By Lorna Pappas

Key fundamentals in the multifamily market are strengthening across the U.S., both regionally and nationally, following a period of significant pressure.

With job growth the primary driver for multifamily demand, the sector over much of the last six years faced a weak market, with low increast rates, contributing to the decisions of many consumers to own as opposed to rent. U.S. Census Bureau statistics showed home ownership increasing to 69 percent from the late 1990s to early last year, the highest ever tracked. Demographics showing a significant decline in the prime rental age group population (ages 20 to 35), compared to the 40-plus-year-old cluster, a key homeownership segment, had further stressed the market.

But with employment on the rise in the last two years, interest rates increasing since mid-2005, stronger rental demographics, higher pricing for single-family homes, low vacancy rates, accelerating rents and other favorable conditions, the sector has moved into a period of higher growth.

Industrial
# of REITs	19
Industry Market Cap. (in thousands)	$15,906,900
% of industry	4.2%
Yield	3.72%
YTD Total Return	26.24%
One-Year Return	14.62%
Three-Year Return	16.43%
Five-Year Return	4.88%
Average Daily Trading Volume (Shares)	315,706
Source: NAREIT. Data as of July 31, 2006

“While the multifamily REIT sector generally faced challenging fundamentals throughout the first half of the decade, the second half promises better underlying economic conditions, improved earnings growth and stronger relative share price performance, with each sub-sector poised to capture consistent though varying levels of greater overall demand,” says David B. Rodgers, an equity research analyst specializing in multifamily REITs for RBC Capital Markets. “Employment growth and rising interest rates support greater traction for occupancy and rental rates among apartments, while rising construction and land costs could limit additional supply.”

“Multifamily performance led all major REIT sectors through June 2006, with apartment REITs recording a year-to-date total return of 21.0 percent, 810 basis points (bps) above the 12.9 percent posted by the FTSE NAREIT Equity REIT Index, and exceeding the S&P 500 return of 2.7 percent,” says Stephen Swett, senior analyst with Wachovia Securities. He adds that core operating results for the multifamily sector in the first quarter of 2006 were ahead of expectations, due to continued improvements in overall operating fundamentals. Pricing power and higher occupancies have been significant drivers, he says, adding that his company “expects this trend to continue into 2007.”

Not Just a Regional Phenomenon

Demand is expected to outpace supply in most major U.S. markets, where job growth and significant improvements in apartment fundamentals clearly are taking place. Though unaffordable home costs could drive most revenue growth in U.S. coastal markets, particularly in San Francisco, New York, Boston, Washington, D.C., and Southern Florida, revenue is rising everywhere, in what Swett considers “a national recovery for the multifamily sector.”

What to Watch For: Multifamily Market.

POSITIVES: » Improving fundamentals with better job growth and higher interest rates » Rent growth acceleration » Shorter lease terms can provide inflation hedge » Rising construction and land costs could limit additional supply

NEGATIVES: » Significant drop in the prime rental age group population (ages 20–35) » Potential weakness in condo market could provide alternative supply » Low cap rates make external growth less accretive

Though 12-month supply through mid-May 2006 is up, with new apartment permits rising 9.7 percent from the previous year, for-sale construction and conversion activity counteracts this movement. With net demand forecasted to exceed net supply, the fundamental trend in occupancy will be rising, states Swett. “Given these relatively high occupancies and an expanding economy, landlords nationwide are seeing pricing power in the face of these higher occupancy rates,” he says.

As rents continue their steady ascent, and with vacancies under the national average of 5.8 percent in 17 of the 25 top U.S. markets, rent growth could hit some very impressive levels by the end of this year, according to a recent industry update issued by Deutsche Bank. “With continuing rent growth acceleration and modest deliveries over the second and third quarters, which cover the peak leasing season, year-over-year growth in the major metros could hit five to six percent by the fourth quarter of 2006,” says Lou Taylor, research analyst with Deutsche Bank.

“On a regional basis, we estimate that the occupancy rate has moved above the threshold rate in every region except the Midwest,” Swett says. Therefore, we believe rental rates can accelerate in four of the five regions, at a slightly higher rate in the coastal regions [5 percent to 6 percent] and a slower rate in the Midwest [3 percent].”

In comparison, year-over-year rent growth in the top 25 U.S. metropolitan areas only saw 0.1 percent growth in the fourth quarter of 2003, 2.3 percent a year later, and 3.4 percent in the fourth quarter of 2005, according to Deutsche Bank’s industry report.

The overall rising cost of purchasing a single-family home adds to the positive rent picture. In the single family housing market, a 77 percent increase in the median sales price in new homes between 1998 and 2005, and only a 25 percent increase in rents during the same period has generated a historically wide gap between the costs of renting versus owning the average home, according to Karin Ford, REIT analyst with RBC Capital Markets.

“In 1998, the monthly mortgage cost for the median home was 120 percent of the average monthly rental cost. In the first quarter of 2006, that ratio stood at 164 percent,” she wrote in a recent report on the multifamily sector. “This suggests that, assuming home prices remain stable, as rates rise, there will be a significant financial advantage to renting versus owning in the near term, which should improve apartment demand.”

Investors also like the multifamily segment, especially in a market like today’s, due to its shorter lease terms compared with other sectors in the real estate market, such as retail and office. When fundamental conditions are good, shorter leases translate into cash much sooner, resulting in faster, steadily rising cash flows.

Multifamily market challenges come from the fact that sector cap rates have been down, making external growth less accretive, though these rates could start to rise due to the rising interest rates, notes Swett.

Positives outweigh the negatives, making the multifamily sector a good regional and national choice as key fundamentals intensify.