Uncertainty and Volatility Lead to Market Decline in 2009
The multitude of woes that has plagued all real estate sectors, combined with the broader economic downturn, created a noticeable cooling in the multi-family investment market over the past year. Although apartments have not suffered to the same degree as the single-family sector, the bursting of the housing bubble, and collateral damage to our nation’s economic and financial markets, have had a negative impact on multi-family investments. The destructive combination of: excessive unemployment, the mortgage market meltdown, and a consumer confidence crisis have led to steadily declining market conditions for apartment owners. Overall Ventura County rents were down 5.7% in January 2010, from the previous year. While the countywide vacancy rate has remained relatively stable in the 5% range since January 2008, competition has dramatically increased for qualified renters. Tightening of credit markets, and a gap between buyer and seller price expectations, combined with general uncertainty as to how soon an economic recovery may be evident, have led to a dramatic drop in apartment building sales transactions for 2009. However, based on the limited sales data available, multi-family property values remained relatively stable, indicating a lack of truly “distressed” sellers. While 2010 may bring some further rent reductions until the economy gains momentum and job creation occurs, the mid to long term outlook for multi-family investment remains strong. A myriad of factors will contribute to increasing demand for rental housing, especially in highly desirable, high cost-of-living, high barrier-to-entry areas, like Ventura County.
Countywide Overall Average monthly rents have fallen significantly, in each of the three survey periods since July 2008, based on our semi-annual Ventura County Apartment Market Survey, including over 20,000 multi-family rental units located in 9 market areas throughout the county. Many properties had significant turnover during late 2008, and the early months of 2009. At the same time, the number of qualified applicants also fell off sharply, causing vacancy rates to climb to the highest level in years. Rents declined steadily during the first half of 2009, but started to flatten out toward the end of the year. Tenants who have been forced to “tighten their belts” due to reduced work hours or income, furlough days, or fear and uncertainty regarding job security are becoming more pro-active and assertive in finding the best available “deal” in housing. Many tenants are trading away seldom used amenities, such as luxury clubhouses, pools, and gyms, in exchange for cheaper rent on basic, clean rental housing. With the contraction in the labor markets, young people are delaying household formation or moving back home with parents. Even mature, well established renters are being forced to move out of the area to find jobs and cheaper housing, choosing to live with family members, or combining households to save money.
There has been a steady stream of renters making the move into homeownership, taking advantage of lower prices and interest rates, as well as the tax stimulus offers. However, this trend is somewhat balanced by previous owners who have lost their homes to foreclosure, and are now entering the rental market While there is still additional competition for tenants from the “shadow market” of unsold homes and condominiums currently being leased, it appears that the greatest competition is coming from other apartments. Several property owners are completing upgrades to attract new tenants, while others are becoming more aggressive with advertising, move-in specials or even new “no risk lease” programs that allow tenants to break their lease with no penalty if they are laid off from their job. As leases come up for renewal, many renters are relocating in order to take advantage of promotions, or negotiating with their current landlord for a rent reduction in exchange for signing a new lease. Net operating incomes and property stability are also being negatively impacted by increased evictions, slow pays, higher turnover costs, and reduced credit standards, as well as by landlords accepting smaller security deposits, and for the first time, permitting pets. One property had two “skips” on the day I called, where tenants moved out during the night with no notice. These trends seem to have peaked in the third quarter of 2009. Many of the property owners and managers we interviewed have seen an uptick in rental activity, and have issued fewer notices to vacate, during the first few weeks of 2010.
Ventura County rents started to slide in early 2008, with virtually flat rents during the first half of that year, and a decline in rental rates after July 2008. The steepest declines to date came during the first half of 2009, with Countywide Overall Rents down 3.5% between January and July; then dropping another 2.3% by January 2010. Several cities saw even sharper declines, like Camarillo, where overall rents fell 7.6% in the first 6 months of 2009; and Simi Valley with a 7.2% drop in overall rents during the same period.
The smaller market areas of Fillmore and Santa Paula have been less volatile, probably due to the limited supply of available apartments and the relative stability of rents over time. These more geographically isolated communities did not see the same levels of rent appreciation during the “boom years” as did the larger cities, which has helped to insulate these markets somewhat from the recent downturn. In fact, overall rents in Santa Paula actually went up 1.9% during 2009, to a new average of $1,077. However, there does seem to be some weakening of the rental market in the Ojai Valley, where rents started to slide in the second half of 2009 (down 3.1% from July, and unchanged from the previous July), and the vacancy rate reached an all time high of 7.53%. Some of the owners with whom we spoke have explained that in the current economy, given rising transportation costs, Ojai is just too far for people to drive for jobs elsewhere in Ventura County, or in L.A.
