Pigeons, Chickens and Interest Rates

There was a hilarious video making the rounds on social media last week that featured a pigeon strutting around a barnyard with a puffed up chest and its head cocked high in the air. The pigeon was imitating a flock of brown chickens who were parading about, pecking at the seeds on the ground. I did what anyone would do when presented with such fantastic barnyard comedy: I pressed the screen and gave the pigeon a heart sign.

I sought deep meaning in this pigeon strutting about. It must be some kind of zoological phenomenon. Genetic mirroring or telepathy. Do pigeons have ESP? I have little knowledge of the biological world, and much less about the psychology of pigeons, so I gave up this notion. Instead, I decided this pigeon must have something to do with interest rates. A natural conclusion.

I couldn’t help but wonder which bird was better off. The chickens were destined for one of those plastic containers with the transparent lids sitting under heat lamps, but they would end up on someone’s dinner table. A meal for a happy family. A short life, but a useful one. The pigeon seemed free. It could fly off at the first sign of the farmer. But it’s death was certain to be grisly: Picked apart by a marauding hawk or flattened by an onrushing vehicle.

You can delude yourself into believing that your fate is different, but the end result is the same. In the long run, we are all dead. So goes the old economist joke. Interest rates are the great equalizer and the tombstone of many speculators are marked with a percent sign. Rising interest rates don’t care much if you’re a pigeon, chicken, or real estate developer. Yes, it’s one hell of a stretched analogy, but I’m running with it.

If you have borrowed a lot of money (something real estate developers love to do), rising interest rates can foul up (or fowl up) any investment equation. To see why, let’s look at a hypothetical building that generates income from rents. After paying expenses, the owner is left with $1,000,000 per year in net operating income. How does one value such a building? The equation is fairly simple, you take the net operating income and divide it by an interest rate known as the capitalization rate, or “cap rate” for short.

The cap rate is a weighted average cost of capital. It weighs the investor’s desired return on his or her equity invested as well as the borrowing cost of debt. The cost of debt is more than simply the interest rate. It includes a factor for the amortization of principal. The resulting cost of debt is known as an annual constant.

In November of 2016, the 10-Year Treasury Yield stood at 2.15%. Lenders usually price their loans at about 2% above the Treasury (known as the spread). So, in November of 2016, the rate was 4.15%. Once you add on the amortization of principal (let’s use 30 years as the amortization term), the annual constant was 5.90%. What was the hypothetical the cap rate? Assuming the developer sought a 7% return on equity and the equity comprised 25% of total capital, the resulting cap rate was 6.175%. What’s $1,000,000 of annual income worth? $16.2 million. The developer was able to borrow about $12 million and made up the balance of the funding with equity of around $4 million.

Today, the 10-Year stands at 3.24%. The annual constant is 6.63%. Holding the desired return on equity at 7% results in a weighted average cost of capital of 6.72%. Dividing $1,000,000 by this cap rate results in a value of $14.9 million. This is a decline of 8%. The developer borrows $11.1 million and invests equity of $3.7 million. All is well and good. The value declined, the debt declined, and the equity required declined in tandem.

But what happens when the building was built in 2016 and now its time to refinance a construction loan in November of 2018? We said the developer initially put up $4 million for a $16 million building. The debt amount of $12 million made up the difference. Now the building is worth $14.9 million. The bank will only loan $11 million. The developer must make up the difference between the original construction loan and the new permanent loan. An additional $1 million of equity is required – a massive 25% increase.

This horrifying situation is already playing out on the global stage. Today’s news brought reports that Chinese developers face $55 billion in debt renewing in 2019. Already Chinese Evergrande, perhaps the world’s biggest developer, witnessed a $1.8 billion bond issue go begging. Fortunately, the majority owner Hui Ka Yan was able to personally put up $1 billion to salvage the deal. Meanwhile Indian developers facing a glut of luxury condominiums have watched short term funding costs surge. Investors have pulled $30 billion out of the money market accounts of non-bank institutions that fund such developments. Indian developers are suddenly in a mad dash for capital.

