Bentall Kennedy plans to break ground by June on a 654-unit luxury-apartment complex in downtown Seattle, a $200 million wager by the real estate firm that it will be cheaper to build than buy as the foreclosure crisis drives up demand for U.S. rental properties.
The project, at Sixth Avenue between Lenora and Blanchard Streets, will be the first apartments the company has built in the city in 10 years, said John M. Parker, president of the U.S. arm of Toronto-based Bentall Kennedy. The firm oversees $23 billion of real estate.
“There will be a spike in rents over the next one to three years,” Parker said in an interview at the company’s U.S. headquarters in Seattle. “It’s in anticipation of the spike in rents that we can be comfortable on our return on costs. A few years ago, we couldn’t do that.”
Companies like Parker’s and AvalonBay Communities Inc., the second-biggest publicly traded U.S. apartment owner, are stepping up new rental construction as vacancy rates fall and building costs hold steady. Starts on multifamily homes, including townhouses and apartments, jumped 78 percent in January from the previous month to an annual pace of 183,000, the highest since February 2009, the Commerce Department said Feb. 16. Work on single-family houses decreased 1 percent.
The producer price index for construction materials rose 4.9 percent in January from a year earlier, while the PPI for new office buildings -- the best proxy for luxury apartments -- gained 0.4 percent, according to Associated General Contractors of America, a trade group based in Arlington, Virginia. The PPI for office buildings reflects finished projects and includes contractors’ bids.
Pressure on Contractors
“Materials costs are rising, but contractors aren’t pushing them through because they’re bidding so fiercely to get work that they’re offering to deliver the building at the same price as a year ago,” said Ken Simonson, chief economist of the contractors’ trade group. “The trend throughout 2010 was for these bid prices to stay pretty flat or even drop.”
Many would-be buyers have turned to renting after the median price of existing homes tumbled 27 percent in 4 1/2 half years.
“Most people feel that home-price appreciation is a thing of the past,” said Tom Craig, a commercial and multifamily real estate broker in Seattle. “Capital markets are bullish on multifamily and that’s where people are looking to do deals.”
With the foreclosure rate at a record 4.63 percent in the fourth quarter, thousands of homeowners have been forced to rent. Home ownership in the U.S. dropped from a peak of 69.2 percent in 2004 to 66.5 percent at the end of 2010, with each percentage point representing about 1.1 million households, according to the Census Bureau.
“There’s going to be something like 1 to 1.5 million additional renters per year over the next few years in the U.S., and that’s going to be concentrated in places like Seattle, San Francisco, Washington and New York,” Doug Poutasse, head of research for Bentall Kennedy, said in a telephone interview.
Developers are scrambling to catch up, Poutasse said.
New apartment construction fell to a 50-year low in 2009, according to the Census Bureau. Two years ago, builders started 97,300 apartment units in multifamily buildings of five units or more, the lowest since the Census Bureau began tracking the data in 1959. The record high was 906,200 units in 1972.
“Nationwide, supply is needed right now and it’s going to increase,” said Dean Frankel, who oversees about $1.7 billion of real estate securities as senior portfolio manager for Urdang Securities in Plymouth Meeting, Pennsylvania. “In the next 24 months, I expect a meaningful pipeline of new apartments.”
Bentall Kennedy’s Parker said Class A apartments, or the highest-quality buildings, are yielding between 4 percent and 5 percent. The yield is based on the capitalization rate, or a property’s net operating income divided by purchase price. The company estimates it can build at Sixth and Lenora for a return of between 6.5 percent and 7 percent.
“It’s not exactly apples to apples, but it’s still indicative of a premium you get for building versus buying,” Parker said. “You take the construction risk and to some degree the lease-up risk, but in multifamily that’s quite a bit less than an office building or a retail complex.”
AvalonBay has said an estimated 700,000 new renter households were created in the U.S. during the past year, about half of which were in multifamily buildings. That helped push its rental revenue from apartments leased at least one year up 2.5 percent in the fourth quarter compared with a decline in the first quarter.
Expanding the Pipeline
The Arlington, Virginia-based real estate investment trust started 11 developments in 2010 with a combined 2,446 apartment units for a cost of about $643.4 million, 70 percent more than it had forecast at the beginning of the year. It also added more than $600 million of deals to its development pipeline and expects to add more than $300 million more this quarter, Chairman and Chief Executive Officer Bryce Blair said on a Feb. 3 conference call.
“The outlook for multifamily is dramatically better than for other sectors in the near term,” said Richard Parkus, head of commercial real estate debt research at Morgan Stanley, in an appearance before a congressional panel in Washington on Feb. 4.
Apartment landlords began to raise rents last year as vacancies fell to a national rate of 6.6 percent in the fourth quarter, the lowest since 2008, from 8 percent a year earlier, according to Reis Inc., a New York-based property-research firm.
