Vacancy/Concessions

Vacancy in most submarkets in the PMA has increased since the end of 2008. Most of PGP’s recent survey’s show vacancy typically in the 5-8% range for stabilized properties. Most managers are reporting that they are able to maintain reasonable occupancy, but have needed to start offering concessions, which were very uncommon in the market from 2005-late 2008.  Concessions range from waiving move-in fees to 1 month free rent (most common).

The downtown market; however, is expected to be impacted significantly more than the suburban markets due to the large amount of new supply in the market. Between January 2008 and December 2010, more than 3,000 apartment units will come on line in the downtown, or close-in east side markets. All of these units are elevator served and plan to serve the upper end of the market. However, due to the national recession, many of the potential tenants (22-30 year olds) have been hit hard by unemployment and can no longer afford to pay the rental rates that developers had planned in the $2.20 – $2.50/SF range. Absorption is in process at many of the projects with more developments to come on line in the next year. Stabilized complexes have already begun to lower rental rates dramatically and concessions are prevalent and typically include 1 month free rent and discounts, or free, garage parking. Vacancy has dramatically increased to near 8-10% in many of our recent surveys for stabilized properties. It is unclear where the downtown market rental and vacancy rates will end up, but due to the large new supply, everyone’s guess is that it will likely be below $2.00/SF and near 10% for multiple years.

Rental Rates

Similar to occupancy, rental rates are also declining in most submarkets. In suburban areas, managers are typically reporting rental rates $20 to $100/unit lower than a year ago. Managers at more luxury suburban complexes have seen the most significant decrease in rates as tenants are trying to reduce spending during the national recession and are opting to decrease rental payments when possible. Thus, where a luxury suburban complex was getting $900 – $1,000 for a 2BR/2BA unit in mid 2008, rents have typically decreased close to $100/unit and a concession of 1 month free may still be needed.

This rental rate decline is hitting the downtown market as previously discussed, but is also affecting some new suburban development. There are a few newer complexes around the suburban areas of the PMA that were originally planned as condominiums, but were converted to apartments due to the decline in the single family market. Many of these units are 1,400SF + townhouse units with attached garages, etc. The developers had expected rents close to $1.00/SF. However, the market is definitely experiencing a “rental cap”, where tenants are generally not willing to pay more than about $1,300-$1,400/unit, no matter the amenities or unit size in the suburban areas at larger apartment complexes. As these complexes lease-up, concessions of 2-3 months free have been seen, which decreases the overall economic rent. It will be interesting to see long term how these projects progress at a stabilized occupancy.

Investment Market Conditions

The current investment market conditions are very unstable in the PMA and greater Oregon area for multiple reasons: 1) decrease in investor demand for product 2) increase in capitalization rates 3) lack of available financing/ changes to underwriting requirements 4) investors who have capital are waiting on the sidelines in many cases for the market to bottom out. All of these market conditions tie together in one way or another and have led to a definite decrease in apartment values across the board. However, many sellers do not need to sell and have not been willing yet to capitulate to new market conditions

The biggest impact on property values has been from a significant increase in capitalization rates. Early in 2009, there was literally no good sales data to show what the increase was. However, recently, there have been a few sales of complexes (20+ units) that show cap rates generally 7.0+. To illustrate the dearth of sales in the first half of 2009, it is noted that in the first half of 2007, there were 60 sales of 20+ unit properties, 47 in 2008 and only 24 in 2009 according to CoStar. However, of the 24 sales, 5 of them were Section 8 properties that were purchased for LIHTC rehab and are not considered typical arms-length investment transactions. Thus, only about 19 sales have occurred during the first half of the year. Of the sales, only 2 have been 100 units or more and one of these sales was a 100 unit LIHTC property in Springfield. In regard to supply of properties for sale, LoopNet shows about 90 apartments for sale in Oregon of 20+ units as of early July. This number was about 30-50 typically during the height of the market in 2007 and early 2008.

In discussions with brokers, buyers are typically looking to purchase investment grade properties at 7.25 to 8.0% cap rates. The one closed sale of 100+ units in the PMA was in Tigard for a 1970s property and sold for a 7.6% OAR. This property would have likely been a 6.25 to 6.50% cap in 2007 or early 2008. Brokers report that most sellers are not interested in selling for 7.5% + and therefore, there is a large supply of apartments for sale on the market with little activity. Brokers have reported frustration with sellers who believe that conditions will “return to the way they were” with rates back in the 6 to 7% range. This is especially true with the less savvy sellers of smaller properties.

