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Lots to let

Even before the prospects for the U.S. economy dramatically deteriorated in mid-September, the rental market was surprisingly weak.

Even before the prospects for the U.S. economy dramatically deteriorated in mid-September, the rental market was surprisingly weak.

By Kerry Hannon
October 2001
Institutional Investor Magazine

Real estate markets did not unravel after September 11 - but they did weaken, across virtually all regions and categories. In the residential sector, after setting a record annualized rate of 5.5 million existing home sales in August, sales slowed markedly last month. The National Association of Realtors' chief economist, David Lereah, now expects home resale activity to average below the 5 million-unit rate through the first quarter of 2002.

When an economy is teetering on the edge of recession, one would expect to see a relatively buoyant rental market. Buying a home is a major investment, after all; renting is a way of hedging one's bets. But even before September the rental market was surprisingly weak.

A new quarterly Merrill Lynch & Co. report, compiled by Axiometrics, a research firm based in Dallas, tracked rental apartment markets in 31 major cities. The vast majority of these markets took a turn for the worse in the second quarter. Asking rents for apartments that had just been vacated remained flat, versus a 0.7 percent gain in the first quarter. Concessions became widely available, and vacancy rates rose to 4.1 percent in the second quarter from 3.2 percent in the previous quarter.

"We've never seen a housing market like this before," says NAR's Lereah. "Truly, it's counterintuitive."

Real estate investment trusts hit the hardest by the shift include Alexandria, Virginia-based AvalonBay Communities, San Francisco-based BRE Properties and Palo Alto, California-based Essex Property Trust. All three have a heavy concentration of multifamily housing units in Northern California.

The average rent in Northern California was down 15 percent through the second quarter compared with last year. In San Francisco average rates dipped 10 percent, and in San Jose rents softened by as much as 20 percent. Austin and Phoenix were also mired in the muddy tech fallout, with no growth in rent, sharp hikes in vacancy rates and soaring concessions. Significant signs of weakness also appeared in Atlanta, Charlotte and Cleveland.

Still, AvalonBay report-

ed a 13 percent increase of funds from operations for the first six months of the year, compared with the same period a year ago. That's because although AvalonBay has 40 percent of its 42,232 apartment-home properties in Northern California, 60 percent are outside that region in some very robust markets. FFOs for BRE are up 7 percent through the second quarter; they're up 17 percent for Essex for the same period.

"The apartment market has had the wind at its back since 1993," says Steve Sakwa, the Merrill Lynch director who wrote the brokerage firm's report. "It couldn't go on forever."

Still, some urban markets are doing just fine. In Boston, Chicago, Houston, Miami, Philadelphia, St. Louis and Washington, D.C., supply is generally tight. These markets have limited land availability and tough zoning restrictions.

In Northern California limited supply had been a plus for landlords - until the dot-com implosion. Rents in 2000 spiked as much as 30 percent in some areas. A two-bedroom apartment in the Bay Area that leased at $3,500 a month in 1999 had jumped to $10,000 one year later. Now the same space might rent for $6,000.

"Rents had been pushed off the charts," says Nicholas Buss, vice president of PNC Real Estate Finance in Pittsburgh. "But now the tech markets have been massacred across the board."

Nevertheless, apartment REITs remain safely above water. Year-to-date through September 24, apartment REITs posted total returns of 2.5 percent, according to the National Association of Real Estate Investment Trusts. That compares with a 4.5 percent gain for REITs overall and handily beats the 24 percent decline in the Standard & Poor's 500 index.