Boom or bust?

With area rents as sky-high as the buildings going up, is the multifamily boom headed for a fall?

From the pages of In Business magazine.

Every yin has a yang. Every flow, an ebb. So when considering the strength of the multifamily market in this area, from 14-story behemoths downtown to multi-building developments stretching from Middleton to Fitchburg to the Sun Prairie/DeForest area, one might wonder if it will all come to a halt one day soon.

Is the area overbuilding? How can there possibly be enough renters to fill all the apartments? What happens then?

First of all, we’ve heard it all before. Madison is a unique and somewhat isolated market, being the seat of state government, the flagship of one of the best university systems in the world, and home to solid and storied businesses that have been around for decades. That’s all true.

And then there’s Epic.

One expert we spoke with suggested that Epic employees, who likely can afford the bumped-up rents, occupy as much as one-third of any of the higher-end apartment complexes in the downtown area.

In 2016, the U.S. Census reported that millennials (ages 15-34) made up 85.9% of residents in the downtown/isthmus area.

Obviously, a big chunk are students, but the multifamily buildings that many of them occupy, according to commercial real estate developer Oakbrook Corp., make up 13.4% of the city’s total tax base yet account for 28.4% of the real estate tax increase in 2017.

In total, Madison has 948 multifamily projects (eight units or greater) in its multifamily assessment pool. In fact, two buildings alone — Hub I and Hub II (aka The James) — represent a $120 million increase in assessed value and 20% of the total assessment increase.

But this story isn’t all about Epic employees or the Hub. This is about what happens when the area’s multifamily market builds up, up, up, reaches the apex, and then begins a backward slide. Can it happen here? Will it happen? And will there be telltale signs?

The city’s take

Matt Wachter, housing initiatives specialist for the City of Madison Community Development Authority, has just completed the first of what will be a biennial housing report. He admits that some current data is lagging because the city relies on other sources that may not have real-time numbers, but it’s the best look available, he says, and takes various reports into consideration.

Wachter states his case for continued multifamily housing. “From 2007 to 2015, renter households in the city increased by about 17,000. Most of those were under age 34, in the primary rental age group.”

Madison, he says, looks at several metrics when arguing for more development, including supply data and building permits. “For years we were gaining more renters than units. That’s when vacancy went from 5% to 2%,” Wachter explains. In 2014, building permits came up near the level of households added.

“Only since 2014 has vacancy crept up close to 3%,” he says, per a quarterly Madison Gas & Electric report that measures activity by zip code. The city considers a 5% vacancy rate to be a target rate. “When the vacancy rate is one or two percent, people don’t have choices,” Wachter explains. “So the balance of power between landlords and tenants favors landlords who can then afford to be choosy and raise rents.” Banks also hope for a 5% vacancy rate, but Wachter notes that hasn’t happened “since 2007 or 2008.”

Some zip codes are at 5% vacancy while others are far lower. The 53719 zip code, for example, has less than a 1% rate (.71). “On the demand side, we’ve been adding 1,500 to 2,000 renters per year, so when we talk about all the new apartment construction, the large developments may have 200 to 300 units but many have just 20 or 50 apartments. How many of those do you need to reach 1,500?”

Madison has been blessed for decades with demand growing about 1% per year and closer to 1.5% per year since the recession. On the supply side, new projects can take as long as two years to complete, sometimes more. “We look at the pipeline of products,” Wachter says. “What’s under development right now? What permits have been pulled? And we look at what is currently in the approval process, which can be hard to measure. Just because something gets proposed or submitted doesn’t mean it will cross the finish line.”

Does he see a softening of the multifamily market in the near future? “It’s tough,” he sighs. “On the demand side we look at leading indicators like unemployment rate and GED growth.” With Madison’s unemployment rate currently at 2.1%, he is confident that demand will remain strong.

On the supply side, Wachter says given the strengths of the local economy and the jobless market, multifamily construction needs to continue to meet existing demand, though he doesn’t think building will remain at 2014–2015 levels. “I’m sure it will slow down and taper.”

It may come down to a capacity issue, he suggests. “After the recession, the construction industry lost so many people. Developers are tied up in projects but there’s a cap on how much they have the capacity to do, and the lending community is in the same boat. They can’t get too far out with their money being lent out, so all of these things throttle how much development is happening.”



