Intense Interest Among Developers in Urban Markets

NNN Lease Market News

"Investors have shown a willingness to pay aggressive caps for urban properties"

"There are markets that we're operating in that are not seeing enough of a premium in terms of what people will pay for new development [or] to start speculative new construction," said Doug Linde, president of Boston Properties, the nation's largest office landlord. The company recently completed two apartment projects adjacent to their office buildings in Washington and Boston of 335 units and 86 units, respectively, above retail space. Monthly rents start at roughly $3,000.

The intense interest among developers in apartment buildings reflects rising rents and falling vacancies. In the third quarter, the national vacancy rate dropped to 5.6%, down from 7.1% a year earlier and the lowest rate since 2006, according to Reis Inc. Average monthly rental rates hit $1,004 nationwide, up 2.4% from a year earlier.

More Americans have been opting to rent in recent years as the allure of owning a home has diminished, due in part to tight lending restrictions, falling prices and rising foreclosures. These forces are driving up apartment building values—to levels unseen since 2007, in some cases.

The rush into apartment building development is raising the specter of a bubble, particularly in urban markets such as Washington and New York. While more than 173,000 units are expected to be started this year, 225,000 and 280,000 starts are expected nationwide in 2012 and 2013, respectively, according to Zelman & Associates. That still is less than 2005, when starts were at 352,000.

The recent spike in development is why some companies aren't joining the rush into multifamily projects. "I think there is a real possibility that anyone investing in multifamily right now is getting in toward the top of the market," said Doug Donatelli, CEO of First Potomac Realty Trust, which owns office, business parks and industrial properties.

Major real-estate companies generally stick to what they know best. Those who have strayed into unfamiliar businesses have had mixed results.

For example, analysts criticized Vornado Realty Trust in 1997 for leading a venture that purchased the nation's largest supplier of cold-storage space in a deal valued at close to $1 billion. Although Vornado eventually made a profit on the deal, if it would have purchased New York office buildings instead of cold storage "it would have done unbelievably better," said Michael Knott, an analyst at Green Street Advisors.

More recently, suburban shopping center landlord Kimco Realty Corp. is retreating from a $1.2 billion strategy to invest in mixed-use office and retail properties in urban markets. The company embarked on the strategy in 2007 to chase higher yields when prices for suburban shopping centers got too high, but realized that it didn't have the expertise in downtown development to make it a big success.

Apartments require a far different skill set than retail or offices. Turnover is high, so landlords constantly have to adjust prices to fill empty units. Tenants can easily be lured away by something newer, better located or offering more modern amenities. Landlords also have to worry about the economy worsening—plenty of apartment owners had to reduce rents after the financial crisis—and the for-sale market making a comeback. Investors have shown a willingness to pay aggressive caps for urban properties.  An increase in mixed use residential condominiums brought about by population movement toward the urban core  and  a pause in expansion by national retailers has contributed to the wide-ranging demand for NNN urban properties.  Coming on the heels of the recession and the ensuing across-the-board hike in cap rates, this move to dense, high traffic urban locations signals where investors want to be over the next decade.

Recently identified as a top niche investment trend by the Urban Land Institute (ULI), mixed-use urban projects have drawn retailers and investors to this asset type even in the current market cycle.  Driven by a desire to spend less time in traffic, live in a smaller footprint and work and play within an urban atmosphere, aging boomers and Gen XYZers alike are leaving the edge and making their way back to the city.  Developers have capitalized on this trend by coupling high-rise condominium living with easily accessible ground floor retail space.  The convenience of these on-hand amenities makes for an attractive lifestyle for local residents and nearby office workers.