A message to developers of new apartment buildings in Greater Boston from lending experts – don’t be late to the dance unless you want to be stuck holding your own corsage all night.
Some 1,300 rental units are slated to be delivered into the Downtown Boston market in the next 18 to 24 months – by some of the best-known names in local development, and in some of the most desirable areas in town.
There is now ample demand for those apartments, according to most industry professionals. But there is also plenty of supply to meet that demand. It also happens that debt and equity are not hard to come by for apartment developers and traders, making it even more enticing to embark on new projects.
Which is to be expected at the tail end of a crippling recession, industry experts say. There’s a good amount of catch-up going on right now because there wasn’t a lot of supply delivered in the last few years as a result of tight capital markets.
Overheating?
Now that the rental market has tightened a bit and the general picture looks pretty good for the next few years, investors and equity are willing to invest – to a point.
“Today I think the outlook is good, but that’s not to say there will be a thousand units in construction at the time with a thousand new ones coming in right behind it,” a local investment banker that lends in the multifamily sector told Banker & Tradesman. There’s a lot to be very cautious about here. These are big deals … and I think everyone needs to step back and be a little more cautious when it comes to looking at these deals.
“Clearly there will be a benefit to being first in, as it were, with new developments,” the same source added. “There will be a point when there may be a new potential development opportunity and it might feel as if you might be sort of on the back end of the current supply and demand situation. It will be very interesting to see once a couple developments get underway how deep that part of the market really is. Then you get a true indication of how they’re accepted and the depth of the market.”
Michael Roberts, vice president of development at AvalonBay Communities, said he thinks there is room for the new supply in downtown Boston, but it will be interesting to see how those flush through the market in the next five or so years.
AvalonBay has one of several apartment projects already permitted for construction in the city. AvalonBay Communities will place about 240 units on the edge of the Prudential Center complex in the Back Bay; Millennium Partners is permitted for 265 units at Hayward Place in Downtown Crossing; 100 Arlington St. will be converted into 128 apartments by the Congress Group and AREA Property Partners; Simpson Housing will create 286 units at its mixed-use Bulfinch Triangle project; and Kensington Investment Co. will locate 385 units at The Kensington at the corner of Washington and LaGrange Streets.
Lenders will no doubt be watching that cycle with eagle eyes. But right now, many traditional banks are lending in the multifamily sector, including Wells Fargo, Sovereign Bank and Brookline Bank. Life insurance companies have also become big players in apartment lending, with companies like John Hancock, Northwestern Mutual and Principal Life Insurance among the most active, according to industry professionals. Their aggressive tactics provide construction loans, permanent long-term fixed-rate loans and occasionally equity, said one lender.
With new construction, projects often end up covering 65 percent of the costs with debt, with the remainder coming from equity, one lending expert said. Oftentimes a developer ends up with a syndicated deal, where two or three lenders need to pool their commitments to satisfy the request. Depending on the size of the bank, lenders are reluctant to have too much exposure to one deal, and $30 million to $40 million is usually the high-water mark for most banks to commit to a single project.
“This is a great time to get something permitted because City Hall wants construction jobs,” another lender opined. “A challenged economic climate is a dream for developers.”
‘Bordering On Irrational’
But in some cases, apartments have been trading at sub-five percent capitalization rates, indicating a sellers’ market.
Capitalization rates, or cap rates, are the percentages used to determine the value of a property based on how much income it provides. For example, a building that generates $20,000 in annual income and sells for $200,000 would have a cap rate of 10 percent. If that same building generated the same income, but were to sell for $300,000, the cap rate would fall to 6.6 percent. From a buyer or investor standpoint, higher cap rates are generally preferable because they indicate a lower selling price relative to a property’s income generating potential.
Currently low cap rates on apartment building transactions could mean investors are paying a premium for well-located properties, betting that paying more now will prove worthwhile as rents grow in the future. Still, one lending professional at a major investment bank said current deals under a 5 percent cap rate are “bordering on irrational.”
Notable deals for existing buildings include Park Lane in the Seaport district, which JP Morgan bought from Joseph Fallon and Cornerstone Real Estate Advisers for $194 million in December with a cap rate of 4.7 percent; Denver-based UDR, a REIT, purchased the Garrison Square apartments in Boston’s St. Botolph neighborhood for $98 million with a 4.25 percent cap rate in September; and TIAA-CREF bought the Residences at Rivers Edge off Route 28 in Medford for $80 million at a 4.75 percent cap rate in April. “Those are just indicative of how much investor interest there is, particularly in Boston residential units,” an attorney that raises debt and equity for commercial projects told Banker & Tradesman. “This is not a new phenomenon, but it’s particularly strong right now. I think some of the pricing represents pent-up demand, and some believe there will be a period of decent rental growth.”
Boston-based Property and Portfolio Research group, which follows real estate trends, has predicted a 22 percent rental increase in Class A apartments in metropolitan Boston between now and 2015. However, that is also rents catching back up to where they were before they dropped during the recession.
But a hot apartment investment market in Greater Boston doesn’t seem to be translating to other parts of the state. Statewide, there were 332 multifamily transactions of four or more units sold from January to May last year. In the same period this year, only 259 such properties have traded – a more than 20 percent drop, according to information provided by The Warren Group, publisher of Banker & Tradesman.
And higher cap rates outside of Boston indicate more of a buyers market.
In the secondary and tertiary apartment markets, properties have been trading for as high as 11 percent cap rates, creating a bifurcation in the sector, said Bob Horvath, senior associate director at multifamily specialist Marcus & Millichap Real Estate Investment Services. Although they don’t do much multifamily housing brokerage in Boston, the firm just did a deal in Somerville for about 12 units that had a cap rate of seven percent.