Bullish for now

We asked other experts around town for their opinions. Steve Harms, director of pre-construction at Tri-North Builders, believes any slowdown is at least a couple of years out. “The first thing everyone looks at are vacancy rates,” Harms states. Another factor is the city’s willingness to consider TIF for larger projects. “If they start backing off, it’s worth checking out,” he says. “There may be other factors, but market saturation is one of them.”

And what if signs hint at a slowdown? “We wouldn’t look at any new projects,” Harms explains. “Rents start stabilizing and once rents go down, it’s good for consumers but not developers. It would slow things up pretty quickly, even with
a 4.5% vacancy rate.”

Jeff Tubbs, vice president of business development at Findorff, agrees that any slowdown in multifamily development, if it occurs, is down the road a bit. “We have not seen any softening,” he states. “We continue to work with developers that are looking for additional sites and lots to do more housing. We get indicators through architects and lenders and both are remaining very busy and looking at deals for new apartment complexes, so the demand is still great out there.”

With a slowdown of absorption in the luxury apartment market, some believe Madison needs more middle-of-the-road multifamily construction. Photo by Chelsea Weis

Kian Wagner, director of investment sales and acquisitions at Oakbrook Corp., agrees that Madison has always been resilient and the market remains healthy. “What we’re starting to see is more interest from larger groups who are viewing the positive attributes and long-term resiliency.” Case in point, he says, was Artis REIT’s purchase of the Vanta portfolio. “That was a newsworthy event and planted a flag here locally that said ‘this is an institutional market or portfolio worthy
of national and international interest.’”

Why is that important? Wagner describes a typical investment life cycle: “You buy it, you run it, you hopefully increase the value, and you sell it. So if you’re an existing owner here and you want to refinance your property, if there are comparable sales out there at good numbers, that allows you to get better terms when you’re financing your property. More activity and turnover only benefits the market.”

Wagner says it’s difficult to gauge the success of any project unless you are privy to a behind-the-scenes look. “From an outward appearance, one project may seem like the best in town. But what you don’t know is what the anticipated rent levels are versus what the project actually got, so it’s hard sometimes to know how healthy a project is even though it may be fully leased.”

Brian Wolff, vice president at CBRE, projects a strong 2017 with supply projected to outpace demand slightly in 2018. “Madison has always been revered for its recession-proof economy,” Wolff notes. “It’s not just the millennials. While a majority of the newcomers are in their 20s and 30s, another big group is the aging, empty-nest baby boomers. What both groups share is their tendency to form smaller households.”

Wolff acknowledges the numbers of people expected to move to the area, but says the industry can’t just continue to assume everyone will be able to afford luxury apartments. “There needs to be more middle-of-the-road construction. Everyone seems to go after that luxury market, but that’s where the slowdown for absorption is occurring, in the upper end. That’s where we’re starting to see it.”

The benefit Madison has, he says, is that as young tenants age and move to the suburbs (either to rent or own), they’ll be replaced by a new wave of young renters. “The community won’t stop growing,” he states. “Lenders are very comfortable with multifamily vacancy rates in this city.”

Peter Mortenson, senior vice president at US Bank, is one such lender. Whether or not the multifamily building boom busts, he says, is still to be determined. “The most likely scenario is that we’ll continue to build because there’s interest from development in creating more multifamily projects from a capitalist/entrepreneurial aspect. Also, the capital market (banks, financial services) are willing to put debt on future projects.”

But larger banks, he notes, including US Bank, Wells Fargo, and Chase, are “taking a pause but not saying no to everything.”

Lenders, Mortenson explains, look at market rents in general, which vary widely around the area. Generally, he says, a high-end project downtown rents for about $2 per square foot per month, or $2,000 a month for a 1,000-square-foot apartment.

“So, if a developer comes in saying they’ll get $2 per square foot per month for rent, in my mind I say that might be today’s rent but tomorrow’s could be less. We might discount that to $1.80 or $1.75 given a building’s location, amenities, quality, or other factors.”