Outpacing S&P 500
There are risks to the outlook for apartments. As home prices come down and interest rates stay low, it becomes more attractive to buy. Also, a large part of the anticipated market recovery may already be priced into apartment-property stocks.
The Bloomberg REIT Apartment Index rose 45 percent in the past year, outpacing the 28 percent gain by the office REIT index and the 36 percent rise by the retail REIT Index. The broader Standard & Poor’s 500 Index climbed 21 percent. The numbers exclude dividends.
“Everybody’s piling into multifamily,” said Morgan Stanley’s Parkus in a telephone interview. “That means a lot of the improvement is probably priced in.”
In Seattle, a city of about 602,000 residents, Bentall Kennedy will be competing with other apartment complexes going up near downtown in the next two years, said Craig, who heads the commercial broker TSC Realty Partners LLC. The Sixth and Lenora apartments are due to be finished in the first half of 2013.
Risk of Overbuilding
“A major risk for that project is they’re going to overbuild the higher end of the apartment market and it’s going to be a very long lease-up,” Craig said. “High-rise apartment construction is very expensive and requires market rents that don’t exist today.”
The median rent in Seattle is $721, according to the city’s website.
The supply of U.S. apartments could surpass demand by 2013 or 2014 as developers complete buildings being started this year and next, said Andy McCulloch, senior analyst at Green Street Advisors Inc., a Newport Beach, California-based firm that researches REITs.
“Usually when big development cycles start, developers over-deliver,” McCulloch said. “I see that as being a potential issue, but I think it’s concentrated in a lot of low-barrier markets. We consider Seattle high-barrier, but there are low-barrier parts. Seattle is a market that overbuilt during the last cycle, especially Bellevue” on the east side of Lake Washington. Seattle is located on the west side of the lake.
From 2005 to 2010, 12 apartment complexes with a total of 2,825 units were built within Bellevue’s downtown. The number of units went up almost fourfold from the previous five years, when eight complexes were built with a combined 1,087 units, according to the city of Bellevue.
Several condominium developments also were built during this same time period. A total of 1,127 condo units came online in downtown Bellevue, compared with 373 units from 2000 to 2004, a fourfold increase. This would have been even higher had the 455 units in the Bravern, an office, residential and luxury retail development, not switched from condos to apartments in 2010, according to the city of Bellevue.
Bentall Kennedy aims to capitalize on the growing pool of workers near the project, located between the city’s business and retail core and the new head office of Internet retailer Amazon.com Inc., as well as the new headquarters of the Bill & Melinda Gates Foundation to the north. The design calls for two 24-story buildings with mainly one-bedroom and studio apartments that will rent for an average $2,000 a month.
The units will have amenities designed to let the firm convert them to condominiums for sale in the future if the market shifts, Parker said. The features include a car-sharing service and a bike-storage facility along with a washer/dryer in each unit. The apartments will have stainless-steel appliances and wood floors as well as a rarity in Seattle: air-conditioning.
Many younger workers no longer equate home ownership with financial security and increasingly favor renting for lifestyle reasons, said Poutasse, Bentall Kennedy’s research director.
“The psychology has changed and that’s why I think this will go on for several years,” he said.
Besides Amazon and the Gates Foundation, which oversees the philanthropy work of Microsoft Corp. co-founder Bill Gates and his wife, other big employers nearby include Russell Investments. The investment adviser last year moved its headquarters to the former Washington Mutual Inc. main office from Tacoma, Washington, bringing about 900 employees.
“If you look at what is in the pipeline for delivery over the next two years, it’s a really small number of units,” Parker said. He cited three projects with a combined 518 units in the downtown market that Bentall Kennedy aims to compete with. “By historical standards, that’s not very much. We have absolutely no qualms about our ability to lease product.”
Seattle apartment vacancies dropped to 5.8 percent in the fourth quarter from 7.3 percent a year earlier, and are approaching their average since 1990 of 5.4 percent, data from Reis show. The rate probably will decline over the next two years to the 2 percent to 3 percent range, Parker estimated.
The area, which held up relatively well during the housing crisis, has weakened in the past year. Foreclosure notices in Seattle-Tacoma-Bellevue rose 23 percent to 27,926 properties in 2010, the second-highest rate among the 20 largest metropolitan areas behind Houston, according to RealtyTrac Inc. Foreclosures nationally rose 2 percent last year, the Irvine, California-based real estate data firm said.
“That’s going to generate a lot of pressure on rents and that’s part of what we’re underwriting,” Parker said.
Bentall Kennedy has acquired four existing apartment properties during the past year, in Houston, Washington and Florida. The company also is looking at building apartments in the Los Angeles area and in Manhattan, Parker said.
“It’s our intention to increase multifamily as a percentage of our portfolio,” Parker said. “We think it’s going to be an attractive performing sector over the next 10 years.”