Detroit leads nation as highest-yielding apartment market

Gordon Navarre

Gordon Navarre

By Gordon Navarre, Marcus & Millichap

The multifamily property sector resoundingly outperformed industry expectations in 2014. With the national vacancy rate at equilibrium or tighter for the previous four years, enormous pent-up demand surpassed the total number of units delivered. The addition of 238,000 units to the national inventory of apartment units marked a 14-year high for new supply; similarly, net absorption surged to nearly 270,000 units, the highest level in nearly a decade.

Key factors included strong, consistent employment gains in metros across the country, favorable demographic tailwinds and a sustained lifestyle preference for multifamily renting. In addition, the homeownership rate dropped to a 19-year low of 64.4 percent as of the third quarter of 2014, not surprising given the social narrative of mobility, flexibility and burdensome student debt following the financial crisis of 2008.

The national apartment vacancy rate was 4.7 percent at year-end 2014. Although new supply curbed CBD rent growth, the undersupplied suburban, mid-tier product has fueled rising rents. Most markets continued to favor owners, as same-store rents re-accelerated to a robust 3.8 percent annualized growth. New supply may present short-term challenges at the submarket level, but several factors affirm the positive apartment outlook. The demographic windfall still has legs, not only due to the size of the millennial age cohort, but also steady immigration, a higher number of household formations and changes in household composition.

Midwestern markets also outperform the U.S.

This year, Detroit tops Marcus & Millichap’s exclusive Yield Index of 10 markets, followed by Cleveland, Pittsburgh, Indianapolis and Cincinnati. Detroit earned top honors because of the superior returns investors can yield for certain multifamily properties. Although the index highlights markets with higher than average cap rates, premier submarkets and neighborhoods within these metros may carry premium pricing.

Exit strategies from high-yield markets can be a risk factor, as market performance does not always align with investment horizons. Detroit – along with the other markets in the index – is better suited for open-ended or long-term hold strategies. Strong demand for Detroit rental housing also resulted in this top placement in the index. The vacancy rate in Detroit ended 2014 at a multi-year low, and only a slight increase is projected by year’s end 2015 as the local economy continues to display renewed vigor.

Due to strong demand for apartments in the Detroit metro, occupancy will remain elevated through 2015, even as construction reaches a 10-year high. Jobs created by redevelopment projects will generate new demand in many neighborhoods throughout the metro. Significant interest surrounds the $650 million Red Wings arena and entertainment district, which encompasses 45 blocks in the lower Cass Corridor. This project will create an estimated 5,500 construction jobs by completion in 2017.

Thousands of other jobs will come from the M-1 light-rail project that will travel through the downtown and midtown areas of Detroit, where vacancy is especially low. In these two locations, rent growth has reached levels that allow ground-up apartment development to be feasible. The Royal Oak, Auburn Hills and Plymouth suburbs also have new buildings underway. Higher home prices in desirable neighborhoods within these cities preclude many tenants from transitioning to homeownership, keeping rental demand elevated.

By the numbers, payrolls in the Detroit metro will expand 0.8 percent in 2015 as local employers add 15,000 workers, marking an increase from last year’s 0.5 percent gain. This year, developers will bring 1,000 apartments into service, a 0.3 percent advance in inventory. This is the highest rate of completions since 2005. During 2014, 525 rentals were delivered throughout the metro. The rise in deliveries amid restrained job growth and an improving housing market will push up vacancy 40 basis points to 4.1 percent in 2015. Last year, vacancy fell 70 basis points. As vacancy inches upward in 2015, owners will restrain rent growth. Effective rents are expected to edge up 1.1 percent to $839 per month, following a 2.2 percent climb in 2014.

Out-of-state investors actively target Michigan properties

Detroit’s improving financial outlook post-bankruptcy, the redeveloping urban landscape and a selection of properties with relatively higher yields compared with other markets of its size are coming together to draw new investors to the area. Last year, there were several out-of-state buyers active in the Detroit metro area and throughout Michigan, aggressively chasing yields, a trend expected to continue through year’s end. In 2014, the market-rate multifamily investment sales team in Detroit helped facilitate a quarter-billion dollars in Michigan multifamily assets. More than three-quarters – or 78 percent – of that activity came from out-of-state investors, while 22 percent of the buyers were local. A majority of these buyers are located outside the Midwest, hailing from New York, Colorado and California.

Massachusetts and Minneapolis buyers have also been active in the marketplace. While there are not many REITs or institutional investors, private equity funds with money to place were active last year and should remain active in 2015. With interest rates still at historic lows, these entities are able to secure good financing terms. In addition, interest-only financing is starting to become more prevalent in the market.

The added interest has elevated buyer demand well above available supply, creating a competitive pricing environment. Attention is particularly intense for assets in the downtown and midtown areas of the city where apartments are favored by many young professionals and empty nesters seeking an urban lifestyle. Buyers who target properties with value-add potential may seek assets near the numerous redevelopment projects throughout the metro.
The investment outlook remains strong

Stabilized assets in Detroit will offer buyers upside potential through rent increases and should garner added investor attention throughout 2015. Lower-tier properties will lead rent gains as top-tier assets compete for tenants. Class B/C properties face more demand than supply in most metro areas, which will support rent appreciation. Risks include affordability pressures as rent gains have surpassed wage and income growth, possibly tamping down future rent gains for mid-tier properties. Since each property and submarket in Detroit varies, sellers should consult with a local brokerage market professional before executing a disposition strategy.

Although it is still too early to forecast, maturing CMBS debt and interest rate concerns could potentially moderate pricing in 2016 and into 2017. With $126 billion in CMBS debt expected to mature in 2016 and $126.8 billion set to mature the following year, Detroit and other Michigan metros may transition into buyers’ markets.

Gordon Navarre is a senior associate in the Detroit office of Marcus & Millichap. He is also a member of the firm’s National Multi Housing Group. Contact him at gordon.navarre@marcusmillichap.com or 248-415-3023.

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