Loan-to-value ratio is an important consideration when deciding whether to lend, adds Mortenson, with developers typically wanting between 65% to 80% loan-to-value. An even more important determinant, though, is loan-to-cost. “Value is an arbitrary number,” he states. “Cost is fixed or based on fact. So when developing a project from the ground up, we look much harder at loan-to-cost to make sure the developer and their equity providers have skin in the game.”

Loan-to-cost is a key factor, he explains, particularly because of Dodd-Frank rules. On a $20 million project, lenders would like developers to have adequate capital — usually 15% to 20% at a minimum.

“Equity at risk is a big thing for examiners when they look at banks and commercial loan portfolios. They want to know that a bank is looking at a developer’s equity at risk because if there’s a problem, if there’s not a lot of equity at risk relative to the total amount of the deal, you won’t get a lot of help from your developers. But if they have significant equity at risk, say $2 million to $3 million on a $20 million project, they’ll pay more attention.”

That doesn’t mean the banks are pulling back, he says, but in general they’re being more prudent about supply and demand. “I’m a debt provider. I don’t get any upside. If rents increase tomorrow, all I get is my principal return and whatever interest I charge. So we have to be realistic, but if we keep bringing on more and more product, rents will certainly have downward pressure.”

Mortenson’s view, like others, is that eventually the supply and demand balance will favor supply. At that point he says, consumers will have more housing options “and the projects that are deficient from the design or layout or location or amenity standpoint will be the ones that first experience downward rent pressure.”

To compensate, Mortenson suggests a developer that is “smart with his lender” and provides room for rents to decline with relatively little pain will be okay. The more aggressive developer, on the other hand, will be less successful at fighting a downward rent cycle. “Someone sitting on a bunch of cash and looking to acquire assets for nickels on the dollar will be the winner.”

So will the multifamily housing bubble burst in the Madison area? If so, when?

Brad Hutter, president/CEO/owner at MIG Commercial Real Estate, watches industry blogs, particularly from Harvard University, and studies real estate cycle models for clues. Since the late 1870s, economists have been tracking the national real estate cycle’s ebbs and flows. In the 1930s, economist Homer Hoyt determined that the predictability of the nation’s real estate market, predicated by supply and demand, had been on an 18-year cycle since 1800. In 1997, economist Fred E. Foldvary revisited the concept, predicting:

“The next major bust, 18 years after the 1990 downturn, will be around 2008, if there is no major interruption such as a global war.”

Boom. People, including Hutter, took notice. “That was pretty impressive,” Hutter says. “The point is, they’re getting better and better at making these predictions.”

Many in the industry still subscribe to the 18-year model, which suggests a national housing bust could hit again around 2026. Plenty of signs would precede such an event, and other occurrences — wars, interest rates, and presidents — could alter it.

It’s just a matter of whether the market takes heed.



Studying the real estate cycle

The real estate cycle, first noted by Henry George in 1876 and refined through the years, is comprised of four quadrants of activity along a bell curve: recovery, expansion, hyper supply, and recession.

Recovery is when demand for goods and services increases relative to a growing population. The Federal Reserve drops interest rates and companies expand their businesses, hire more people, and purchase new infrastructure. Vacancy rates begin to fall. “A lot of factors begin to realign,” comments Hutter.

He describes Recovery as the “best period” when opportunistic people begin moving back into the market, reinvestment and building take hold, and demand grows. “That’s when everyone wants to get in.”

The second phase, expansion, is in essence more of the same. In an article titled “How to Use Real Estate Trends to Predict the Next Housing Bubble,” Teo Nicolais, a real estate entrepreneur, owner of Nicolais LLC, and an instructor at Harvard Extension School, says expansion occurs when “companies and individuals have bought up or rented most of the available buildings.” Demand begins to overtake supply, landlords raise rents, and new development ensues.

As long as occupancy rates exceed the long-term average, which also happens in the expansion phase, there will be upward pressure on rents, keeping new construction financially feasible, Nicolais explains. That marks the third phase in the real estate cycle, hyper supply.

“In hyper supply, everyone realizes that the entire market is in a total recovery,” Hutter explains. “Everyone jumps in and you create this period where there’s all kinds of construction going on. That’s the apex. People are working at good paying construction jobs, infrastructure is being improved, and everyone feels the best.” But if multifamily building overcompensates, he cautions, “that’s when people like us think, hmm, maybe we shouldn’t do apartments right now.”