The reason why cap rates are unlikely to return to their historic lows is due to a significant change in underwriting loans, availability of financing, and increased risk pricing of real estate. When interest rates were 5.0-5.5% with an 80% loan to value rate with mezzanine financing available, investors saw little risk. Plus, at that time, underwriting was very lax, and often lenders used “proforma” rents, which expected 12 month rent growth. However, current underwriting and lending conditions are extremely different. First, there are very few lenders even willing to lend on apartments at this time. A few larger banks will lend at their own terms, and a few smaller banks may be willing to lend on small properties. However, for the main segment of the apartment market, the only current lenders are Fannie Mae or Freddie Mac. Thus, these two lenders are really driving the investment market. Currently, a 1.25 DCR is driving lending compared to a previous standard of 1.15 to 1.20. Current LTVs are 75% for refinances to 80% for acquisitions.

However, the most significant change in the process is the underwriting both by the lenders, but also by potential buyers. The lenders will only loan on current, in-place rents (sometimes lower if market rents are declining in the area), and expenses generally based on historicals. This expense standard has been significant because in the past, properties were typically sold using “proforma” expenses for some categories including R/M, turnover, on-site management, and admin. If the property had seen R/M expenses of $700/unit for the past two years, the market still expected to us a number of $400-$500/unit for a stabilized proforma. However, now, lenders are generally unwilling to do this and will place most emphasis on historical expenses. Thus, where proforma expenses would have been $3,200 for an apartment 2 years ago, expenses are now $3,600. This change in underwriting significantly lowers valuation.

When looking at investment grade deals, buyers are also being very conservative at this time due to declining market conditions. If current actual, average rents are $750, but current asking rents have declined to $700/unit, investors are typically using rents lower than the current average in their investment proformas, say $730/unit. Also, instead of the typical 5% vacancy, which was common to use in previous years, investors are projecting income in line with 6-10% vacancy/concessions/bad debt. Overall, these changes in estimating income reflect lower income levels than in 2008 as investors feel that market conditions will likely further decline before they get better. Investors are also basing their expenses on historicals, generally because this is how the loan will be underwritten by Freddie/Fannie, and the DCR depends on these estimates.

Even with the changes in financing, brokers and lenders report that there are still many buyers in the market. However, these buyers are only interested in buying properties that provide a good return, and thus, require cap rates in the 7.25+ range. One broker said that historically, a reasonable cap rate should be 100 basis points over a loan rate. With current market conditions being unstable, it is reasonable to assume that this 100 basis point, or higher estimate, is reasonable. Thus, if current rates at 6 to 6.25%, then cap rates should be 7.25% or higher for most properties. Overall, due to the lack of sales, the market seems to be supporting this theory.

Summary

Overall, apartment market conditions in the PMA are declining with lower rents, rising vacancy, and increased use of concessions. This will likely continue into the next 6-18 months, or until the economy regains strength and jobs are created and tenant spending confidence strengthens. Sales of apartments will also continue to be much lower than typical until owners either need to sell for financial reasons (upside down loan coming due, etc), or until owners realize that cap rates in the 5-6% range will not be seen again anytime soon due to the changes in financing, underwriting, and buyer expectations.

PGP Valuation has been serving the Portland Metro Area and Greater Oregon for the past 30 years. We have the largest real estate appraisal and consulting firm in Oregon and serve all property types including Industrial, Office, Retail, Apartment, and Land. Feel free to call the office to speak with an industry expert for any real estate consulting or appraisal needs.

Jeremy Snow, MAI is the Multi-Family team leader in the Portland office.  His team completes more investment grade apartment appraisals in Oregon than any firm.  Jeremy also has a specialty in restricted rent apartments (LIHTC, Section 8, and RD) and has completed these appraisals all over the State of Oregon.  Feel free to contact Jeremy for investment grade apartment questions or for your appraisal/consulting needs throughout the State of Oregon.

