Do rising rents signal a bubble?

A key question is whether industry norms still apply

What is going on in the world of commercial real estate in New Hampshire this summer? 

The short answer is the continued shortage of product is pushing up prices. This has been, and continues to be, true for multi-family apartments as well as condos. 

What is new is that it has migrated to development properties — older buildings to be redeveloped into apartments and new construction. Demand for permitted projects has prompted a number of housing developers to sell their entitled property to others — letting the buyers assume the risks of construction and lease-up. This phenomena means that existing cash flowing properties are even more dear. 

A recent set of articles about New Hampshire reported that apartment vacancy rates are under 2 percent and in some cities under 1 percent. The industry norm is that when vacancy drops below 8 – 10 percent it’s time to start permitting projects and then when it drops to 5 percent vacancy it is time to build.
A key question is whether the industry norms still apply. The Great Recession of 2009 has skewed things. The rise in rents is significant, especially for young people. Many are paying much more than 30 percent of their income on housing. Is this sustainable? For those of us long-time practitioners it feels like a bubble. Yet we see lots of capital ready to invest, ongoing low interest rates and new cohorts of buyers (Gen-xers, older Millennials, empty-nesters). 

Then there are the regional differences. The aging, greying, expensive Northeast is very expensive to build. That is true for residential, commercial and industrial. The “smile” states (Virginia south to Florida, west to the Gulf Coast through Texas to California then up the Pacific Coast to Seattle) are booming. The two “eyes” on the face are Denver and Chicago. The cost to build in the Sun Belt is literally one-half of that in New England. Excellent custom built homes, very energy efficient, etc. are selling for $125 per square foot. Today in Southern New Hampshire, they are above $250 per square foot. Now some would argue that New England wages are higher. Yes, perhaps, but real estate taxes, utilities, snow plowing are higher too!

So when we now see apartments sell, we see low cap rates (the rate of return on investment). Currently we are still seeing 4 – 5 percent. This reflects the perception of low risk. Investors like apartments because after an initial one-year lease, tenants often go month-to-month where landlords can increase rents frequently. In the current hot market this translates to increases every 6 months. But if or when the economy softens, and demand drops, rents can drop because there is not a lease in place dictating the agreed-upon amount.

Office leases usually spell out rent increases, as the dollars are typically 1.5 to 2 times apartment rents when expenses are included. For example, if I rent a two-bedroom apartment of 720 square feet for $1,000 a month, that equates to $16.67 per square foot per year. But this is a “modified gross” lease, as the landlord pays real estate taxes, the water and sewer, plows the snow and maintains the building. The tenant pays the electric and most often the heat. So the “net” rent to the landlord (before expenses, well, actually after expenses) might be $10 – $12 per square foot.  If the same landlord had decent retail or office space on the ground floor of the same building that might command $15 – $20 per square foot of “net” rent.
So do not expect to go out and buy an apartment building for a good price anytime soon. That is the case in prime markets. Forgive me, but that is not the case for Claremont or Berlin. All real estate is local! 

A month ago I was in LA attending the spring CRE (Counselors of Real Estate) meeting. After 48 hours of dialogue, the consensus was that there could be a slight downturn correction for two or three quarters, but nothing like 2009. While I am hoping this is true, deep down inside I am skeptical. To wit, we just had three parties bidding to pay more than asking price for an office building. They each had their reasons, but that is unusual. At the same time, we have seen the same thing for a redevelopment project to build 30 – 40 apartments. Now this is in Manchester, NH — not Boston, New York City, Washington, Chicago or LA. Manchester is a tertiary market, on a good day, and a quaduciary market most days. 

Bill Norton, president of Norton Asset Management and principal of Harrington & Reeves, is a Counselor of Real Estate (CRE) and a Facilities Management Administrator (FMA). He can be reached at wbn@nortonnewengland.com.