While rents have gone down in most areas, countywide vacancy rates have remained amazingly strong, albeit at the highest rates since our survey began in 1997. We have certainly seen a shift away from the previous decade when Ventura County’s vacancy rate hovered at or below 3%; but even with the countywide rate of 5.24% for January 2010, the rental market is still very healthy compared to other types of real estate assets, or even based on accepted industry standards. (5% vacancy is generally considered to represent “equilibrium” in the market … meaning there are ample choices for tenants, with owners still enjoying strong occupancy levels.) Countywide, the vacancy rate reached a peak of 5.83% in January 2009, and has been declining slightly since. However, the market dynamics vary widely between different cities, and individual properties. Some properties reported vacancy rates as high as 35%, while others claimed to be fully occupied. And more owners than ever before were reluctant to answer our survey question regarding occupancy, until assured we would not publish information on their individual property.
Camarillo’s vacancy rates soared to 8% in January 2009, the highest level in more than a decade. However, after a 7.6% drop in overall average rent to $1,368 during the first half of the year, units were absorbed quickly and the vacancy rate dropped to 4.1% in July, then down to just 3.1% in January 2010. Camarillo also saw rents rebound quickly, with a 2.4% increase in the second half of 2009 to a new average overall rent of $1,403 … just about $100 less than the peak of the market in July 2008. In a very different trend line, Simi Valley vacancy rates have remained relatively constant in the mid to low 4% range throughout this recession, but rents fell nearly 9% during 2009, resulting in a current overall average rent of $1,362, the lowest in Simi Valley since January 2005 when rents averaged $1,349. The worst may not be over yet in Thousand Oaks, which had the highest vacancy rate in the county in January 2010, at 7.3%, and an overall average rent of just $1,491/mo, the lowest since July 2005. Rents in Thousand Oaks increased steadily for years, reaching a peak of $1,676 in January 2007, but have since fallen steadily. In order to enhance their ability to adjust quickly to changes in the market, many of the larger properties have gone to a system of “daily pricing” where rental rates are continuously adjusted daily, based on a formula that considers vacancy for each unit type, yield expectations, and other factors.
While the rental market softened somewhat, there was a sharp decline in multi-family sales volume in 2009! Based on research conducted by CoStar Group, there were only 9 apartment buildings sold throughout Ventura County last year; as compared to 26 sales in 2008, and 35-37 transactions each year from 2005-2007. This downturn in activity is not unique; nationally apartment transactions in 2009 fell 70%. There are a number of factors that contributed to this extraordinary decline in multi-family investment activity, the most prominent of which has been a dramatic tightening in the availability of mortgage financing, especially for larger properties.
In general, commercial real estate markets have had increasing difficulty accessing capital since the demise of the CMBS (commercial mortgage backed securities) market in 2007. Traditional capital sources for commercial real estate, such as insurance companies, pension funds, commercial banks, Wall Street, and other equity sources have fled the market. As a result, Fannie Mae and Freddie Mac are virtually the only remaining viable sources for permanent debt financing for apartments, accounting for approximately 90% of multi-family loans made nationally last year. But, these GSEs (Government Sponsored Enterprises) have been in a transitional period, with much uncertainty as to their ability to continue meeting the financing needs of the apartment industry, following federal takeover of the agencies. Fortunately, a dangerous bullet was dodged in late December 2009, when the U.S. Treasury issued an important announcement confirming its unlimited support of Fannie Mae and Freddie Mac through 2012, and easing previously planned portfolio limits on the mortgage giants. The prior statutory requirements would have forced each agency to cap its retained portfolio at $800 billion, and each would have been required to reduce their portfolios by 10% a year beginning in 2010. This issue is much more significant to apartments because multi-family loans are more likely than single family loans to be held in the GSEs portfolio, due to increased complexities in securitization. Anticipation of implementing these portfolio reduction requirements brought apartment lending to a virtual standstill in 2009. This important policy shift means that companies will not have to take immediate actions to reduce their portfolios, and should enhance credit availability for multi-family investment over the next couple of years, which is especially important given the volume of commercial real estate loans that will become due, and need refinance sources in the near future.
Despite concerns about the large number of CMBS loans that are maturing over the next few years, Ventura County’s apartment market does not face the level of risk from potential loan defaults as many other regions or asset types. A large percentage of the apartment properties in this county consist of smaller, “mom-and-pop” owned buildings that are encumbered with minimal debt and were underwritten to conservative standards, which are still viable today. In fact, during the last decade, 70% of the apartment buildings that sold in Ventura County were purchased by individual investors, versus purchases by REIT’s, national and regional developers, and other trusts (each of which captured 5% of the market), with the remaining 10% of the sales to investment managers.
Based on the limited data available, median apartment values per unit actually increased slightly over the previous year to $138,884 in 2009, but this value is down sharply from the peak of $156,171/unit in 2007. While the 2009 sales price per square foot of $188.39 was also up from the previous year (at $158.98/sq. ft.), it is important to note that the median building size of 4,910 sq. ft. for transactions in 2009, was substantially smaller than in 2008, at 10,000 sq. ft. per transaction. The limited number of sales in 2009, all but one of which were small (7-8 unit) buildings, has somewhat skewed the statistical data for last year. Generally speaking, one would expect smaller buildings with fewer units to sell for higher dollars per unit and per sq. ft., and at lower cap rates, than larger investment properties of similar age and quality. This trend is further evidenced by the gap between the cap rate of 6.5% on the one large multi-family property sale in 2009, versus the median cap rate for the year of 5.25%, which was virtually unchanged since 1997. Buyers of smaller buildings are less influenced by cap rates, then they are by other purchase priorities, such as location, unit mix, or tenant profile; whereas larger property investor are more likely to weigh the comparative value of a properties income stream against other investment opportunities, in an effort to maximize returns.
