At the beginning of 2017 most said it was the beginning of the inevitable slowdown; however, as we roll into a new year and look back at our forecast, the market ended up right where we expected. 2017 was not only a solid year in terms of investment activity, it was also a strong year from the owner/investor side. We experienced positive sales volume growth, positive rental growth and even managed to push the occupancy a little higher, a multifamily trifecta. Although the year started off a little shaky with many reports citing pressure on rents and occupancies, the rebound in Oklahoma’s economy was a welcome boost pressing the multifamily market forward. Although the boost was the result of several business sectors and industries, there’s no question the important oil and gas industry had a large role to play. In 2017 Oklahoma saw its total rig count double as oil prices reached $63 per barrel, an over 40% increase from the previous year. The increased drilling activity helped the oil and gas industry add 5,300 jobs in 2017, approximately 25% of the total jobs added last year. Although that’s an impressive number, the entire workforce increased by 1.2% with all but three job sectors having positive employment growth for the year. This continued job growth caused the Oklahoma City metro area to have a decrease in unemployment from 3.9% at the end of 2016, to 3.3% at the end of 2017, virtually full employment. On top of the added job growth Oklahoma employees experienced an average weekly wage increase of 5.37% from the same time last year.
Nationally, actions in 2017 had more impact on the multifamily market than most people realize. Regardless of which side of the tax reform bill you are on, there will likely be a negative impact on the development of affordable housing at a time when we are already well behind the demand. Although there was strong bipartisan support from the house and senate to keep the low-income housing tax credit (LIHTC) active, only time will tell how the reduction in corporate taxes will affect the appetite for investors to purchase those tax credits. It’s estimated that the corporate tax reduction alone will reduce the future supply of affordable housing by nearly 235,000 units over the next ten years. Further, it is anticipated that other changes to the tax code, such as those relating to bonus depreciation, depreciation, and interest expense limitations, will impact equity pricing. Fortunately, the legislation retained the new market tax credit, with no change to its expiration which is after the 2019 allocation. The 20% historic tax credit was also retained, but with significant modification,
Additionally, rising construction costs and a shortage of labor have plagued developers in 2017, and those issues are only being exacerbated by the natural disasters in the fall. Developers in most markets claim it’s difficult to get bids on projects in even the hottest of markets because there is so much demand for construction trades. Even worse, projects in rural areas could ultimately pay a premium just to get the labor into those areas. Those developers with existing relationships with contractors they trust will fare better than those who are starting out.
Following 12 years of negative home homeownership growth, from 69.2% in 2004 to 62.9% in 2016, the US homeownership rate appears to have hit its bottom and even increased slightly in 2017, up to 63.9% as of the third quarter. 2016’s homeownership was the lowest since 1965, while 2017’s rate was the highest since 2014. The number of renter households in the US increased by 19.2% between 2005 and 2016, from under 37 million to nearly 45 million. Despite millennials recent movement into homeownership, new caps on mortgage interest tax deductions could help keep that rate low on higher end homes, in turn, increase the demand for luxury multifamily rentals.
Although the beginning of the year seemed to have negative pressure on rents, the Oklahoma City apartment market came through in the second half to end the year with positive rent growth. We surveyed 73,157 market rate communities across 336 properties and arrived at an average rental rate of $0.92 per square foot per month for the Oklahoma City Metro Area. This is a 2.22% increase from the previous year, which is right in line with the national rent growth of 2.33%. Although positive rent growth is excellent when construction activity has been as high as recent years, it’s still below the historical average of 3.02% since when we first surveyed the multifamily market 29 years ago but very few markets can claim 24 consecutive years of positive rent growth. In addition to positive rent growth, the average concessions also declined 31% from $11 per month, or 2.09% of the asking rent in 2016 to $10 per month, or 1.45% of the asking rent at the end of 2017. Although slight, this decrease in concessions indicates that the market demand is catching up to the supply. New construction still required a little higher concession giving away $42 per month or 3.6% of the asking rent. Overall, the market was not affected by the 1.58% inventory growth and absorbed 2,285 units over the year, bringing the overall occupancy up to 90% from 89% the previous year. When further digging into the rent growth, the leader overall were the two-bedroom units. Across the board they increased by 12% year over year, with one-bedroom units declining by 7%. Efficiency style and three-bedroom units increased by 9% and 3% respectively. All bills paid properties averaged $1.20 per square foot per month, 30% over the market rate average rent.