Pigeon meets hawk. Chicken meets guillotine.

Does Omaha need any more apartments?

A couple of years ago I published my views about the supply and demand of multifamily rental housing in the Omaha metropolitan area. My conclusion was that softness would appear by late 2017 due to an acceleration of supply. I have been pleasantly surprised by the continued strength of the market. Occupancy levels are at 95% or better in most parts of the city.

Unfortunately, the day of reckoning has only been postponed, not cancelled. I believe 2018 will be the first year since 2010 that landlords will be caught short-handed. While I don’t see vacancies rising to the 10%-plus levels we experienced during the dark days of 2004-06 when just about anyone with a pulse was purchasing a house, any pullback in occupancy will feel painful simply because we haven’t been exposed to much adversity in recent years.

Omaha has become large enough now, at nearly 950,000 people, that submarkets can have widely disparate experiences. Northwest Maple Street is an entirely different beast from the Blackstone neighborhood. However, on a macro level, a decline in occupancy of 2-3% seems possible.

There are two reasons why my prediction of market softness has been delayed until 2018. Omaha has grown faster than I thought and developers have been mindful of delivering units at a slower pace.

On the supply side, it’s hard not to ignore the revival of midtown Omaha. Over 1,200 apartments are under construction or just opening south of Dodge and east of 72nd St. Prudent builders released units to the market more slowly than anticipated, however, and the real impact will be felt in 2018 and 2019 when major projects in Blackstone, Aksarben Village and other midtown neighborhoods hit the streets.

On the demand side, population and employment growth have been stronger than I thought possible. We have exceeded 1% population growth for the past few years with a high degree of contributions from international and domestic migration.

My theory has been for many years now that Omaha can absorb 1,200 apartments per year without disrupting decent rent growth in line with inflation. During the recession multifamily permits dropped precipitously to just over 300 units in 2009. Pent up demand and pinched supply signaled a robust market from 2010 – 2016. Now supply is exceeding the 1,200 unit “magic number”. By 2019, Omaha could experience a glut of 2,000 apartments. In the grand scheme of all rental housing, this amounts to about a 2-3% weakening in occupancy levels. This is not disastrous when taken in the context of the metro area.

The pain will be be felt at the top end of the market. The 2,000 unit overhang will attempt to command units nearing $2 per square foot due to the massive building cost and land inflation since 2013. Geography matters. East Omaha will suffer the brunt of the weakness. Developers are correct to recognize the trend towards urban living. It’s unfortunate that they all decided to recognize the trend at the same time.

Like most booms, the story is more about cheap money than it is about demographics. There was a moment this past summer when the 10 year Treasury bond yield began to head towards 3%. Cassandras who had been warning for years that hyperinflation was lurking just around the corner and gold was a safe haven, suddenly began to sound like they were on to something. But as the summer waned, the Treasury dropped to nearly 2% again. It is only about 2.3% now. This rate reprieve has given green lights to many new projects.

Forecasting interest rates is a fool’s errand, but what can not be disputed as we enter our 10th year of extraordinary central bank intervention in the money supply, is that asset price inflation has been rampant. Stock market multiples are as high as they were during the dotcom bubble. If you call a broker looking to purchase an investment property today, you will go straight to voicemail.

The problem is not one of America’s sole making. The Federal Reserve is planning to decrease its purchases of agency bonds and Treasuries. Under normal circumstances, this would signal a dramatic rise in rates. But America does not operate in isolation. Japan, Europe and China have been increasing their supply of money at an ever faster pace. If the US Treasury rises to 2.75%, a fund manager in Zurich will surely be buying when the alternative is less than 1% domestically. The yield on American bonds can not escape the gravity of sub – 2% yields elsewhere. The international market for capital won’t let this US diver come up for air.

