Bill Evans
Managing partner, Madison Realty Investors
Is this equilibrium?
This question has different meanings to all of us in the apartment industry; whether you are a buyer or seller, landlord or tenant, developer, borrower or lender. But, regardless of your perspective, it seems the current circumstances and market conditions will yield an answer of yes. As the owner of apartment properties in Colorado and Florida, all of these perspectives are relevant and important, so let’s quickly review.
Supply/demand. For over five years, we have been looking over our shoulder at the ominous shadow of the construction pipeline, worried that new deliveries were going to cast our vacancy percentages past the tipping point and inflict weakness that we don’t want to remember or experience again. However, year after year the demand side has responded with the strength and endurance of an Olympic athlete with record absorption that continues to surprise.
Fortunately, the supply pipeline project announcements and permit applications, which forecast 18,000-20,000 units of delivery, have not materialized. Many reasons contribute to this, which includes (but not limited to):
- Capital discipline: Exercised by senior-level equity and debt sources that remember prior cycles, requiring stricter underwriting and more substantive sponsor resumes and balance sheets;
- Delayed starts: Influenced by political, social, environmental and neighborhood approvals (be grateful we don’t get all the government we pay for); and
- Prolonged completions: A consequence of the strength of our economy, the shortage of skilled trades has understaffed construction crews and delayed grand openings. All said, true new unit deliveries are perhaps in the 10,000 unit per year range.
On the demand side, our economy is rated in the top five to 10 across the country and has held that position for years. Each major cycle its seems Denver recovers with more depth and diversity and less reliance on singular sectors. The attributes that always made Colorado attractive (weather, recreation, mountains) obviously have not changed, but the transportation infrastructure of Denver International Airport as an international hub, our investment in the commuter/light-rail system and the evolution of our urban core has launched our recognition and acceptance on a global scale. The mere size of our population now qualifies Denver for many employers and investors who had disqualified it previously. The talent reputation of our people attracts new employers, which conversely attracts people. Job growth is the key driver, which begets population growth, which begets household formation growth, which equals absorption – 6,000 units, 8,000 units and now 10,000 units of record-breaking absorption.
If population growth continues at 50,000 people a year, which is not extraordinary given our overall population, then normal household formation ratios and declining homeownership percentages may make these absorption records the new norm: 10,000 units of supply vs. 10,000 units of absorption equals equilibrium (at the moment).
Buy/sell. Buy vs. sell vs. hold reflect more signs of equilibrium. As an owner investor, we constantly address these decisions. On the buy side, there still are strong arguments to continue to acquire multifamily assets. Just like inside a corporate environment where various departments compete for capital allocation, real estate competes for capital allocation in the investment market. Capital seeks risk-adjusted yields, and real estate still competes favorably compared to alternative capital markets like domestic equity, international equity, emerging market equity, debt markets, etc. Acquisition underwriting parameters still can work whether you rely on cap rates, cash-on-cash returns, return on cost, absolute profits or internal rate of return. However, none of these are without some pressure points. Revenue growth continues, although muted compared to the tail winds of the past five years. In our typical asset class, raw increases are limited as potential residents have choices and constraints of affordability, as resident income growth has lagged, which is creating collars on what can be paid toward rent. Revenue growth is more associated with loss to lease burn off, which implies resident retention and renewals have greater importance.
Operating expenses have pressures as well. Labor is extremely tight, and talent is hard to find, causing material increases to payroll costs. It seems we just worked our way through a real estate tax reassessment year, and now another one is seven months away, with more increases coming. The insurance markets are volatile, with carriers reassessing risk profiles and reinsurers passing on the cost of major hurricane and hailstorm catastrophes. Hard to earn revenue growth is eroded by increasing expenses, limiting our bottom line net-operating income growth. NOI supports our debt service, which is its own topic, but the upward pressure on interest rates squeezes all the metrics on the buy side. Buyer experience, ability, credibility and access to capital are critically paramount.
The sell vs. hold decision is more difficult than a buy decision. During the ownership cycle we gain knowledge and confidence in an asset’s performance, its durability and resiliency to market challenges. Cap rates still are a very compelling reason to monetize and capture value and profit gains earned and achieved by execution of a repositioning plan. However, it is hard to sell and forego known performance, known qualities for uncertain performance and uncertain physical conditions, and it is difficult to find and procure reinvestment opportunities that can replace known results. The sell decision often is driven by forces and reasons that overshadow pure performance level circumstances. These forces may be family events, partner evolution, estate planning, the deal cycle itself, the owner cycle or the capital cycle. While a hold may be attractive for many reasons, ownership may have ancillary reasons for executing a sell, but it’s a tough decision.