Multifamily completions rescinded from 2016 with 1,554 units being added to the inventory in 2017, 54% below the previous year. The slowdown is even more visible going forward with only 1,230 units scheduled to be completed in 2018 and around 3,000 in planning stages. It’s important to note, that not all units in planning stages actually make it to completion so the units planned number is always higher than what gets delivered. Demand remained strong in 2017 and the market absorbed not only the 1,554 in deliveries, but an additional 731 units as indicated by the decrease in vacancy rate. This is a welcome trend after multiple years of negative absorption created by overbuilding during a slow economy; however, one wonders whether it is due to construction finally slowing down, or to increased demand. For more than a decade, the number of renter households in the US has expanded year after year, sometimes by more than 1 million a year. This year, the explosion of renters in the wake of the foreclosure crisis has maybe, finally begun to fade, as 2017 was the first time since 2004 that the number of renter households declined. This extended period of growth has permanently transformed the housing landscape. High-income earners account for a much larger share of renters in the US today than they did when the growth spurt began in 2005. Between 2006 and 2016, the share of U.S. households earning more than $100,000 who rented their housing grew from 12% to 18%, a spike of nearly 3 million people, or almost one-third of the 9.9 million increase in renters overall.
One does have to consider the new tax reform, and the impact it could have on the “rent by choice” movement. Just as the home ownership rate finally began to increase for the first time since it hit the all-time low of 62.9% in the second quarter of 2016, how will the limit in mortgage interest deductions take effect. Although the new changes won’t affect the majority of taxpayers, will it have an impact on the high-income earners nudging them to decide that the pros no longer outweigh the con’s when deciding to buy or rent. Should rental housing demand increase as a result, then developers are certain to listen and fill the pipeline back up assuming there is available debt and equity. While debt is still readily available, it has tightened slightly in the last twelve months. In the years past, developers could easily get loans up to 75% loan-to-cost with conventional financing and 90% with HUD financing; however, many lenders are raising the equity requirements and pushing for larger down payments, thereby pushing many projects out of the black.
If demand does increase as a result of tax reform or any other reason, one issue is whether developers will be able to build at a per unit cost that ultimately makes sense. A biproduct of the recent construction boom is an increase in land costs. Only a few years ago it was said that you cannot pencil out a multifamily project with land costs over $2.50 per square foot. Now it’s not uncommon to see land selling above four or even five dollars per foot in suburban areas. Not only have land costs increased, but also labor and materials have risen significantly, thereby creating an environment where developers are forced to build luxury products to get the rents, and ultimately cater to the higher income earners while increasing gap in affordability.
In 2017, there were several projects built that were worthy of note. In traditional fashion, the Urban Core produced the most units with three projects either finishing or being substantially complete by the end of 2017. The first apartment community to be built in Bricktown opened its doors after a very long development timeline. Plagued with environmental issues, contractor setbacks and other delays, Steelyard opened its first phase of two adding 220 units. Phase 2 is already under construction with another 97 units planned to open in 2018. Just east of the Bricktown entertainment district, along the eastern edge of the Innovation District, local developers took on the monumental task of redeveloping the historic Douglass High School into an affordable community that has already won multiple awards. The Douglass was a creative combination of old construction repurposed into housing with the new construction adjacent built to match the old. There are 60 units in the original high school building, and an additional 68 units added to the attached newly constructed building. The project was received so well that the developer decided to add 38 more units in a more contemporary style across the street in a project named The Seven. Time will tell how the demand is for this product type, but the market is watching, and if it does well there will likely be other schools that get similar treatment nearby.
In the southern quadrant of the market, two other projects were built. One along the Interstate 240 corridor called The Landing. This 252-unit project takes advantage of the tremendous growth that is happening along the Interstate in that area, drawing a large number of their residents from the Oklahoma Heart Hospital and Tinker Air Force Base. Further to the south in Norman, another local developer built what is considered an urban style project in a suburban area. Terra at University Park consists of 303 units and is on the northern edge of the rapidly growing University North Park area. This is an area that has experienced a surge in commercial development with practically every major retail venue in our market within one mile. The same developer also built a very similar project in the northern part of Oklahoma City in a similar rapidly growing location called Chisolm Creek. The project is named Agron Apartments and has excellent visibility along one what most consider the best retail corridor in Oklahoma City. Chisolm Creek is a large scale live, work, play development with names like Top Golf, Cabela’s, iFly, and many others. When complete the development will have an amphitheater, residential units (other than Argon) and a vast selection of retail, dining and entertainment.