The truly international scope of cheap money infects housing as well as securities. Try bidding on properties in San Francisco, Sydney, Vancouver or Toronto and you’ll see what I mean. Even in Omaha, the numbers are distorted. When developers can continue to borrow money at cheap rates, the estimate of risk gets diminished.

I identify five major risks threatening the Omaha apartment business today: The first is the persistently low interest rate cycle. As mentioned above, the cheap cost of capital is giving green lights to developers who might have otherwise tapped on the breaks by now. The second is student loan debt. Young people are the lifeblood of new apartments. They are under tremendous financial pressure today due to the enormous amount of college debt that’s been incurred. While we have a robust economy with local unemplyment rates hovering near 3% today, a slowdown in the economy would stall wage growth and diminish the affordability of high rents. Student loan debt has surpassed the eye-watering level of $1.4 trillion dollars. Yes, that’s trillion with a “T”. Number three is the challenge facing university enrollment. UNO has been growing but is nowhere near it’s target of 20,000 students by 2020. Small colleges are shrinking or disappearing (Grace University is the most recent casualty). National college enrollment peaked in 2011. Fourth, the possible limitations on international workers from the current administration could dampen population growth. Omaha grew by 9,800 people in 2016 and over 1,000 represented international migration.

The fifth challenge facing apartments deserves its own paragraph. The apartment market must also compete with its big brother: the single family home market. The very slow recovery in single family home starts has worked in the apartment market’s favor. Peaking near 6,000 units during 2005, the supply of houses has only now climbed back above 3,000 on an annual basis. The lack of inexpensive new homes has prolonged the renter experience. But this trend will reverse if the economy stays strong and wages continue to grow. Single family permits are on an upward trajectory. When coupled with multifamily permits, the  entire supply of housing is exceeding levels not seen since 2008. The same low interest rates that help apartment developers are the double-edged sword that drives house affordibility.

What’s more, I do not subscribe to the belief that there has been a permanent paradigm shift away from homeownership. Young people still want to start families. When they have children, and if they have the means, they will move to Elkhorn and Sarpy County where pristine schools beckon. Homeownership will probably never return to the insanity of the mid-2000’s but the dream of owning a home did not vanish from society. Millenials may have delayed their family expansion, but the overwhelming human instincts of procreation and self preservation have not ceased. And there’s no place better than a good suburban home for this most American of pursuits.

 

 

 

 

 

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Omaha Apartment Market, Pockets of Oversupply but No Worries

We continue to have positive views on apartment demand going forward. Occupancy has exceeded 95% for over two years. However, we view 2016 with some trepidation as a surplus of 500 units reaches the market in 2016. 

Market Breakdown

We believe the Omaha Metropolitan Area apartment market is heading towards an over-supply level of 500 apartments. However, this amount is fairly insignificant in light of the pace of job creation, population growth, and the overall amount of units in the market.

Three reasons support this idea.

  1. Supply is roughly in line with demand, but has slightly outpaced typical homeownership percentages.
  2. Multifamily supply has been in line with job growth, but has recently exhibited a ratio that signals some caution.
  3. The perceived amount of oversupply is not only a function of job growth. It is also a function of income growth. Construction costs have pushed rents to levels that many new entrants to the housing market will lack the means of stretching for rental payments in new projects.

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Supply and Demand Equilibrium Levels

The Omaha metropolitan area has grown beyond a population of 905,000 and has a consistent level of household formation around 4,000 per year. With about 70% of new housing demand typically attracted to homeownership, rental housing stays at rough equilibrium between supply and demand at 1,200 units per year. That number is roughly line with current supply numbers, but there are signs that new apartments have begun to outpace growth.

As a percentage of total housing supply, multifamily units have, in aggregate over the past three years, exceeded the typical homeownership ratio by 2%. There were 3,041 single family permits issued in 2013, 2,639 permits in 2014, and 2,830 for the trailing 12 months ending September 2015. Multifamily housing hit 1,370 units in 2013, 1,533 in 2014 and 1,114 through September 2015. The sum of the three years shows that multifamily has been approximately 32% of new housing. Meanwhile, historical averages for homeownership in the Omaha MSA have hovered at 70%. In this instance, the oversupply of 2% translates in 250 excess apartments.

