A market that moves to a different beat.

Author:Gordon, Sally
Position:Cover Report: Commercial Real Estate

The health of local apartment markets does not simply track the stages of the business cycle. Isolating investment opportunities in multifamily markets takes astute analysis from many different perspectives.

MANY INVESTOR SURVEYS FIND THAT multifamily property is "the investment of choice" in today's market. The most frequently cited reasons are supply-side constraints, the dependability of the cash flow and the relatively easy adjustment of rents to inflation.

Multifamily housing traditionally has been a major portion of both debt and equity commercial real estate transactions and continues to attract active investor interest.

Thorough analysis of multifamily investments requires evaluating these investments from a property markets perspective, as well as from a capital markets perspective. Property markets reflect the supply of and demand for space, and capital markets reflect capital flows, interest rates and alternative investment returns and vehicles.

In approaching multifamily investment, a critical question needs to be addressed: Is multifamily investment an unalloyed opportunity or a selective trap? Any time an investment sector is so pervasively perceived as attractive, there is the potential for a "herd mentality" to drive investment choices. Accordingly, it may be prudent to rethink the rationale for that investment choice.

The widespread perception of the attractiveness of multifamily investments is often based on the premise of a constrained supply line. It is certainly true that we have seen a very low pace of apartment construction for several years. Supply constraints alone, however, are not sufficient to generate a healthy market.

This article has two objectives: To identify some of the more powerful macroeconomic variables that drive demand for multifamily housing and to highlight a different definition of portfolio diversification.

In terms of the first topic, the most powerful economic variable that drives and sustains multifamily rents and values appears to be growth in income per employee. In assessing this variable, it is important to remember that income growth does not necessarily correspond with the business cycle; there can be job formation and little or no income growth and income growth without many new jobs. Income growth is, however, influenced by the nature and well-being of the local economy, particularly by the industries that are represented in the local industrial profile.

On the second issue of diversification, when examining the composition of a portfolio or the collateral for a security, it is important to recognize locational variety for what it is and is not--it is not necessarily economic diversity. To label a portfolio diverse just because the properties are located in several different cities or areas is inadequate.

Consider the following examples. Assume a security backed by properties in three cities. The local economy of one city is dominated by a glass factory; another city is the site of a large plastics company, and the third city is home to a steel factory. Although the properties are in three "diverse" locations, all three local economies will be strongly influenced by the health of the automobile industry as a major user of all three kinds of products.

Consider, as well, a somewhat less transparent example. Assume a security with properties in New Hampshire; Boston; Nassau County, New York; Raleigh; Cleveland; Anaheim; and San Diego. While this appears to offer a wide geographic spread of locations, in fact, these economies have about three times the concentration in manufacturing of electronic equipment and high-tech instruments as the national average.

In either example, one might actually want to "make a bet" on either the automobile industry or on electronic equipment and high-tech instruments. The point is to know what "bet" one is making, by understanding any concentration of economic risk in a portfolio, and not to confuse locational variety with real economic diversity.

Investment decisions may be improved through selectivity and recognition of the factors that drive economic conditions:

* Given that the underlying economic and demographic forces that drive apartment rents and occupancy are not immensely powerful and can't necessarily be expected to recover with the macroeconomy, "average" economic growth is probably not enough to support multifamily values dependably. Choosing locations with above-average growth in income per employee would enhance the success of multifamily investments. Thorough analysis of the local economy in the market where a property is located can aid in assessing economic risk.

* It would be prudent to employ strategies to mitigate economic risk to a portfolio or security after examining the combination of economic drivers that are represented in the individual local economies.

Office markets and the business cycle

Changes in real estate markets do not necessarily correspond to the business cycle. The office market best illustrates the caution that must be exercised when extrapolating from the business cycle to the well-being of a real estate market.

The office market does not move with the economy as a whole. Figure 1 shows that office vacancy rates are not necessarily high during recessions or low during recoveries. Nor does vacancy rise or fall in a pattern stimulated by the business cycle. The vacancy rate, which is really the ratio between demand...

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