As I finished off my bear claw and thought things were finally wrapping up, a banker asked a question related to appraisals. My ears perked as the gentleman asked if appraisals were indeed contributing to the downward spiral in values. It seemed like a fair question; prices are negotiated based on other recent prices, which are affirmed and often modified after appraisers declare market value. The problem lends itself to the old complaint that appraisers are sitting backwards on a forward moving horse.

Gratefully, Dr. Hoenig accurately assessed that such a relationship between declining sale prices and declining appraisal values is usually a symptom rather than a cause. Appraisal report what is happening in the market. But, because the issue hits so close to home, I thought I would treat of what causes property values to decline from an appraiser’s perspective.

What causes declines in Market value?

 First let me preface my comments: Purchase price is not always equivalent to Market Value. For a myriad of reasons a seller or buyer may be willing to give or take on a purchase price for reasons unique to them. Market value is a theoretical value that assumes what a sale price should be between two very typical parties, each with equal skill sets and full knowledge of the property.

Consider this example: Royce the appraiser concluded that the Market Value for JoJo’s office building was $2,000,000 in 2006. Later, when asked to do the same assignment in 2009, he concluded Market Value to be $1,600,000. Only two things could have lead Royce to conclude a lower market value in 2009: the Net Operating Income (NOI) was significantly less in 2009 and/or market capitalization rates were significantly higher in 2009.  

Capitalization rates represent the ratio between annual net income and sales price. While the NOI may be falling at many properties (due to increased vacancy rates and/or more competitive rental rates), it almost certainly does not account for the entire value decline in this market. Major value declines also come from the changing status quo between buyers and sellers. Buyers have become much more patient and are expecting a much more favorable ratio between their NOI and purchase price. In other words, when there are fewer buyers (as often is the case in a down market) capitalization rates move upward.

In situations where there are recent comparable sales, anyone valuing a property can easily extract and apply very current and realistic capitalization rates to estimate Market Value. This is because during times of appreciation, the market is usually active. Extracting supportable capitalization rates is easy. However, when transactions are scarce finding market capitalization rates can be significantly harder. When this happens, oftentimes sellers have an unrealistic opinion of value because they are relying on dated capitalization rate sources.

Finding Market Capitalization Rates without Recent Transactions

When comparable transactions are not available, the appraiser’s best option is to look at the most recent transactions, assess how much economic conditions have declined since that time, and appropriately apply some type of upward adjustment to the dated capitalization rates.

How do you make that adjustment? How do you capture the subjective impacts of tighter lending standards and lower market confidence in a quantifiable manner? There are multiple ways to do this. Interviewing active brokers or other market participants for both general information and details on listings and failed transactions is a good place to start. Another option is the Underwriter’s Method. This method can give an appraiser a rough guideline of what a reasonable capitalization rate would be in the current lending and investing environment. Other ideas include going to other markets where recent transactions may have occurred. National surveys of investors provide yet another source that may be applicable to some property types. Explaining these methods and the pros and cons of each one will have to be saved for another article. However, I will say that each of these has strengths and weaknesses. In reality, a good appraiser should incorporate all of these into their capitalization rate analysis where appropriate.

When attempting to conclude a market capitalization rate in a down market, it is important to remember that these other methods take a hefty amount of market knowledge, reliable data, and astute judgment.

Bankers, brokers, appraisers, investors, and developers are all looking forward to when the bleeding stops and confidence again returns to the market. While in the past appraising was sometimes viewed as a necessary evil, market participants are now leaning heavily upon our work. More than ever an appraiser’s un-biased opinion combined with expertise of these complex issues can help buyers, sellers, lenders, and brokers make realistic informed decisions during a tough economic period. 

Existing home sales were down consistently across all 4 counties in 2008 by 32 to 34%
New Detached sales followed a similar trend, with Clark, Washington & Multnomah down 29-33%, and Washington down 18%
Attached housing market faired the worse, down from 40 to 54% across all four counties.
Overall, the volume of home sales was down an average of 35% for the Portland Metro Area
Pending sales dropped 30%, and New Listings Dropped 8.7% for the year, and 20% compared to the same quarter last year
Foreclosure sales now approaching 10% of existing sales, with Clark County higher at 17%
Per the local RMLS service there is a 14.1 months of inventory based on current monthly sales rate, up from 8.5% in December 2007
Total Marketing Time for Homes Per MLS is up 13% to an average of 138 days