As an aside, the peak single family construction occurred in 2005, when 5,877 units were permitted.

Total Units

Units         Single Family    Multifamily    Total      % Multifamily

2013             3,041              1,370            4,411              31%

2014             2,639              1,533            4,172              37%

2015 ttm       2,830              1,114            3,944              28%

Total             8,510              4,017            12,527            32%

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Job creation and Housing Demand

Apartment demand follows job creation levels in a fairly lock-step pattern. The Omaha employment market has been robust since 2012. Between the 2008 nadir of 437,000 jobs and the recent 2014 figure of 462,500 jobs, Omaha has created over 25,000 jobs. This level far outstrips the supply of housing by more than double. By comparison, the stock of housing increased increased by an astonishing 56,700 between 1999 and 2008, but jobs only grew by 26,200!

Typically market research firms such as Axiometrics use a ratio of 5 jobs per unit as a demand equilibrium ratio. In an ideal equilibrium, the 25,000 jobs created in Omaha since 2008 implies a maximum apartment supply of 5,000 units. In fact, over 6,000 multifamily units have been permitted between 2008 and the end of 2014. This implies a ratio of 4 jobs per unit. If one assumes a job growth rate for 2015 of just over 1%, it can be figured that 5,000 jobs have been added during the past year. The ratio for 2015 is, therefore, slightly better at 4.50.

The ratio of jobs to units at a sub-5 level implies an oversupply of about 750-1000 apartments in the metro area.

Year Employment Population Jobs/Population
1999 411,240 761,603 54%
2008 437,478 845,119 52%
2014 462,515 904,421 51%

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Income Concerns

So far, we’ve established that an oversupply of between 250 and 1000 apartments exists in the metro Omaha area. While this number is statistically insignificant out of Omaha’s 100,000 rental units, the direct peer group for new construction is much smaller. The peer group for these units really amounts to about 10,700 units built over the past ten years. These apartments have been built at the top end of rental rates. In this case, a 5-10% oversupply is a number that deserves watching.

Why do we say this? The new apartment math requires an annual income of $38,800 per year. This is towards the high range for single person households who have recently entered the workforce. With young people graduating with significant amounts of student debt, the ability to afford rents approaching $2 per square foot per month may be under pressure.

In Conclusion

Apartment supply as a percentage of homebuilding implies a 2% level of oversupply – about 250 units. When a job ratio is applied as a benchmark, the oversupply level rises to between 750-1,000 apartments. Our best estimate is that the Omaha MSA is heading towards a 500 apartment surplus in 2016 that will cool the occupancy levels from the peaks enjoyed the past several quarters. Additionally, units being delivered to market must be cautious about the pressure of income levels. While employment growth has been robust, student debt is high and many new jobs are below $35,000 per year.

Are we concerned? Not yet. We believe that many of the areas receiving supply have been absorbed at a rate that has exceeded our own expectations. Meanwhile, some experts believe that the Midtown Omaha area is going to be pushing the limits of absorption by late 2016. Also, while supply may have been running ahead of demand recently, the level of occupancy has been in excess of 96% for a few years now. Anything above 95% implies a very tight market. In this regard, there is proof of continued high demand.

One final caveat: We are not in the camp that there has been a paradigm shift in home-buying attitudes. Millenials will eventually get married and have kids. This process may have been retarded by the recession, but it will continue.

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Alchemy Development presents: A New Urban Living Development located in Aksarben Village.

Alchemy Development presents:  A New Urban Living Development located in Aksarben Village.

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Located in a neighborhood with history; and now, with a great Vibe – progressive, education, youthful, urban.  Around the corner from shopping, entertainment and Stinson Park events; the new buildings will be a part of Pinhook Flats.