Accordingly, there are opportunities to buy, but the buyer might be a little more uncomfortable than the past few years. Similarly, there are strong opportunities to sell, but it’s an uncomfortable choice compared to forfeiting holding a good asset. But there is some overlap between buyer and seller objectives, which lead to transactions, but maybe tighter than before, and thus closer to equilibrium.
Debt markets. Despite the factual increases in the cost of real estate secured debt, the overall cost of that debt is still good compared to long-term historic rates. We all have seen the increase in the underlying indexes whether it be short-term rates (Libor or prime) or long-term treasuries. Some of this increase has been absorbed by the lender, by a tightening of spreads, which as borrowers we are very appreciative. While capital still is available, it is more difficult to obtain as lenders recognize the mature phase of our current cycle and the challenges of our operating conditions, and they have responded with appropriate tightening of underwriting metrics and increasing importance of stress testing (debt yield) and borrower sponsorship. Borrower sponsorship is extremely important and valuable to both lender and borrower. Lenders have capital but are reserving dry powder to support their favored depository clients and borrowing customers. Borrowers who nurture and protect these banking relationships are rewarded with access to capital, with fair terms and increased certainty of execution. This symbiotic relationship is only developed over years of time, experience and successful transactions. Sellers and brokers need to keenly vet and recognize this.
Agency lenders serve a crucial role in capital markets today. The Federal National Mortgage Association, Freddie Mac and Federal Housing Administration (U.S. Department of Housing and Urban Development) have successfully maneuvered through the near apocalypse of 2008-2010 and now return huge profits to the government associated with their own restructuring. FNMA and Freddie Mac, whether conventional or small-business platforms, serve a key role in potential acquisitions and refinances, while replenishing the resources of shorter-term lenders. FHA is growing in relevance again as interest rates climb. All debt markets have migrated to a more balanced lending environment, yet another symptom of the case for equilibrium.
Tax reform. The tax gods have shined upon us. Again. We win. Be grateful. Virtually all tax law provisions that favored real estate investing have been preserved going forward in the new Tax Cuts and Jobs Acts. Depreciation survived, even with better features than before. The 1031 tax-deferred exchanges were preserved, perpetuating a key and vital component of transactional incentive and capital pipeline. If not executing a trade, capital gains rates were saved at or less than 20 percent (excepting Medicare surcharges), which is merely a tip on profits. Carried interest rules associated with the disproportionate profits allocable to general partners and sponsors in the event of outsized and extraordinary gains were assaulted by the new legislature as it relates to Wall Street and hedge funds, but real estate was recognized differently and with preference, as merely holding for three years protects that taxable income as capital gain rather than ordinary income (a benefit of 20 to 30 percent on your gain depending on what and how your income may be accumulated). Finally, corporate tax rates were slashed to compete on a global scale, which may not affect us directly, but will have significant impact on job growth with the repatriation of enormous capital to America. Similarly, small business was protected by getting a deduction or offset against income, so its effective tax rate is not punished relative to individual rates.
While it is ambiguous how this feature may be determined or calculated, it most certainly will be beneficial to many. The preservation of these tax code items also helped our equilibrium because debated alternatives to any of these provisions could have sent our market into a tailspin. Please be aware that none of these victories were achieved without a great deal of work in the trenches by our friends and lobbyists in Washington, D.C. So please seek out our representatives who serve political and government liaison roles with Apartment Association of Metro Denver Alliance or National Apartment Association committees and make a point to thank them for their effort and service that often falls short of recognition and appreciation.
Summary and recap. One final note that conflicts with the theme of equilibrium, and that is the for-sale housing market. The apartment sector has certainly benefitted by our shortage of for-sale housing, in particularly affordable housing. The dramatic shift and decline in the overall percentage of homeownership has led to more households being renters. Some of this is associated with societal shifts to preference of renting, but a significant portion unfortunately is attributable to the unaffordability of our housing stock. Ownership is simply unattainable to many. With average home values now exceeding $500,000, it may have padded the balance sheet of the existing owners, but it is demoralizing to those who can’t buy. Furthermore, this might lead to decisions by businesses considering Denver that it may not be affordable for its workforce, and location selections may shift away to other regions and hurt our future job growth. Might this be a double-edged sword?
Our current market conditions do have many indicators that support a state of equilibrium. But that balance is fragile and fleeting. It presents good opportunity to execute your plan with strong support to buy, sell and hold. Be alert and aware of additional risks present today and stick to your strengths. Avoid being drawn outside your expertise to chase a speculative deal. Be cautious, patient and, most of all, disciplined, but be ready to strike at appropriate opportunity.
