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Rental market rebounds as housing market slides
By Gene Walden
From the Minneapolis Star Tribune

As mortgage foreclosures rise and home sales slump, there’s another side to the housing market that is quietly enjoying a recovery. The apartment market, which has been battered and beaten the past few years, is finally rewarding long-suffering investors for their patience. 

“They always say location, location, location,” says Robert Fransen, president of Bloomington-based
Timberland Partners, “but I say ‘timing, timing, timing,’ and this is a great time to invest in apartments.”

The fortunes of the apartment market have moved in direct contrast to the rise and fall of the homeowner market. While lower mortgage rates and rising home prices spurred a surge of homeownership among American families over the past decade—from 64 percent in 1995 to 69 percent in 2005—apartment vacancy rates steadily worsened.

But those two markets have experienced a reversal of fortune over the past year or so. While homeownership declined slightly last year—for the first time since 1993—apartment vacancy rates improved for the second year in a row after edging up steadily from about 7.5 percent in 1995 to just over 10 percent in 2004.

The market for apartments should continue to brighten now that housing prices have flattened out. With less incentive for young families to buy a home, they are more likely to stick it out in a rental unit, which should help improve vacancy rates and rental fees.

“It has been a very difficult market for us since 2001,” explains Fransen. His firm owns about 5,000 apartment units in Minnesota, Iowa, South Dakota, Michigan, Kansas, Nebraska and Texas. “Rental rates really haven’t moved since 2001 even though our expenses continue to rise. And the problem was compounded by the increase in vacancy rates.”

But Fransen has seen a solid recovery in his business recently. A year ago, Timberland had a 10 percent vacancy rate among its apartment holdings even though the firm was offering new tenants a month of free rent as an incentive to sign a new lease. Now the firm’s vacancy rate has dropped to 5 percent and it is no longer forced to give tenants a free month. “That means we’re collecting about 11 percent more than we were a year ago,” says Fransen.

He predicts that rental rates will increase by about 5 percent per year, on average, for the next five years as vacancy rates decline and demand increases. He does not anticipate wide scale construction in the apartment market for several years—until rental rates have increased significantly.

Five forces that move the market
When Fransen looks ahead to future values of the apartment market, he focuses on five key factors, which are beginning to favor investment in apartments:

  1. Construction. Because of low rental rates and high vacancies, construction in the apartment market has been minimal recently and is not expected to pick up for a few more years. The lack of new construction should ultimately reduce the supply of available units and give apartment owners the ability to raise rental rates.
  2. Interest rates. Interest rates are expected to remain fairly stable in the near future, so they should not have a significant impact on the apartment market.
  3.  Inflation. Inflation has been hovering around 3 percent per year, so if rental rates rise by 5 percent per year in the apartment market—as Fransen predicts—real returns should improve considerably.
  4.  Flow of capital. The flow of capital into the rental market has been strong and is expected to continue to remain steady, so capital flow is not expected to create any significant changes in apartment values.
  5.   Job growth. Job growth is the fuel for population growth because new jobs bring new people into a market. Job growth has been strong in many parts of the country, which should help boost demand for rental properties.

Fransen predicts that the combination of those five forces will help improve profits and values in the apartment market over the next five years.

Investing in apartments
Unless you’re prepared to become a landlord, investing directly in the apartment market is probably not for you. The most common way to buy a stake in the market is through a limited partnership. Firms such as Timberland Partners pool money from a group of investors in order to purchase apartment properties that the general partner believes to be good investment.

Typically, investors are expected to pony up $40,000 to $100,000 or more to participate in a limited partnership and that money is often tied up for several years. But returns can be outstanding in a good market. It is not unusual for a limited partnership to pay dividends in the range of 8 to 10 percent and those dividends are often tax-free because of depreciation write-offs.

Real estate investment trusts (REITs) offer another way for investors to buy a stake in the apartment market. REITs, which typically invest in apartments and commercial property, trade like stocks on the major exchanges. As a result, they provide more liquidity and a lower cost-of-entry point, but they generally do not provide the same tax benefits that limited partnerships offer.

Most of the REITs that focus on the apartment market have been concentrating on buying properties on the East and West coasts where the recovery in the apartment market is already well underway.

Finding REITs with a presence in the Midwest—where the recovery is just beginning—is a little more difficult. But there are a few, such as Investors Real Estate Trust, a Minot, North Dakota based REIT that trades as IRET on the NASDAQ exchange, that do specialize in Midwest apartments.

If current economic trends continue, the slump in the homeowner market should be music to the ears of apartment investors.

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