These new buildings will have a combined 53 apartment homes:  Studios, One Bedrooms, Two Bedrooms, Two Bedroom Lofts.  Each having its own washer and dryer and beautiful finishes.  Each apartment will have access to garage parking, trash chute, recycle program andhave access to Pinhook Flats amenities.

Combining the practical needs of life with urban living spaces for those aspiring to an elevated lifestyle –

             Upscale Living…Next Level Lifestyle.              CUE “Up. Next.”

Final CUE rendering (4)

 

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Thoughts on the Omaha apartment market – March 2015

The apartment market will continue to experience healthy demand in 2015, but increasing construction costs and higher property taxes are producing strong headwinds. Supply will exceed demand by 300 units this year: not enough to cause discomfort for owners and developers, but enough to reduce occupancy rates by 1-2%. Vacancy, especially in the core submarkets, will stay below a tolerable rate of 6%.

The biggest challenge this year for developers won’t be demand, it will be construction costs. It is likely that many projects that receive building permits will be delayed due to cost overruns.

The Omaha metro area will have 1,500 units permitted in 2015, but not all will be started due to costs outstripping rents. This is the same number as 2014 but slightly higher than needed.

The market will experience 2% rent growth, but gross income will be up by 3% by passing through more expenses – especially water and sewer fees.

There are additional threats to the apartment market on the horizon:

Home buying will pick up this year as people gain more confidence in the jobs market. The “people don’t want/can’t afford houses” has become a tired cliche.

The biggest challenge to existing properties is the property tax re-assessment which occurred this year for the first time in 5 years. Real estate taxes for multifamily units (especially B and C properties) are set to increase 20% to 50%. New taxes kick in in 2016 – a hellish wake up call for those who aren’t prepared.

The agricultural economy is down. I don’t think people realize how much the farm business filters into Omaha. With commodities down, you’ll see lending decline, cutbacks at Claas, less vehicle spending and shopping trips to Omaha etc.

The sewer separation project is another problem. Every massive infrastructure project run by the government has been over budget. The previous rate increases are already reducing demand as people conserve water. With less water use, The City is going to be forced to raise sewer fees again in 2 years.

Here is my wild card… a major corporate downsizing or defection will occur. We’ve heard about Yahoo! and Woodmen, but there are others in transition: First Data, ConAgra, CHI Hospitals, Gavilon, Kelloggs, and Gordman’s are all searching for ways to cut costs.

Crime is a major factor in choosing where to (or where not to) live. The gun violence rate is appalling for a city of our size. This poses a very challenging environment in which to continue to attract residents to emerging neighborhoods in east Omaha. Marginal developments at the fringes of downtown may struggle from oversupply and perceived lack of safety.

Do I have any optimistic trends? Yes!

  • Entrepreneurs are creating jobs shed by corporates at a healthy rate. Omaha has a diverse economy and has a creative group of young people that used to leave the city but are now choosing to stay.
  • The education “industry” is strong and growing as UNO adds sophistication and UNMC is enhancing it’s services and growing in prestige.
  • The PayPal spin off from Ebay could unleash some advancement in electronic payment systems.
  • Companies like Home Instead and Right at Home growing with the elderly trend.
  • The Omaha 1% annual population growth story has been intact for years – nice and steady – and it will continue.
  • More disposable income will result from tighter labor markets and moderate gas prices.
  • The Fed is unlikely to raise rates. The dollar is too strong.

Lumber up 35%. Could that cool off the housing revival?

Lumber prices have dropped slightly since a January high of $400 per 1,000 board feet. But the price has surged over 35% since February 2012. I imagine mills shut down during the recession haven’t been able to ramp up production fast enough. The Canadian forests have been hit by the same pine beetle that has devastated much of the Colorado Rockies. I would suspect the stronger Canadian Dollar has also impacted import prices.

Source: NAHB

It made pricing our project at Shadow Lake much more difficult than anticipated.

Could high lumber prices slow the housing construction revival? What do you think?

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