While the economy continues to improve, cap rates in core markets have continued to compress. As a result, multifamily trends are leaning toward secondary and smaller metro areas. The relatively impressive demographic and economic trends in select small communities are believed to provide an opportunity in the form of higher cap rates initially and upward pressure on rent rates over the hold period. The combination of these factors would result in higher returns for investors and has resulted in increased interest in the Harrisonburg metro area.
Over the past few years, capitalization rates – which represent operating income as a percentage of sales price or value – for multifamily properties have fallen steadily in the 40 largest metropolitan areas around the country. In core cities (think New York, DC), cap rates can average as low 5.4%, while properties in the outlying suburbs of major metros average 6.5% according to researchers. By comparison, multifamily properties in the Harrisonburg and Staunton metro areas have sold with cap rates above 8%, but generally have an average 7.5%-8%. (Note: this comparison does not account for apartment types or number of units).
So what’s driving these multifamily trends?
In a word, demand. For the first time in a decade, multifamily has replaced office as the top investment sector. Thanks to an economic meltdown and accompanying housing crash, tenant demand for rental properties is up – and investors are betting it’s not going anywhere for a while. Whether potential tenants are renting out of caution, choice, or financial need, the demand for rentals is holding strong and, as a result, has transformed multifamily properties into an extremely desirable asset class.
While this may be especially true when it comes to class-A investment properties in gateway markets, there’s only so much supply available, leading commercial investors to turn to secondary markets, smaller cities, suburbs and even class-B and class-C properties. And with decompressing cap rates comes higher yield – thus, the desire for multifamily continues to grow.
Expanding Investment Parameters to Increase Yield
In an effort to generate the desired return, investors have demonstrated a willingness to compromise in order to discover the right deal. Factors that would have been deal-breakers a year or two ago, such as submarkets, sub-tier properties, and out-of-the-way locations, seem much more desirable in today’s market.
To a degree, higher cap rates exist in smaller markets like Harrisonburg and investors find the presence of JMU and projected population growth particularly appealing. Anecdotal evidence would suggest increased interest in the Harrisonburg metro area from across the country, but investors specifically concentrated in the Northern Virginia/Washington D.C areas have shown a willingness to compromise on scale, rent rates, and location when considering the Harrisonburg metro area. As the number of available properties dwindles and cap rates continue to compress in other markets, it is expected this hunger will grow stronger. The promise of a tight rental market for the foreseeable future, low market prices, and rock-bottom interest rates should feed this demand and decrease cap rates in the Harrisonburg metro area (another win for investors)
A Fresh Supply
Over the next few years, expect to see more multifamily properties become available as construction of new units increases to meet demand. 2012 statistics from the General Associated Contractors of America indicate that new multifamily construction increased by 45% year-over-year in July and that developers doubled the volume of multifamily site acquisitions over 2011.
In 2012, building permits for an additional 261 multifamily units were issued in Harrisonburg and Rockingham County, but many of these units will be dedicated to serving the university population in the form of student housing (Overlook at Stone Spring, Campus View). By comparison, there was not a single building permit issued in 2011 for multifamily housing. This would suggest the fresh supply in the Harrisonburg metro area is still a few years away from completion and rent rates could realize a fairly healthy increase during that period.
Regardless of class and market, these investments depend on the potential for strong demand for rentals in the future. One thing is certain, however: in a mirror image of the changing demographics of the country as a whole, renters’ demographic profiles are changing in a myriad of ways, from age to country of origin, head of household to family composition. Investors considering purchasing multifamily properties should educate themselves on the characteristics of the “renter of the future.”
By far, the largest population affecting today’s rental market is the so-called “Echo Boomer” generation, or those born between 1980 and 1995. Experts estimate that about 15 million Echo Boomers will enter the renting market over the next decade. These young, relatively affluent renters gravitate toward high-tech, urban apartments located near city amenities (whether the city is large or small). If you are seeking a local example, just think of downtown Harrisonburg ten years ago and compare it with the waiting lists for downtown apartments today.
In contrast, a growing immigrant population tends to seek out larger apartments in the suburbs. Online searches reflect a growing number of queries for three bedroom units to accommodate families’ need for space. Ethnic minorities, female-headed households, and Baby Boomers who’ve sold their homes constitute other large rental populations.
Considered together, all of these factors would seem to suggest a bright future for multifamily investors. However, even the “sure thing” deserves a little healthy skepticism. While renter demand is increasing, cap rates are compressing to extremely low levels. Interest rates for multifamily properties remain extremely low and special products are being developed to accommodate the demand, which permit yield even with lower cap rates. However, a fair portion of this debt is not fixed and is interest rates are expected to increase with an improving economy. Investors are speculating that rental increases will outpace interest rates, but cap rates are likely to rise with increased interest rates and new product increasing supply.
Is the demand in multifamily driven purely by market fundamentals and based on rational thought? Is the value of the property, determined by the cap rate, sustainable? Are interest rates for this product type well below their natural rate? Is the anticipated future value based on more than just projections of rent rate growth? If the answer to many of these questions is “no,” you might consider asking yourself one final question—“what are the signs of a bubble?”
You Might Be Interested in the Following
Commercial Real Estate Market Reports | Local Information, Local Report, Updated Quarterly
Resource Center | White Papers, Commercial Real Estate Tips, and Investment Information
Search for Property | Search for Commercial Real Estate Throughout the Valley.
About Tim Reamer | Your Position Will Always Be Informed and Well Represented