Several market participants including owners, lenders, and brokers provided excellent dialogue at the 2015 Mid-Year MN Apartment Update held at the Golden Valley Country Club. Thanks to the Minnesota Real Estate Journal and Jeff Johnson for another successful event. The panel speakers discussed current apartment trends, capital markets, and apartment sale activity. Additional topics included a National Student Housing Market Update and Minnesota Student Housing trends. This article highlights cap rates, apartment trends, and investment sale activity.
Market participants always seem interested in direction of capitalization rates and this is a common question I receive. Several panel members indicated Class A apartment cap rates are trading in the 4.0% to 5.0% range. Cap rates on the low end of the range are perceived to have upside rent growth potential.
Class B apartment sales in the Twin Cities are trading in the approximate range of 5.5% to 6.0% and Class C apartments are about 6.25% to 7.0%. Most panel members opined cap rates have held generally flat since the start of the year, with slight compression in Class C buildings. Based on recent transactions I’ve been involved in, I would generally agree with this. However, each property is unique and may have specific influencing factors that push the cap rate up or down.
Second and third tier locations are seeing strong competition as more buyers are pushed out of the urban core and suburbs in search of yield. One broker cited as an example a 72 unit apartment in Cloquet, Minnesota near Duluth. Many bidders sought the property including several out of state investors.
Current Apartment Trends
The Minneapolis/St. Paul apartment market continues to fare well when stacked up against large cities across the United States. This is attributable to several factors including positive job growth. Evidence of this job growth was provided by a developer/owner involved in the Pioneer Endicott apartment project. Clinton Blaiser, Halverson and Blaiser Group, Ltd. stated 25% of the tenants in the lease-up stage were from outside the five-state region. This reflects people relocating for jobs in the Twin Cities.
A new trend among empty nesters has been developing with penthouse suites in some of the luxury Class A apartments. Instead of standard 12 month lease terms, tenants are signing three to five year leases with annual rent increases. Some of the reported rates range from $4,000 to $5,000 per month, per unit. This certainly appears to be a new trend in the Minneapolis/St. Paul market.
Construction costs continue to increase with some estimates of 6% to 12% from the recent past. This is due to a combination of rising material costs and labor shortages. One builder stated continued strength in the senior housing and hotel markets is leading to greater competition for good development sites. On a positive note, rental rates have increased significantly.
According to Rick Fenske, Weis Builders, over 5,000 apartment units have been delivered annually since 2012. About 4,500 units are expected to be delivered in 2012. Over the past 15 years, about 60% of all new units have been market rate, 10% student housing and 30% affordable units.
A repeated theme among all panel discussions is the significant need for more Class B/C units with lower rents. While the Class A luxury apartments have absorbed well and support new construction costs, higher construction costs make it difficult to justify building Class B/C units. This is particularly evident in outstate Minnesota where the lower rental rates make new development difficult, despite very strong demand.
Year-to-date, over $500 million in Twin Cities apartment sales have occurred including the Doran developed University of Minnesota apartments that sold. It appears transaction volume is expected to reach $1 billion in 2015. While actual sale volume is up due to several large transactions, the sale market for smaller apartments has not been so robust due to excellent operations enjoyed by owners. It’s a good time to be an owner and they are less inclined to sell.
There is a huge opportunity to raise rents on older apartment stock. A big concern is pending increases in real estate taxes. Some assessed values are currently about 50% of expected or actual sale values. High per unit taxes of up to $4,500 per unit on new Class A apartments reduce yields by up to 50 basis points.
With increased sales activity and more people bidding on listed properties, brokers are seeing non-refundable earnest money to secure deals. Ted Bickel, Vice President with Colliers International indicated five of the 9 transactions he has been involved in 2015 have been 1031 exchanges. For local owners selling to consolidate and buy larger units, it’s difficult to find upgraded replacement properties.
The yield spread for stabilized vs non stabilized new construction apartment projects has declined due to amount of capital chasing deals. A few brokers cited about a 25 to 50 basis points gap exists on non-stabilized properties.
Mitchell Simonson, MAI is an expert commercial real estate appraiser and investor. Thank you for taking the time to read this article. If you have any valuation questions, please feel free to call at 612-618-3726 or email [email protected].
Mitchell Simonson, MAI