Mind The Gap

11/5/2012 | By Hans Nordby

Published in the May/June 2012 issue of REIT magazine.

Class-A apartments, especially those in urban locations within primary markets, have again proven to be great assets to have in one’s portfolio. Rent growth has been torrid over the last couple years and near-term demand looks great—young, tech savvy (and cost effective) people are capturing more than their share of job growth. As a result, 24-year-olds are moving out of their parent’s basements in droves, taking their egalitarian ideals and iPads to fancy high-rise digs. In addition, their 28-year-old siblings are not interested in buying a house, and may not be for a couple more years. Therefore, those that are buying Class-A apartments downtown today are making savvy investments, right?

Well, in terms of income, the numerator side of the cap rate equation, recent evidence would say “yes.” In fact, 2011 CBD apartment rent growth of 8.2 percent spanked suburban apartment gains of 2.4 percent. And while rent gains have been very good, the rent level has become downright startling in some metros. Class-A rents in Chicago, Boston and D.C. are 10 percent or more over peak levels from the prior cycle.

The bigger potential problem with taking your money downtown lies on the denominator side of the equation—how much you pay for the asset. Buyer reported cap rates are very pricey downtown, averaging 6.7 percent in the CBDs versus 7.7 percent in the suburbs.

"The gulf between CBD and suburban trades reported is wider than it has ever been."

But, mind the gap! The gulf between CBD and suburban trades reported is wider than it has ever been. Even more telling is the price per unit. The average premium paid for a CBD apartment unit, versus a suburban one, averaged 120 percent since 2000, but recently stood at 225 percent—by far the widest gap on record. New York, San Francisco and Washington D.C. CBD rental projects built in the last 10 years averaged a stunning $600,000 per unit at the beginning of 2012, versus $550,000 on average at the peak of the market in 2006.

If it cost more to buy the asset than to build it, wouldn’t investors be better off sticking a shovel in the ground and having a shiny new building in two years. In Boston, there’s a plethora of CBD apartment projects underway, so developers seem to think so. High sale prices are inspiring construction even in downtowns with high barriers to supply, and that should impact rent growth when those buildings deliver.

Don’t get me wrong, apartments are a key component of a balanced portfolio for most institutional real estate investors, and most CBDs will not be oversupplied. That said, Adam Smith’s invisible hand is at work–don’t assume every tall shiny building downtown is worth the price.


Hans Nordby is managng director of PPR, A CoStar Company.

Other Features

Investing in Real Estate Smartly
What’s the best way to invest in commercial real estate – REITs or directly? This topic has been debated seemingly forever in trustee board rooms,...
Hans Nordby
When is the Next Recession?
Nobody likes a wet blanket. But the current economic cycle is six years old, and the commercial real estate party has been a raging good time for...
Perspective is Needed in the Investment World
After spending dozens of hours poring over REITs’ recent financial information and listening to their first quarter conference calls, my belief in...
Hans Nordby
Apartment Investors Need to Aim Small, Miss Small
Many apartment investors, especially big institutions, are making two big mistakes in the way they’ll underwrite investments over the next year. Both...
Ralph Block
REITs: The Next 10 Years
Equity REIT stocks, measured by the FTSE NAREIT All Equitys REITs Index, posted an amazing average annual total return of 11.22 percent in the last...
Population chart
Apartment Demand: Better, But Different, Than You Thought
Much has been written about oversupply in the apartment market, and certainly too many newly constructed class-A units are chasing far too few new...
Ralph Block
The Great Buyback Party
The Great Stock Buyback Party is in full swing. According to The Financial Times, in the 12 months ended March 31, 2014, “S&P 5010 companies...
Hans Nordby
It’s All Relative
All investing is a relative, not an absolute, game. If the stock market pops by 25 percent in one year and your fund is up 18 percent, you’re sort of...
Confident, Connected and Open to Change
THOSE APPROXIMATELY 80 MILLION individuals born from 1980 through 2000 are commonly referred to as “millennials;” they are now teen-agers, 20-...
Demographics Are Destiny
FOR COMMERCIAL REAL estate investors, demographics don’t matter over any short period of time; instead, changes in the economy and new space on the...