Median Sale Price Trends

Median Existing Home Price down from 2 to 6%, averaging 5%
Median New Home Price more static in Washington and Multnomah Counties, but down 13% in Clackamas and 19% in Clark County
Attached housing down average of 5%
Median Sale Prices Are Likely Skewed by Concessions and by the number and location of the sales

New Home Trends

Construction activity and starts are at all time low
Generally selling close to 1/4 of the new units as compared to the peak of the market
New home and lot inventories are declining, but slowing sales are still keeping the overall months of inventory high
Most plat in Clark County with new detached product have absorption from 0 to 2.50 sales per month, with average at about 1 per month
Attached townhome absorption similar to slightly lower at 0 to 2 closed sales per month
2009 Volume of New Home Sales Could Go Down Further 20% if Economy Does Not Improve
More builders will file bankruptcy in 2009 & we will see builders work together or consolidate to survive
Some production builders trying to get detached housing down to $180,000 for starter home
Affordability is improving with home prices continuing to decline & very low mortgage rates, but recession & tighter lending standards offset
Long term trend for production builders: goal to match of starter home pricing to median incomes, and conform to underwriting standards.
During the peak of the market, starter home prices far exceeded the affordability based on median incomes and traditional underwriting
Median Income are likely to drop given unemployment on the rise, and near term deflation is likely
Lot and land prices have to adjust further
Interest Rate Buy downs More Common as Incentive From Builders
Trend to continued increase in number of attached town-homes entering rental pools by builders.
Some discussion between building community and jurisdications to put a temporary freeze on increased impact fees

Banks & FDIC

Restructuring of the financial system & underwriting requirements likely in near future
Continued Bank Closures Likely in next two years
Bank closures typically result in frozen lines of credit and loans being called- ripple effect for the community
Opportunity for brokers to represent buyers & to inform them of inventory becoming available
Also recommend learning the process and establishing relationship with FDIC on selling side
Fed is injecting money (liquidity into banking system), but banks are stockpiling the liquidity and not passing it on.
Commercial Real Estate Problems will hurt already troubled banks in the coming year.

Lot Value Trends

25-40% value declines in many markets
Most transactions are individual retail sales or take down sales tied to home absorption to builders
Larger custom lots and acreage lots showing big declines, with the exception of very unique parcels in limited supply
Spec financing for smaller custom builders is extremely limited, so only buyers of larger lots are production builders or individuals
Most bulk discounts analyzed using Discounted Cash Flows range at 25-35% from retail, with some up to 50%
Increase in short sales for lots, will result in builders offering new below market product with competitive advantage
Some Recent Potential Buyer Comments on Liquidation Values for Land and Lots
Developer/Builder 50 cents on dollar because they can immediately react as a producer
Inventor buyer at 20-30 cents on the dollar for wait and hold scenario

Residential Land

Demand almost non existent in 2008, and will likely be limited to short sales, liquidation sales, or speculation in 2009
Reductions in land values have been magnified by the slower home sales, lack of demand for lots, and lack of financing
Land Valuation – Focus on supported finished product type, price it right, run conservative costs, and calculate residual on yields w/holding periods.
A&D Loans are essentially non-existent except for unique well positioned projects with high equity requirements of a limited scope.
Multi-Family Land – Few sales, developers have quoted likely range from 8,000 to 14,000 per door for land at 18-24/acre garden style.
Value of entitlement no what it used to be, and entitlements will expire for many projects
Developers will continue to obtain post decision reviews to phase larger projects, in attempt to extend length of entitlements
New Washington State Stormwater Rules Effective in April 2009 have caused a rush of new applications for subdivision to maintain lot yields

Overall Comments

Really in uncharted waters- Deep Recession, new administration, new stimulus plan, new direction for TARP
Demographic Trends also shifting to more conservative for savers in the future
Hard Money Lenders Coming into Play Now
My guess is that we will bottom in early 2010, with a signs of a recovery in later 2011.
Some national experts say housing crisis could last another 3-4 years.
Private parties need to start looking at housing as a long term investment, not a quick flip product
Future success in housing market will be dependent on bringing product to market that is supported by incomes and new underwriting requirements
Qualified buyers will have a great opportunity with declining values and low rates
If you are ready to pull the trigger on a home purchase & have a good deal you should do it as long as you are qualified and not heavily in debt.

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