It would almost be detrimental to not mention a few projects under construction, specifically the iconic First National. After sitting virtually vacant for a number of years, and being bought and sold by owners who just never followed through with any promises to renovate, local developer Gary Brooks has taken on the project of his life. The $200 million renovation will take several years, but once complete will consist of 150 residential units, with a five-star hotel, parking garage and retail with dining on the first and basement levels. The project has started but not out of the woods yet as tax credits and various financing methods are being navigated, all while trying to keep 86-year-old building together.
Another large project underway and also testing the market is West Village. This 345-unit property is being built along the outside of the 21C hotel and museum. The property will feature some retail along the ground level and have attached structured parking. The developers are testing the west side of downtown, which is an area that hasn’t been proven yet, but are optimistic that the energy from neighboring areas like Film Row, Farmers Market and the Core-to-Shore will help bolster the occupancy once it opens. Just to the north, The Lift seemed to have a slow lease-up, and some say it’s because there is not as much interest on the west edge of the urban core. However, if you were to gauge the interest in the area by the level of activity at the neighboring Jones Assembly, then the large crowds and long lines would say the area is sure to be a hit. Scheduled to begin leasing in late 2018, we’ll keep a close eye on West Village to see how quickly they are able to lease the units.
2017 was another excellent year for the multifamily market. One veteran lending source has become very aggressive over the last 24 months, and its specialty is very positive for Oklahoma apartment investors. Freddie Mac has started to be a common name mentioned by apartment buyers and it is beginning to dominate the local market with its new small balance loan program. What makes this specific loan program such an ideal fit for Oklahoma boils down to our average deal size fitting perfectly in their niche. While most large institutional lenders are chasing the luxury property market and portfolio size transactions, Freddie Mac has drawn its loan limit at $6 million. To put it in perspective, 81% of the 2017 transactions would have qualified for this loan based on purchase price alone. Now, buyers of small balance loans can compete for the non-recourse, 30-year loans, or even have an interest only period which drives their yield up. As of mid-2017, Freddie Mac has funded over $9.7 billion in small multifamily loans with it’s mission to support liquidity, stability and affordability since small multifamily properties are a major source of affordable rental housing.
Multifamily investment sales provided another strong year with transaction volume up almost 20% from the previous year. Reaching almost $370 million, this was the strongest year in Oklahoma City history excluding 2015, 21% above the bull market experienced in 2007 and a staggering 44% over the ten-year average. With just over 7,500 units selling, we ended the year with an average price per unit of $48,700, 4% below 2016’s average. The slight drop in per unit price isn’t an alarm; the largest factor to the overall price per unit is the quality and age of the assets that sold in any given year. A better indicator of the markets overall health is to break down the asset types and compare them.
Overall volume was up in every asset class with the one exception, Class A assets. The one transaction considered a Class A asset resulted in a 32% reduction in Class A volume, and is the main reason the average price per unit was down across all assets classes. The lone transaction was an urban property just north of the Deep Deuce and Bricktown areas and sold for a $64 million. Consisting of 329 units The Metropolitan was purchased for $194,529 per unit. This price is 62% above the five-year average of $120,036 for Class A assets; therefore, the 2017 Class A average price per unit is not a reliable market average to use since it was the sole transaction. Class B had a 102% increase in volume over the previous year with a total of $87,220,000 in transaction volume. There were 1,149 units that traded giving Class B an average price per unit of $75,909, virtually flat from the previous year.
As always is the case, the Class C category had the largest volume with $215 million in transactions. This is a 25% increase over the same time last year, and makes a statement about the strength of our market. The average price per unit on Class C assets is often followed closely to determine the health of the market, and it was flat from the previous year increasing just $200 per unit to a new average of $37,763. Of the just over 5,600 units that traded 524 were considered distressed; therefore, when you remove them from the total transactions, the performing price per unit for Class C assets increases to $39,494. There is a 91% premium over performing to non-performing Class C asset pricing. Class D transactions are those that are typically referred to as virtually or completely abandoned. Typically, these units are beyond repair and need to be razed; therefore, they can be purchased for pennies on the dollar compared to assets of similar age, but have significant cost to cure the damages and bring them back to life.
In 2017 the Class D transactions picked up compared to the previous year, with four properties totaling 381 units trading. The total sales volume for Class D assets came in at $1.9 million, with an average price per unit of only $4,987. One property worth mentioning was sold for $987 per unit, which is the lowest price per unit any apartment has traded for in over twenty years. This property had been abandoned for many years, and most would say could not be salvaged. The buyer worked with the city to remove liens placed on the property to pay for the demolition of seven buildings and now plans to invest over $2 million into brining the property back to life.