Hyper supply is also when indications of trouble first begin to appear, notes Nicolais, and usually it’s an increase in unsold inventory and more vacancies.

Real estate, driven by supply and demand, always moves in cycles and always will, Hutter emphasizes. There’s no stopping the cycle. “A lot of people are predicting the next downturn sometime between 2023 and 2027, but again, that’s a general statement because apartments will be first. Office will follow.”

After the Great Recession, Hutter says the multifamily market in Madison rebounded first. “People were building apartments about five years before there was money for me to do large office.” That fits neatly into the modeling, which predicts commercial real estate will follow multifamily by three to six years. “I’m one of the farthest back on the curve,” he says.

An expansion period makes it harder for someone like Hutter to enter the market. Multifamily and retail increases but banks aren’t lending yet for commercial office, and conservative businesses aren’t electing to expand until they’re really squeezed.

“We follow multifamily up the curve like a caboose,” Hutter states. “As that happens, spending increases, salaries and compensation increases, investment grows, and unemployment goes down. Then The Fed, to guard against inflation, starts to raise interest rates. That’s what’s happening right now.”

The second and third indicators of trouble, according to Nicolais, occur in the fourth phase: recession. That’s when occupancy drops below the long-term average and interest rates begin to rise. Supply outpaces demand, prices start falling, and rents stabilize, which Hutter notes is good for consumers but makes developers panic because they may have too many projects in the pipeline. The market falls out of balance.

“Every real estate market has gone through these four stages over and over again,” Hutter acknowledges. “Anyone who says there won’t be a downturn is wrong. It’s just about how gentle or rough or long these periods are.

“If we follow the modeling, we’ve still got five to seven years or more of solid growth, expansion, and consumer confidence,” he adds. “But that confidence often becomes overconfidence, pushing land prices and costs up and increasing rents.”

Hutter studies the 18-year real estate model with interest, understanding that many other indicators can affect the timeline.

“One thing affecting the dynamics is government regulation,” Hutter says. “Twenty-five years ago, I could push through a really large multifamily project or major office redevelopment with one- to two-fifths fewer regulations. Now, regulations really slow things down, increase my costs, and drag out development time. It takes longer to get an investor group together or accrue the capital necessary to go forward with a project that now will take longer and be more expensive.”

So where is the local real estate market now, in Hutter’s opinion? “We are at least in the expansion period,” he states. “The question is whether we’re entering hyper supply.”

Vacancy rates offer the best insight. Are they increasing? Have they increased past the area’s average over the last 20 or 25 years?

“We’re not there yet,” he says. “But how much is in the pipeline? If the pipeline overpowers demand, we’ll have a downturn. We could hang out at the top of the curve in hyper supply for several years if vacancy rates hit 5%, our happy place.”

By next year, Hutter predicts vacancy could inch toward 4%. At that point, he suggests, if just a few developers decided to dial back from maybe doing three or four projects to “one or two really, really good ones,” the market could level out and Madison “could be in the beautiful, happy, hyper-supply period for a longer period of time.”

The rub, he says, is that most people have a hard time backing off. Meanwhile, the city keeps pushing for more units to feed the influx of new residents.

In a perfect world, people would watch the indicators and hold back if necessary, he says. “But we don’t do that. Everyone’s making money so people say, ‘I’ve got to get in this, too. I’ve got to do four, not two projects next year.’” Ultimately, the scale tips, rents fall, and banks get scared, pulling credit and tightening lending.

It’s a concept many very successful people don’t recognize because everyone views the market from different perspectives. Hutter says much can be learned from the activities of some well-established families around town who control a tremendous amount of real estate. He considers George Gialamas and Urban Land Interests among this group.

“In most cases, they haven’t built projects in late hyper-supply periods,” Hutter says. “They don’t start a project and put it in a pipeline right before a market downturn. They usually do most of their expansion during the recovery period or the early part of hyper supply. They focus on stabilizing everything they have, and then they sit back and clip the coupons.

“They’re incredibly intelligent about how the cycle works. It’s never totally predictable, but it’s not weird black magic either.”

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