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Capital Gains
Published: July 01, 2008
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By Michael C. Marshall
Like the elected officials who come and go, Washington, D.C. is in a state of perpetual transition. It's a markedly different place today than it was just 10 years ago—let alone in 1800, the year it became the nation's capital. The Washington metro region has become one of the best performing markets and consistently ranks as one of the top investment markets in the country by national and international investors. Employment and population growth are the centerpieces of a strong multifamily market. The regional population now exceeds 4.2 million, and with 3 million payroll jobs, is the fourth largest job base in the U.S. Over 27,000 jobs were added in 2007, and the 15-year average has been a remarkable 53,000 new jobs per year.
The primary economic driver in the DC region is the federal government, with over $118 billion in localized spending annually. With a change in administrations taking place in 2009, increased federal spending is expected to continue. Despite the government being the 800-lb. gorilla, private sector activity accounts for over 60 percent of the Gross Regional Product, with core activity reflected in the large presence of major government contractors, consultants and technology companies headquartered in the DC area. The presence of so many educated, skilled workers has led to median household incomes exceeding $84,000—considerably higher than the national average. The strong performance of multifamily assets here has been a direct result of the steady increase in high-paying jobs, particularly among the largest demographic of renters, individuals in the 20- to 35-year-old range, who are transient in nature and generally seeking an urban lifestyle centered around nightlife, transportation and retail amenities.
Rental market
The high median home price in the DC area creates an affordability issue for many, including renters-by-choice who are drawn to Class A properties, as well as the large percentage of people employed in the growing service sector, which has kept the Class B market performing well. The recent "credit crunch" and associated problems with residential lending and the sub-prime mess have resulted in higher qualifying standards, higher down payments and have generally been favorable to the rental market.
The flip side has been the dramatic fall-off in condo sales volume and prices in the DC area, with many new or recently converted projects switching or reverting back to rentals, creating an increase in supply of the "shadow" market of investors seeking to rent their units.
Despite an increase in supply, Class A properties have experienced net absorption gains of over 5,300 units for the year ending March 2008, ranking second in the U.S. This is in line with new construction of 5,600 rental units delivering in 2008.
Overall vacancy in stabilized properties has increased to 4.5 percent, from 3.4 percent a year ago, strong by national standards, but showing some signs of softness. Annual rent growth has moderated below the long-term average of 4.3 percent, to approximately 2 percent in the year ended March 2008, with significant swings in submarkets depending upon the supply of new projects. Concessions have been increasing as well, averaging just over 5 percent, with concessions at projects in lease-up running between one and two months free, generally offered up front.
The Class B market continues to perform well, with average rents up approximately 3.5 percent to a market average of $1,300 per month. Downtown DC leads with rent growth of 5.6 percent and market vacancy of 2.2 percent. Overall vacancy in the Class B market ticked up to 4.4 percent, still very strong on a relative basis. Vacancy may increase as a result of the increase in concessions and lower effective rents in the Class A market, creating less of a spread between A and B properties and thus a flight to quality. This will be less significant in urban infill locations such as Arlington, Alexandria, Bethesda and downtown DC, where Class A rents range from $2.00 to over $3.00 per square foot.
Condos
Some have compared the housing bubble of 2007 to the stock market crash of 1929 when there was a firm belief that prices had no where to go but up, leverage only worked one way and flippers believed that the bull market would continue forever. Things have changed as we see a return to a more realistic view of condominiums as places to live and prices needing to reflect some reasonable multiple of household income and affordability, as the availability of no-money-down, interest-only mortgages become less attainable.
As of March 2008, there are approximately 16,000 condo units on the market in the district, down by about 3,600 units just in the first quarter '08 as units are being removed from the pipeline and reprogrammed as rentals or put on hold. This trend has been in place since late 2006, with roughly 3,500 units per quarter removed from the pipeline. The impact on the Class A rental market has not been dramatic to this point, as overall fundamental remain strong. With projected job growth of 25,000 next year and over 30,000 per year in 2009 and 2010 along with a reduced pipeline of apartments, absorption should mean solid performance in the rental market, even with some increase in supply of condo projects. Pricing for new condos has declined approximately 2 percent in the year ended March 2008, with builders offering fewer concessions and choosing to lower asking prices to stimulate sales. Annualized sales of 2,900 units are off from the peak of 12,000 in 2006, the inflexion point in the residential for-sale market. Resale activity remains relatively strong, averaging 15,000 units over the same period.
Investment activity
The DC metro region has been one of the top markets for institutional and private capital investment and ranks second in the world for international investors, trailing only New York City. In the apartment sector, U.S.-based investors have dominated the multifamily arena the past several years, led by private capital buyers taking advantage of low interest rates and aggressive underwriting to acquire value-add apartment properties, with a goal of renovating and re-positioning Class B properties in the greater DC area. This strategy has generally proven successful as operators have been able to push rents $50 to $200 per month, with renovation budgets in the $5,000 to $20,000 per unit range. This is evidenced by the 25,000-plus units in various stages of renovation.
Overall sales activity in 2007 was very strong at $3.4 billion, with a significant portion of that taking place in the fourth quarter, as the sale of Archstone-Smith assets in the DC area contributed $1.6 billion, or roughly 50 percent of the total. This was on top of a strong 2006, with $2.2 billion in closed transactions.
Activity in the first quarter of 2008 has been off significantly, down over 60 percent from the same period in 2007. The "credit crunch" prompted by the sub-prime issue kicked in in the summer of 2007. The virtual shutdown of the CMBS market and pullback by lenders in general have put the brakes on sales activity, particularly in the private capital market, where the cost of capital and more conservative underwriting has created a bid/ask spread in the market of 5 to 10 percent, based upon our experience. The result has been an increase in properties pulled from the market or marketing efforts put on hold. We are seeing strong pricing and cap rates in urban markets, with high barriers to entry, where cap rates in the low 5 percent range or below have been recorded. Significant deal activity in the region has taken place as United Dominion Realty Trust sold 86 properties to DRA/Steven D. Bell for $1.7 billion, and, on the flip side, has been one of the most active buyers in the Metro region, completing six transactions in this market since the fourth quarter.
The perception is that cap rates need to go up due to tightened credit. However, we are seeing spreads resulting in mid-5 percent interest rates, with I/O still available to good borrowers for two or more years. Loan to Values have come down and debt coverage ratios have risen, but investors with substantial equity in a deal will still find attractive rates and available capital.
New development and infrastructure
Downtown DC is going through a significant transformation as areas of the city, such as the neighborhood surrounding the new Nationals baseball stadium in Southeast, are being developed into 24-hour live/work environments as developers such as JPI, Forest City and Monument Realty are building Class A office and residential buildings in this location. Suburban Maryland is also seeing significant new development, particularly in Prince George's County with the National Harbor project, located on the banks of the Potomac River, adding millions of square feet of office, residential, hotel and entertainment space. Further fueled by the new Wilson Bridge project, the gateway into Prince George's County will continue to be enhanced.
In northern Virginia, transportation is the hot topic, as the much-anticipated Metro extension to Dulles Airport is on and then off again. This $5.2 billion project would extend the Metro through Tysons Corner, a market with over 23 million square feet of office space and two major malls, with the goal of creating a pedestrian-friendly urban environment with development centered around four new Metro stations. Developers are planning large mixed-use projects for these areas and the need for residential units in the Tysons area will greatly increase as traffic and congestion concerns drive development in this market.
Michael C. Marshall is a senior director of the Mid Atlantic Apartment Brokerage Group for Cushman & Wakefield Inc., based in McLean, Va.
To comment, email Teresa O'Dea Hein at thein@multi-housingnews.com
