Making a call on suburbia

Late in the real estate cycle, some property investors are finding the best multifamily opportunities in the US suburbs. Others believe it is time to sell.

Long live the suburbs – if the latest demographic data is anything to go by.

For the second year in a row, US suburban growth outpaced city growth in the nation’s 53 largest metropolitan areas, according to a May analysis by the Brookings Institution. “The trend seems to be shifting toward a renewed suburban advantage,” wrote William Frey, senior fellow at Brookings’ metropolitan policy program. He cited “high costs of living” and the “increased attractiveness of the suburbs” as two of the factors attributable to the decline in city growth.

Greater affordability in the suburbs has been a major driver of tenant demand in such multifamily markets, according to Sourav Goswami, managing director at Buckingham Companies.

“It is a stretch for people to have to pay almost 35 percent of their income on rent, which is increasingly the case in urban settings,” said Goswami, whose firm has been investing in suburban multifamily assets since its inception 34 years ago. “It’s always been our barometer that rents should reasonably be 25 percent or less of tenants’ incomes.”

Goswami points to two apartment properties that Buckingham owns: Aertson Midtown, located in downtown Nashville adjacent to the Vanderbilt University campus; and Whetstone Flats, located 15 minutes from the city’s downtown. Rents in the latter property are about half that of its urban counterpart, he said.

From a demographic perspective, “millennials are leaving more expensive apartments in the city,” agreed George Kenny, managing director of institutional sales at Greystone, a New York-based multifamily-focused real estate lending, investment and advisory company. “Millennials want experiences, but you can’t do that when all your income is going to rent.”

“Millennials want experiences, but you can’t do that when all your income is going to rent”

-George Kenny

Where demographic trends move, institutional capital often follows. Apartment investment activity in non-central business district markets have been at historical highs over the past several years, with volumes near or above $40 billion from 2015-17 – a significant leap from the $26.59 billion of deals completed in 2014, according to data provider Real Capital Analytics.

Private equity real estate firms like Buckingham typically are targeting more urbanized suburban markets, rather than suburban markets overall. “We have focused on markets which have great connectivity to the city and employment drivers, really extensions of the urban setting,” said Goswami. Meanwhile, the types of investments the firm is pursuing are properties with walkability to restaurants, shopping and entertainment, strong amenity packages and high-end and updated finishes.

Not everyone agrees with the findings in the Brookings report. Jon Moore, managing director of multifamily real estate at Brookfield Asset Management, believes the outmigration of people from the cities to the suburbs is only a short-term phenomenon. “We think urban growth will outpace suburban growth over the long term,” he said, adding that the high living costs in cities ultimately will not be an impediment. “Supply is up and demand is down because of the lack of affordability. You have flattening rent growth and therefore the markets will ultimately self-correct.”

Indeed, institutional investors deployed 22 percent more in suburban apartments year-over-year through the first quarter; while they put 228 percent more capital into CBD apartments during that same period, according to RCA senior analyst Alexis Maltin.

Diverging strategies

The opposing perspectives on suburban multifamily have led to diverging investment strategies during the late real estate cycle.

“Our current focus has been on suburban markets because that is where we are seeing the greatest risk-reward tradeoff, and where we are able to achieve a more balanced mix of income and capital appreciation in terms of return projections,” said Goswami.

He noted more favorable supply-demand dynamics, and consequently more favorable returns, outside of the cities. “There has been some oversupply and an overreach in the pricing of product within the city centers,” he said.

While acquiring suburban apartments often requires amenity upgrades, the yields can be 6 percent or greater on a net income basis after the business plan has been executed, he added. “You just aren’t able to able to achieve a six-cap in cities. That’s just not possible,” he said.

Hence the influx of more institutional investors into the US suburbs, said Kenny. “The faster money is coming because the returns are better,” he said. Relative to similar apartment properties in the cities, “you’re talking cap rates that are a 75-125 basis point differential depending on the city.”

However, private equity firms have overall been net sellers in the suburban multifamily sector, typically trading to core investors like pensions and insurance companies, he said. But “it’s not just them harvesting funds,” Kenny said. “Generally speaking, the returns are played out from a PE perspective, given the returns that they need. They don’t like the pricing going in.”

One such net seller is Brookfield, which currently owns 35,000 suburban multifamily units and 10,000 urban multifamily units across the US. Over the last couple of years, the Toronto-based alternative asset manager has sold three million square feet of suburban apartments and is now in the process of selling a nearly $2 billion portfolio encompassing a total of 10,000 units across 30 suburban multifamily properties.

Brookfield bought the bulk of its suburban multifamily properties from 2012-16 at a 6 percent cap rate and is now exiting its investments at less than a 5 percent cap rate, according to Moore, whose firm now considers suburban multifamily to be at a peak. “The institutional demand for that type of real estate is certainly evident,” he said.

Meanwhile, “we are shifting toward a more urban allocation and a more urban strategy,” Moore said. While it is selling off assets in the suburbs, the firm also is buying or developing urban apartments and intends to reach a 50-50 allocation in the sector over the next couple of years.

With cap rates rising in apartments, “we believe it’s a great buying opportunity in the cities when everyone is chasing suburban multifamily,” said Moore.