“Nobody goes there anymore. It's too crowded.” – Yogi Berra
McLEAN, VA—Is the smart money is preparing to leave the hot markets? When asked where they expect to find the greatest increase in value in the multifamily market, “outside the city centers” was the message from investors at the recent RealShare Apartments Conference in Los Angeles. In 2017, attendees responding to Capital One's annual Multifamily Survey saw their greatest opportunities in the urban core. This year, many are looking farther afield to suburban, secondary and tertiary markets.
The year-over-year difference is quite dramatic. Forty-seven percent of those surveyed last year selected urban markets, 27% chose suburban, and 19% named secondary and tertiary. This year's respondents turned those results on their head: 43% said the secondary and tertiary markets would experience the greatest increase in value in 2018, while another 35% selected suburban markets. Only 17% chose urban markets.
The reasons behind the diminished enthusiasm for urban markets are well known. Rent increases in New York City, Chicago, and Miami were anemic in 2017, and rents in Washington, DC actually contracted. The West Coast did not escape that trend, with rent increases slowing in markets like San Francisco and parts of Los Angeles. More often than not, the cause was an excess of new high-end properties concentrated in already expensive central business districts or in hot neighborhoods like San Francisco's SoMa. It should take a year at least for this oversupply to burn off.
The reaction has been particularly acute among value-add investors. Much of the value-added potential in primary markets has been exhausted during the extended post-recession cycle. As a result, these investors are increasingly turning to those nearby smaller or suburban cities with many of the characteristics of their larger counterparts: entertainment and culture, restaurants and retail, transportation and employment.
Downtown Oakland is a case in point. Companies like Pixar and Pandora are headquartered there, cultural amenities abound, and San Francisco is a quick trip across the bay by BART. The Oakland/Berkeley submarket has grown just 3.6% over the past five years, and of the nearly 4,000 units under construction, only 1,200 are scheduled to be completed in 2018. There is clearly a good reason for investors to follow renters fleeing San Francisco's overheated market.
Value-added investors are also finding attractive transactions in secondary and tertiary locations like Sacramento and the Inland Empire cities. With state government anchoring its economy, Sacramento steadily emerged from the recession by diversifying its employment base. Although developers have taken notice, construction has not been restricted solely to the urban core but distributed throughout the city. Renter demand, which has kept vacancies low and rents rising at an 8% pace, makes Sacramento an attractive investment target. Value-added investors are also looking at the Inland Empire. Job creation has combined with stable multifamily asset values to increase market activity.
Not all investors, however, will be eyeing outlying markets in 2018. Investors with institutional money and longer-term horizons may dip their toes into the suburban and secondary markets, but tertiary markets are still too uncomfortable for them. For the most part, they are adjusting their expectations and investment horizons, confident that the urban cores will eventually absorb their oversupply and that rent growth and appreciation will resume their upward trend.
Kristen Croxton is SVP at Capital One Multifamily Finance. The views expressed here re the author's own.
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