BOSTON—As we've reported before about Boston's office and industrial cycle, relative strength during the downturn has positioned the city well for the current upcycle. In a recent interview with Intercontinental Real Estate chairman and CEO Peter Palandjian, the inherent market diversity has done the same for multifamily, with an asterisk as the middle class faces a possible squeeze out.

GlobeSt.com: Give us a quick play-by-play of multifamily conditions here during the downturn.

Palandjian: We all know the story. Home and condo purchasing was in decline, which sent people to renting because they generally couldn't afford or qualify for mortgages, and even if they could afford mortgages, they were hard to find. Of course, bank balance sheets were getting battered so they generally weren't lending. There was this perfect storm where no one was adding supply and most consumers were getting pushed toward rental.

As the market began to recover, banks learned that if they wanted to drive earnings, they would have to make loans, and the first asset class they began to lend to was apartments because they were seen as safer and there was a perceived lack of supply. We started seeing a lot of cranes in the Boston sky, nearly all of which were apartments.

GlobeSt.com: But even with the lack of lending, Boston didn't suffer the way other cities around the map did.

Palandjian: We're a diverse and supply-constrained market. After all, we're relatively “land poor,” so Boston recovers quickly when it does get punished in down markets. We never have enough supply. If you go to the major lending institutions, they like Boston as a target market in recovery years.

And from the investor perspective, this is especially true now. Think how poorly fixed-income bonds are doing. Pension money and endowments drive a lot of projects here. Whether you see it or not, its pension and endowment and insurance company monies fueling most construction projects. There's a secular shift taking place as these institutional investors, capital allocators, increase their weightings to real estate. In a core market like Boston, investments five years ago saw six-cap. In the last year or two we're seeing low fives or high fours. As low as this may seem, real estate is still sexier than bonds.

GlobeSt.com: Are you starting to see sloppy underwriting?

Palandjian: I only see how we underwrite deals, and my investment committee's mantra is, “hope is not a strategy,” a tenet I learned from an investor whom I admire. I don't mind if someone in the committee makes an argument if they have the intellectual artillery to make the case for a stretch position or certain strategic thesis. I'm ok with that, but it can't be based solely in hope that things will go this way or that.

To answer your question, I think some discipline is being lost in underwriting as investors struggle to make core pricing work. But I don't see it leading to a downturn in the near future. We're in the third or fourth inning.  Here's why. Apartments in gateway cities—Boston; New York; Los Angeles; Washington, DC—are the first to recover.  Apartment markets have been tight, but cap rates are still 25 bp off of the all-time lows of 1999 through 2001. But even when you think cap rates are  too low, they're still better than what bonds will offer for the next 10 years. If there is inflationary pressure, bonds won't offer a whole lot. You'll see real estate in markets like Boston continue to be a safe haven for German and Asian investors and public pension funds that don't mind a 4.5% cap rate. Also, even if you think cap rates will bottom out in 12 to 24 months, you'll see rent escalation, because we still don't have enough supply in Boston. We need to let the market forces play out. We're undersupplied in student housing and market-rate rental housing. You'll see short-term indigestion periods, perhaps some bubble pricing, and you might get to a point where there are too many cranes in Boston, but you'll have rent pressure and concession wars. In short, no bank is playing silly in their lending.

GlobeSt.com: How is the market diversity we've talked so much about feeding employment?

Palandjian: Life science, biotech, engineering all set Boston up very well. Cambridge rents on the commercial side are through-the-roof crazy. We have a building in Central Square where rents are growing by a buck a month. This trend flows into restaurant and apartment rents. It's a natural thing. Historically, when Cambridge gets hot, the 128 and 495 markets pick it up because mid-size and small companies can't afford the rents. We're seeing that now, yes, but overflows can go into the Four-Point Channel of the Seaport District. This is a new relief valve.

GlobeSt.com: So, what worries you?

Palandjian: Rising interest rates are a concern. There's plenty of data that shows a high correlation between rising interest rates and cap rates. You can argue that real estate is a great hedge against inflation because in multifamily, it reprices annually. On the negative side, if I can do debt on an apartment deal today through Fannie Mae at 3.2%, that is astoundingly low money. But it's not accretive to the capital structure if Boston moves toward 3.x-cap-rate trades. If interest rates rise, it'll make apartment underwriting that much harder.

The other challenge is that moderately priced housing for ownership can be tough. On the high end people can afford it, and on the lower end maybe there's affordable help. But the middle class can find it hard as things get expensive.