Four months free rent, free washers and dryers, free health club memberships and waived application fees. These are just some of the lures that owners are using to fill their apartments these days. But occupancy rates are still down sharply and, industry analysts say, managers may have to keep throwing money at tenants for another year. That's the earliest they expect to see an upturn in job growth — the most important gauge of rental demand.

Meanwhile, the number of new projects coming onto the market hasn't dropped significantly, despite the struggling economy.

At the mid-year mark, national occupancy rates registered 94.7%, down from 96.1% in the second quarter of 2001, according to Dallas-based M/PF Research. Rental rates weren't faring much better: At mid-year, rents were down by 1.2%, from $905 in 2001 to $894 this year. That's also well below the $909 rental rate recorded in the second quarter of 2000.

Mark Zandi, chief economist of West Chester, Pa.-based economy.com, says occupancy and rental rates will improve when the economy begins posting consistent job growth — but he doesn't expect that to occur for 12 to 18 months.

According to figures from the U.S. Department of Labor as of Sept. 14, the four-week moving average of jobless claims reached 418,500, up 38,000 from Aug. 10. Those numbers are disappointing to economists who had predicted a decline in jobless claims to below the 400,000 level. National job growth has been stagnant during nearly all of 2002, growing less than one-tenth of 1% from January to August. In particular, job gains in services, government and construction have been largely offset by losses in manufacturing and retail trade.

Zandi adds that lower interest rates have spurred first-time home buying. The average 30-year mortgage rate has nosedived by nearly 2 percentage points, from 7.90% in Sept. 2000 to 6.05% as of Sept. 19. That trend, along with layoffs from the shrinking economy, is siphoning apartment dwellers.

Although the trend toward higher vacancies, stagnant rents and more concessions continued through the second quarter, some statistics provide a glimmer of hope heading into 2003. The national 94.7% occupancy rate in the second quarter of this year was a half-percentage point increase from the previous quarter, according to M/PF. Permits for 323,600 units were issued in the second quarter of this year vs. 327,300 units in the same quarter last year. Those numbers are down from a quarterly average of about 355,000 units from 1998 to 2000.

Meanwhile, markets such as Los Angeles, Seattle and Washington, D.C., are showing the kind of strong demand necessary to begin righting the ship, but most markets are still struggling.

Encino, Calif.-based Marcus & Millichap's National Multi Housing Group pegs the national occupancy rate at 93.2% at mid-year — down from 94.5% a year ago but slightly better than the 92.5% rate in 1993, when the economy was recovering from the prior recession. “I think we're at the bottom of the current run,” says Linwood Thompson, national director of the National Multi Housing Group.

Others, however, see little or no progress over the next year, and say the best-case scenario is a recovery in late 2003. “What we will continue to see is a pretty challenging operating environment for these companies,” says Ross Smotrich, managing director and REIT analyst for Bear Stearns & Co. “While most companies have rebuilt occupancy over the past year, they have no pricing power.”

Smotrich says markets with historically high job growth — such as Atlanta, Dallas, Houston and Phoenix — could lead the recovery, but only if developers in those markets show restraint during the downturn.

A positive sign, Smotrich says, are the demographics of demand. “The demographics will support multifamily — Baby Boomers and their kids will be 60% of the population by 2010,” Smotrich says. Echo Boomers, the children of Baby Boomers, are starting to move out from their parents and renting apartments in increasing numbers. Meanwhile, their parents are becoming empty nesters, looking to simplify their lives by trading houses for apartments. That gives the market hope for the future, but not necessarily in the near-term. “The demand side looks pretty strong. But at the end of the day, it will take job growth to create pricing power,” he says.

Apartment owners and developers certainly are targeting the 73.8 million Baby Boomers and 72.7 billion Echo Boomers in the U.S. Several are customizing projects for those groups, including luxury apartments for wealthy Baby Boomers, (see NREI, September 2002).

Farmington Hills, Mich.-based Village Green Cos. gears its top-tier property, Regents Park, to Baby Boomers. Post Luminaria, a luxury apartment tower opened by Atlanta-based Post Properties on New York's Upper East Side this summer, also is tailor-made for Baby Boomers with high incomes.

Conceding the Market

Declining occupancy rates have pushed owners and managers to offer large-scale concessions to attract residents. “In a lot of these markets, property owners have been in shock,” says Chris Spain, senior director of The Apartment Group, New York-based Cushman & Wakefield Inc.'s multifamily division. “Their energy is going into managing the properties and keeping the occupancy up.”

Free rent, sometimes up to four months, is an obvious draw for tenants, but some owners are attempting to lure residents into their apartments via a variety of other methods as well. Parking and other apartment community fees are being waived and application fees are being refunded.

Some owners are throwing in appliances such as washers and dryers when an applicant signs a 12-month lease, and others are offering gift certificates to restaurants or tickets to the theater, says Chris Cassidy, president of The Highlands Cos., an Atlanta-based apartment developer. And in a novel marketing move, some developments are entering tenants into raffles for new cars if they agree to sign concession-free leases.

Cassidy says the vacancies (and the concessions that have resulted) are having an obvious effect on apartment revenues. “For every month you give away free, it's 8.3% off of your effective rent for the property,” he says. “It does have a compounding effect on your bottom line.”

That means other parties, like lenders or potential buyers, are taking that diminished revenue stream into account when they are pricing properties, according to Cassidy.

Comparing the Booms

On a brighter note, industry observers say the multifamily sector is poised to emerge more quickly from the current downturn than it did from the early 1990s recession because the construction pipeline didn't increase as sharply in several key markets from 1995 to 2000 as it did from 1983 to 1988.

