading among investors that Minneapolis is a smart play. Real Capital Analytics reports that the average capitalization rate based on apartment sales in the metropolitan Minneapolis apartment market fell by roughly 0.3% last year to hit 5.8% at the end of December. Falling yields are a lagging indicator of increased investor demand.

A compelling alternative

“Many of these Midwestern markets are coming into their own,” says Michael Cohen, senior research strategist at PPR. One obstacle that has historically barred investors from pursuing apartment deals in the Midwest is the broad perception that every market in the region is weak, according to Cohen.

The flip side to that argument increasingly is that many Midwestern apartment markets are also less vulnerable to wild economic swings that faster-growing coastal cities face.

Apartment values in the region support the incremental-growth argument. The average selling price per unit increased from $62,659 to $67,603 between the end of 2004 and 2006, or just 8%. In the frothy Northeast market, Real Capital Analytics reports that average prices per unit jumped from $146,642 to $206,772 during that same period, an increase of 41%.

The prospect of owning assets that appreciate slowly has kept many developers at bay for the most part in the Midwest. Despite its abundant land, the region isn't adding new units nearly as fast as coastal markets. According to real estate research firm Reis Inc., the Midwest accounted for only 8.7% of the roughly 80,222 apartment units completed last year.

“Developers don't really pay much attention to the Midwest,” acknowledges Holtzman, who had nearly 1,000 units in his Midwestern development pipeline as of late March. “That means you don't see many competing projects being developed.”

Mediocre versus mercurial

Jeff Elowe, president and founder of Chicago-based Laramar Group, believes that limited new supply is one reason the Midwestern apartment market offers more stability than the big coastal cities. That view runs counter to the perception by many industry experts that a scarcity of land on the coasts keeps supply in check.

Laramar owns 53 properties with 16,000 units located chiefly in the Midwest. The firm has poured roughly $270 million into the Midwestern apartment market during the past four years. “Our up cycles aren't as steep as the coastal markets. But our downturns also aren't nearly as deep,” says Elowe.

Laramar typically holds its Midwestern properties for five to seven years. Between the end of 2004 and early 2006, the firm sold off more than $328 million in coastal apartment assets. Elowe says that heavy demand from condominium converters, who anxiously bid up apartment prices, was simply too hard to resist.

One poster child for apartment market volatility is San Jose. During the late 1990s, a booming technology market that lured thousands of young renters forced apartment vacancy down to a paltry 1.1% at the end of 2000.

But when the technology bust set in over the ensuing months, apartment vacancy spiked to 5.7% by the end of 2003. Such wild vacancy swings are uncommon in the Midwest.

In August, Laramar bought a 198-unit, Class-B apartment property in Chicago's northern suburbs for roughly $16 million. The property was 50% occupied at the time. Laramar is working hard to fill more of those units, but occupancy gains thus far have been small. After spending $4.5 million on interior renovations, Laramar had boosted occupancy to just 5.3% as of late February.

Elowe still believes that the under-performing asset will capture stronger occupancy and rents after the third year of ownership. He also expects it to generate an 18% to 22% internal rate of return by then.

“You really have to be careful with what you buy on the coasts,” says Elowe, who subscribes to the view that future returns are largely determined by the price paid for the asset. “We're chasing cash flow rather than sheer appreciation growth. That's certainly easier to do away from the coasts.”

The naysayers abound

Critics of the Midwest apartment market chiefly gripe about limited liquidity and lackluster growth rates. If buyer demand is flat, property owners have little recourse beyond holding their assets. Perhaps that's why Village Green Cos. rarely buys or builds an apartment complex with the intention of selling it at any point in the future.

Not everyone can underwrite deals that way, however. To George of Equity Residential, the Midwestern apartment market — aside from Chicago — is a risky place to own assets. “Chicago is the last man standing. There are just so many markets in the Midwest with anemic job and population growth,” says George. As of late March, Equity Residential owned just 10 properties in the Midwest — three of them are in Chicago.

Reis reports that five of the 10 weakest apartment markets for effective rental growth during the fourth quarter of 2006 were located in the Midwest. Two large Ohio cities — Columbus and Cleveland — were the second and third weakest markets in the nation with 0.3% rental declines during the fourth quarter. Conversely, six of the 10 strongest apartment markets for effective rental growth were located on the coasts.