With further contraction in rental rates likely during the first half of 2010, and continued constraint in the lending markets, we can expect to see apartment values remain stagnant, or fall slightly during the coming year. However, it is important to note that all Ventura County multi-family investment value factors are still appreciably higher than they were just 10 years ago in 1999, when the median sales price per unit was only $68,286, the median price per sq. ft. was $77.78, and the median cap rate was a whopping 7.65%! We need only look at the trend line for the last decade to see clear evidence of the enduring investment value of apartments.
Despite the most pronounced downturn in the local apartment market in decades, there is reason for optimism during the coming decade, as demographic, economic, and lifestyle trends will lead to a growth in the renter population. The composition of the “typical” American household has altered dramatically, and our housing needs are changing, too. According to the National Multi Housing Council, one third of Americans rent their housing, and over 14% live in apartments. These numbers are expected to climb dramatically… in fact; some experts have stated that there will be more apartments rented in the U.S. in 2011 than ever before! The echo-boomers, the largest generation in American history, will be reaching young adulthood over the next decade. Once the economy picks up, they will be moving out of their parent’s homes, and setting up new renter households in record numbers. Additional demand for apartment living will be created by the over 65 age group, which will be the fastest growing segment of the population after 2010, and will represent nearly 30% of households by 2037, according to the U.S. Census. These active senior citizens are living independently longer, but many choose to downsize into rental housing to enjoy maintenance free living, to take advantage of amenities and proximity to services, or after a spouse passes away. Another important demographic trend that will create additional demand for apartments will be the number of single persons living alone. This cohort will be the second fastest growing household type over the next 10-20 years, nearly half of whom are renters.
Fundamental changes to our economy, and tightening of the mortgage markets in response to the sub-prime loan fiasco, will create new barriers to homeownership for many would-be buyers. Additional growth in the immigrant population, especially in Southern California, will also add more pressure to the rental housing market. And from a political perspective, growth in higher density multi-family housing will help communities meet broader goals of reducing greenhouse gas emissions, promoting energy independence, preserving farmland and open spaces, and creating sustainable development. Particularly in California, with the passage of new legislation (AB 32 & SB 375), which was invoked to help protect the environment, local communities have been given additional incentives to embrace higher density development located near transit or employment centers. Apartments offer the logical solution.
In Ventura County, apartment demand is expected to increase for all of the reasons listed above, as well as sustained population growth, in the face of severely limited new housing production during the past few years. Even during the recent deep recession, the countywide population has continued to expand, with the majority of growth from natural increase (births over deaths), versus net migration. This trend is expected to continue for the foreseeable future, and yet new residential building permits issued in the County during 2009 were at astonishingly low levels. Only 345 new housing units were issued permits last year, 132 of which were for multi-family units including both condominiums and apartments, based on data from the Construction Industry Research Board. New construction has fallen steadily for the past four years, and is down dramatically from the peak of the last cycle in 2005, when permits were issued for 4,516 total housing units countywide (1,923 of which were for multi-family units).
Barriers to entry for new development in Ventura County are notoriously high, with land use policies and local politics that have drastically limited growth, like the Guidelines for Orderly Development and SOAR (Save Open Space and Agricultural Resources), both of which direct new development to within urban growth boundaries comprising the 10 existing cities. However, the County’s newest MS4 (Municipal Separate Storm Sewer System) permit represents one of the greatest challenges to future development. This new law, which will become effective in late 2010, requires most new development, and many renovation projects, to design and incorporate complex engineering solutions that will allow property owners to capture and retain 95% of the storm water that falls onto their properties. While there are some exceptions that reduce these requirements for infill projects, where it may be technically infeasible to meet the higher standards, there are still many questions and concerns surrounding the future impacts of this new regulation to the production of additional housing units. MS4 rules will most certainly increase the cost of housing development, and will likely reduce allowable densities on infill parcels. It remains to be seen how severe the impacts from this and other new land use regulations will be, but they will certainly make new rental housing more expensive to create. As a result, existing units will retain or increase in value more rapidly than they may have otherwise.
Like most other aspects of modern life, the apartment business has certainly become more complex and competitive during the past few years. But there is a growing sentiment among some of the nation’s top economists and housing analysts that we need to move toward a more balanced housing policy, which creates a more level playing field between owning a home and renting. The extensive tax benefits and other governmental subsidies that have helped to expand homeownership in this country have proven to be flawed in many respects. There is a growing consensus that supporting the expansion of apartment opportunities will help us better meet our changing housing needs. And yet, even as demand for new rental units grows, local development is likely to remain well below needed levels due in part to a continuing bias toward single family neighborhoods. Apartments still remain the safest form of real estate investment. This will not change in the foreseeable future!