During the 1980s boom in Atlanta, for example, a new apartment unit was built for every 4.3 jobs that were added to the market, according to Thompson of Marcus & Millichap. That pace slowed to one unit for every 7.3 jobs from 1995 to 2000. In Dallas, the figure went from one unit for every 2.8 jobs to an apartment for every 5.3 jobs, and construction in Phoenix slowed from one unit for every 2.5 jobs to one unit for every 7 jobs. Denver kept an astounding pace during the 1980s boom, building one unit for every 1.2 jobs added to the market. The pace decreased significantly to one unit for every 5.1 jobs from 1995 to 2000.

Los Angeles, historically one of the best-performing apartment markets, overdid it from 1983 to 1988, building one unit for every 2.7 jobs. Construction during the 1990s boom amounted to only one unit per 8.9 new jobs.

“Back in the '80s, we had overbuilt so much that when the recession hit, it was a flood,” Thompson says. Because there was more development restraint during the 1990s, he says the impact of the current downturn has been less severe.

Thompson also points to very strong investor interest in multifamily properties as a sign that apartments are coming back strong. “If you go back 18 months, an investor was comparing the 10% or 11% percent yield [on multifamily real estate] to a stock market that was paying 15% or 16%,” he says.

“Now all of the sudden, most people are predicting stock market yields of 5% or 6% over the next few years and apartments are starting to look a whole lot better” because apartments are still yielding around 10% per year, Thompson says.

Rod Vogel, a managing director with Des Moines, Iowa-based pension fund advisor Principal Capital Real Estate Investors, agrees that capital to buy apartment properties is plentiful, but most of his clients are showing restraint.

Lenders such as Prudential Mortgage Capital Co. of Newark, N.J., and Atlanta-based Column Financial Inc. say their criteria for lending has changed to correspond with the harder times.

Based on conversations with brokers and statistics from New York-based Real Capital Analytics, pricing for properties hasn't changed dramatically in the past year and transaction volume for multifamily properties has been steady. Real Capital Analytics, which tracks deals of $5 million and higher, reports there were 539 multifamily transactions totaling $9.4 billion in the first six months of this year, compared with $9.1 billion on 535 transactions through mid-year 2001.

However, sales volume has declined significantly in some of the hard-hit apartment markets. In San Francisco, for instance, the number of apartment transactions dropped from 15 in the first six months of 2001 to nine transactions this year, according to Hendricks & Partners, a Phoenix-based brokerage firm.

But the Apartment Group's Spain says his brokers are on pace to beat last year's numbers. One reason is that some positive trends seem to be balancing out the negative ones. For instance, the impact on landlords' cash flows caused by decreasing rental rates is being positively offset by lower interest rates on mortgages.

And despite the concessions being offered by apartment managers, Spain says investor enthusiasm for multifamily properties and healthy competition among buyers is keeping pricing at or near last year's levels.

Kieran Quinn, president and CEO of Column Financial, says his firm is keeping a close eye on vacancy rates. Instead of assuming 5% as a benchmark vacancy rate, the company is making sure to find out the exact vacancy rate at a property before issuing loans.

For instance, if the vacancy rate of an apartment complex is 8%, the firm will take the diminished revenues of the property into account and reduce the loan amount accordingly, Quinn says. As a result, says David Durning, managing director of origination for Prudential Mortgage Capital, owners must use varied sources of capital to help fund their transactions.

“We recognize the changing economics in the apartment markets. In some cases, we have to resize the loan and make it appropriate. But often we have to shift the capital source or combine capital sources,” Durning says. That strategy sometimes includes combining mezzanine financing with long-term loans, he says.

Due to historically low interest rates, many owners also are trying to refinance their properties, says Lawrence Stephenson, senior vice president for Bloomington, Minn.-based NorthMarq Capital Inc. “Property owners are trying to borrow right now because interest rates are at historically low levels,” Stephenson says. “Anyone that has a property is refinancing — or they should be.”

Investing Strategies

Buying in supply-constrained markets is a strategy a number of investors — private and institutional alike — are following these days. Vogel of Principal Capital, whose clients have more than $3 billion invested in real estate, says his firm's strategy in advising pension fund clients is two-fold.

One direction is to stick with supply-constrained markets on the East and West coasts — Boston, Los Angeles, Washington, D.C., and even South Florida — where available land is minimal or development is strictly regulated, he says.

Outside of the coastal markets, he is recommending that his customers invest in mid-market properties instead of luxury apartments. “Much of what has been built recently are Class-A (luxury) properties,” Vogel notes. “That market still has a little bit more supply coming on line than makes sense from a near-term demand perspective.”

With a slower economy, “We just think [mid-level] properties are going to be better insulated in markets that don't have supply constraints,” he adds.

Private Money

Marcus & Millichap's Thompson says his firm is seeing more private investors turning to multifamily investments. According to Thompson, 40% of the last 100 deals over $10 million completed by the firm have been made by private decision makers placing their own money, another 40% has been private decision makers placing someone else's money and the other 20% has been institutions.

And with many of the formerly supply-constrained markets experiencing some softness over the past 18 months, deals in less supply constrained places such as Houston, Phoenix and Denver are still attractive to investors, he adds.

“We put a $21 million property in Houston on the market 30 days ago and already have 20 offers on it,” he says.

Multifamily players predict apartment communities will be able to boost rents in about 12 to 18 months — but their projections assume that the economy will improve and Corporate America will begin adding jobs instead of shedding them.

Thompson predicts that job growth will pick up next year and an increase in demand will naturally follow. When that happens, the amount of concessions owners are offering will begin to diminish, occupancy will increase and moderate rent growth will hit home by the first quarter of 2004, he says.

Economy.com's Zandi also is optimistic revenues will improve for the apartment industry in about one year, but warns: “The economy is very fragile. Lots of things could go wrong.”

Matt Gove is an Atlanta-based writer.