Most would agree that the impressive growth cycle we have experienced is partly, if not largely, due to the extended low interest rate environment. For some time, we have all said, “rates will go up soon”; however, we have all been amazed at the length of the low rate environment. Few would believe that it will last significantly longer given the country’s 3% GDP growth over the last year, with many expecting four rate increases in 2018. Regardless of interest rates, the volume of new construction or even the rising property values, we need to pause, take a step back and look at the fundamentals. In general, properties are being underwritten and then traded based on their actual fundamentals and not speculative or unrealistic projections, which is what occurred during the last bubble. This alone should allow us to breath a little sigh of relief.
All in all, there’s little reason to expect a big slowdown in apartment demand independent of a broader economic slowdown. Today, multifamily skeptics fear that Millennials will leave apartments as they age, get married and have kids, opting to move into single family homes; however, one only needs to look at statistics to determine that isn’t cause for a big concern. Moody’s is forecasting that the US will add more people than it loses in the key 25-34-year-old demographic for at least the next six years. Therefore, we won’t see the drop-off some have been worried about, at least not in the magnitude they predict. As one 35-year old moves out, there is another 25-year old ready to move in, and in addition to the 25-year old, we now have the baby boomers also moving into multifamily housing as they become empty nesters. This trend will continue to push the demand for rental housing in a positive direction, and continue to assist on positive rent growth not only in Oklahoma City, but across the US in the near term.
As the rental market stays strong, so should the investment side. However, the question on most owner’s minds isn’t can I get a price worth selling, it’s what how will I reinvest the money after I sell. Essentially, where are the deals to be had? The recent flood of capital chasing urban, luxury apartments has created a surge in development that in turn made it hard for managers to achieve the proforma growth. This abundant supply made it easy for renters, who are often light on possessions, to move two blocks away to a tempting property that is offering better incentives. This is particularly true when the shine has worn off from where they currently live, and compounding the problem, since renters today are very mobile, it doesn’t take them much to cause them to move. Today’s investors are aware of of this urban problem as it’s happening in markets all over the US, therefore many are changing their strategies to more of a value-add approach and are raising and deploying their capital accordingly. This is even more particularly true in Oklahoma City as the gap in rental prices paints a clear picture where the need is. In the 1970’s and early 1980’s Oklahoma City had a large multifamily construction boom, literally 60% of all apartments in Oklahoma City were built in that timeframe. In the late 1980’s construction began to slow significantly, and when the 90’s rolled around construction was virtually non-existent with less than 10% of today’s inventory built in that decade. Today, projects being built are higher end than ever before and likewise rents are breaking records. What this has created is a gap in quality, yet affordable housing. There is an abundance of renters who want quality housing, but cannot afford the new luxury prices. Since there was very little inventory added in the 90’s and early 2000’s, then there is little in that gap to choose from. Today, investors are taking advantage of this gap and renovating the 1970’s and 1980’s vintage properties and then can capitalize on significant increases in rents post renovation. The issue isn’t demand, it’s finding properties that are not too old, or overpriced. For those investors that can, significant value can be created. While not as glamourous as the new luxury construction, these Class B and C working class projects are where the demand is, and where knowledgeable investors can find the yield in todays competitive environment.
The key to maintaining transaction activity like we have seen recently is the ability to find sellers who are willing to sell at a reasonable price. The goal is to find those sellers who don’t compare their property to another that sold down the street at a certain price, without taking into consideration that the aforementioned property had been renovated, and had been through that process. As we have now completed the sixth consecutive year of multifamily transaction volume exceeding $200 million, some are asking whether the good times can continue for the apartment market. Our city – it’s growth, stability and continued reinvesting of tax dollars to improve itself for citizens of all ages - offers compelling reasons to remain cautiously optimistic.
Forecast Bullet points
- Construction activity to continue to decrease to more historic levels.
- Rent growth will remain positive at or above 2017 levels.
- Occupancy across the board will remain level with a slight pressure upwards.
- Concession activity should decrease as new construction slows, and properties begin to lease-up.
- Focus on value-add properties, with an emphasis on 1970’s and 1980’s construction.
- Interest rates are due for a modest increase.
- Strong investor interest will help keep cap rates low, while interest rate increases could serve to push cap rates higher.