By Jake Mooney
For many multifamily REIT executives in recent years, the rhetoric about portfolio allocation has sounded a bit like the old Petula Clark song: “Things will be great when you’re downtown.”
But even as companies have chased the young, the childless and the free-spending toward the cities’ brighter lights, pushing asset prices ever higher in the hottest urban markets in the process, the relatively unglamorous suburbs have maintained a steady appeal.
The suburban thesis, and the fundamentals driving it, came into sharper relief in October when executives at a blue-chip apartment REIT, AvalonBay Communities Inc., said the company would shift its development emphasis toward the suburbs, partly as a result of rent-growth trends and new supply in the cities.
Leaders at several other REITs, including AvalonBay’s fellow sector leader Equity Residential, remain vocal in their urban commitment, and there was no suggestion during the call that AvalonBay, despite the professed new emphasis, would abandon in-progress urban developments such as a planned developments in Manhattan, NY’s West Chelsea neighborhood or Downtown Brooklyn.
Yet the executives’ comments, and the underlying data, underscored the point — sometimes overlooked — that there is still money to be made in the land of low-rises.
An AvalonBay spokesman noted that the data points they cited in the earnings call were from Axiometrics Inc. and from observations about the company’s own portfolio.
According to Axiometrics, suburban apartment occupancy levels, which lagged urban occupancies since before the last decade’s downturn, caught up in 2013, and suburban outperformed urban through much of 2014. As of August, occupancies in both categories stood above 95 percent, the point at which Axiometrics considers properties functionally full.
Meanwhile, rent growth was positive in both urban and suburban properties, but growth had fallen and leveled off in urban properties after a mid-2011 peak. In the suburbs, by contrast, rent growth numbers rose for much of 2014.
Stephanie McCleskey, vice president of research at Axiometrics, said that much of the suburbs’ recent resurgence relative to core urban areas stems from new supply. As of October, seven of the top 10 submarkets for new deliveries in 2014, based on identified supply, are “core urban” areas.
Another, classified as non-core, is the New York City borough of Queens.
In the current cycle, “the urban core areas recovered a little more quickly than the rest of the market, because that’s where the jobs were coming in,” McCleskey said. “But as the new deliveries and the rent level of the existing product continued to rise over the last couple of years, there’s only a certain number of people that can continue to afford increases on their rents.”
Though the causes of flattening rent growth vary by market, “It has to do with, how much did they push rents at the beginning part of the cycle?” she added. “Have they hit the ceiling? And then how much new supply has delivered relative to the existing stock? So, are they able to continue to push rents, especially with all of this competing product that’s at a similar price point and a close proximity to their property?”
One oft-cited argument in favor of investing in urban multifamily holds that urban supply should grow more slowly, because building in cities is harder.
But Steven Marks, managing director and REIT group head at Fitch Ratings, said that there is a “secular shift” of young people, the primary rental tenant base, moving to cities and creating incremental demand for central business district apartments. Yet he said one argument in favor of investing in urban multifamily — the idea that urban apartment supply should grow more slowly because building in cities is harder — masks an underlying tension.
“There seems to be a little bit of cognitive dissonance about how companies want to develop in urban markets because they are supply constrained, yet that’s where everyone seems to be developing,” Marks said.
Regarding the urban rent growth earlier in the cycle, he added: “At some point, something has to give. You can’t just keep pushing rents in the cities. People’s income growth just can’t keep pace. The proverbial tree can’t grow to the sky, especially if you do have new supply coming online, too, which does begin to eat away a little bit at the ability to grow rents.”
Looking forward, there is evidence that urban supply will continue to swell. Similar to 2014’s track record, seven of the top 10 projected new-supply submarkets for 2015 are “urban core,” according to Axiometrics (another is Brooklyn, NY), and the markets at the top of the 2016 deliveries list are in New York City and San Francisco.
Still, McCleskey said, both urban and suburban supply growth is expected to decline in the coming years, and construction starts have already fallen. Urban core growth may decelerate before suburban, she said, adding that overall, “we’re expecting them to come back more in balance.”
Considering such projections, analysts said the increased suburban opportunity AvalonBay is identifying is by no means permanent, or even accessible to most companies.
“There’s money to be made in all walks of life in the sector, and AvalonBay, if anybody’s going to do something different, you kind of believe them, because they do such a thorough process,” Mizuho Securities USA analyst Richard Anderson, commented. That said, he added, “These are not game-changing type of decisions. These are tweaks to the system to find the optimal portfolio to their liking.”
Cantor Fitzgerald analyst David Toti noted that, aside from Mid-America Apartment Communities Inc. and Home Properties Inc., which have heavily suburban portfolios, most multifamily REITs — including AvalonBay — are diversified between suburban and urban.
Executives at Essex Property Trust Inc., the dominant West Coast apartment REIT, said in August that the company would increasingly seek to buy properties in second-tier areas, in part because buying in urban cores is growing too expensive and also to capture tenants fleeing high rents in core areas.
Because AvalonBay is typically a developer of new properties, though, it must look further into the future than its peers that primarily grow by buying assets. One major advantage the company has — and its competitors do not — is a large store of land on which to build, Toti said. Those land holdings may, in fact, mean it is uniquely positioned to succeed in its suburban shift.
“If you have a land advantage, if you have vintage land in your land bank that’s at a low cost basis, you can obviously underwrite development with better returns irrespective of where it is,” Toti said. “If you’re paying market price for land and you’re building in the suburbs, I think you have to be much more careful.”
In part, he said, concerns about demographics, household income and the local employment base are more critical in the suburbs than in cities.
Moreover, while construction of suburban-style buildings is less expensive, Toti added, the properties often wear out more quickly than their urban counterparts — and require more maintenance when apartment turn over — because they are made from cheaper materials. Partly because of such wear, he said, companies with larger suburban holdings are often more aggressive in selling off older properties.
Still, though Toti is another proponent of urban multifamily, he added, “A lot of people still live in the suburbs, a lot of people still work in the suburbs.”
Companies that own suburban assets “have to be more selective,” Toti said, but that does not mean the opportunity doesn’t exist.
“I think all the REITs will continue to migrate towards newer assets, they’ll continue to migrate towards urban assets, and I think that’s the right strategy, but there will always be a market for the other stuff as well,” he said. “The suburbs aren’t dead yet.”
This article was reprinted from SNL Financial news, data and analysis service.