Seasoned veteran Alan Pollack, principal of Chicago-based Providence Management Co. LLC, who has spent the past 30 years owning and operating Midwestern apartment properties, says that attracting institutional capital into the region is a tall order for a variety of reasons.

For one thing, the close-to-the-vest nature of the Midwestern apartment market makes it harder for large institutions to buy sizeable portfolios. Most of the apartments are held by private owners like Village Green Cos., rather than large REITs with huge portfolios.

Then come the inevitable economic questions. “The overall fundamentals give these buyers pause,” says Pollack. “It's not that the Midwestern apartment market gets unfairly portrayed, either. It's just not as vibrant as most coastal markets.”

Growth sponge

The irony is that the shining star of the Midwestern apartment market contributes to the region's woes. Chicago, the largest city in the Midwest, generated 40% of the new jobs in the Midwest between the end of January 2006 and 2007. Richard Florida, professor of public policy at George Mason University, recently called Chicago “one of four or five great U.S. talent magnets.”

This is music to the ears of Chicago apartment landlords. But this dynamic market also attracts young talent that might have otherwise relocated to smaller Midwestern cities.

The fact that the median age in Chicago is 33.7 years, less than the national median by at least one full year, also suggests that young people are flocking to this city. The apartment vacancy rate of 3.7% in metro Chicago at the end of 2006 was also the lowest of any Midwestern city tracked by PPR.

“The Chicago apartment market really is the leader of the pack,” says Cohen of PPR, who believes that positive demographic trends will continue boosting this market for at least another five years.

If low cap rates persist in the largest coastal markets, some yield-hungry investors could increasingly look inland. Dale Anne Reiss, global director of real estate, hospitality and construction at real estate consultant Ernst & Young in New York, believes that price appreciation is bound to slow in the coastal markets.

“There are more and more real estate investors looking for higher yields,” Reiss says. “So they will choose to go [into the Midwest]. This is really a return to basic real estate investing.”

Parke Chapman is senior associate editor of National Real Estate Investor.

WHO'S BUYING AND SELLING IN THE MIDWEST?

While REITs have been net sellers of apartment assets in the Midwest over the past five years, private investors have been active buyers. Here's a closer look at some of the most active players.

Sellers Total
Equity Residential Property Trust $1.12 billion
Archstone Smith $1.04 billion
AMLI Residential Trust $546 million
AIMCO $481 million
The General Investment & Development Cos. $349 million
Buyers Total
American Invesco Corp. $510 million
AMLI Residential Trust** $451 million
Crescent Heights $403 million
RREEF Funds $389 million
Laramar Group $270 million
*deals $5 million and higher
**REIT privatized in 2005
Source: Real Capital Analytics

High-octane submarkets

Minneapolis and Chicago aren't the only Midwestern cities where apartment investors can achieve relatively higher yields. Property & Portfolio Research (PPR) analyst Michael Cohen says that a handful of submarkets in Midwestern cities also offer solid income prospects. But investors need to dig deeply into these markets to find these hidden gems.

Overland Park, which straddles the southwestern edge of the Kansas City metro area, is a perfect example, according to Cohen. Unlike downtown Kansas City, where apartment vacancy registered 8.4% at the end of 2006, the Overland Park submarket was 6.3% vacant with fewer concessions than Kansas City's central business district, says Cohen.

Sales figures show the average price per unit paid by investors in Overland Park's southern district in 2006 was $90,336 compared with $67,823 across the metro area, reports data research firm Reis Inc.

Even in a Rust Belt city like Cleveland, which has suffered from a prolonged downturn in manufacturing, attractive investment pockets exist. The submarket surrounding the renowned Cleveland Clinic, for example, posted a vacancy rate of 6.5% at the end of 2006 compared with 6.8% for the entire metro market.

Even so, a highly affordable pool of single-family homes can siphon off rental demand in markets such as Kansas City and Cleveland, says Cohen of PPR. Roughly 71.3% of all metro Kansas City residents own their homes, higher than the national average of 69%. That problem is not shared by apartment landlords in pricey markets such as Los Angeles and New York.

There can be an advantage for owners buying apartment assets in markets where homes are highly affordable, Cohen concludes. “It can prevent developers from really building a lot of new supply in the market, which means less competition for existing rental properties.”
— Parke M. Chapman