Philly's Multifamily Market Is Showing Worrying Signs

It is exceedingly difficult to build multifamily in Philadelphia right now, while competition for investment has never been more fierce. In other words, it is a dangerous time in the cycle.

Slowing absorption numbers for newer apartment buildings and prohibitive construction costs have contributed to the near-total shutoff of the multifamily development pipeline, a situation exacerbated by the difficult real estate tax system in the city. Southern Land Co.'s new project, The Laurel, is an outlier due to the unique advantage of being in Rittenhouse Square, allowing it to charge well-above-average rents and condo prices.

"With construction prices, we can’t underwrite any new deals at all," Southern Land Senior Vice President Dustin Downey said. “You can’t make the numbers work, even if you get the land for free. So we’re looking at the suburbs where the land prices are lower, construction costs are lower, but it’s still a challenge to make the numbers work.”

The Laurel broke ground at 1911 Walnut St. Sept. 13, the same day Downey joined other notables in the multifamily market for Bisnow's Philadelphia Multifamily event at the Philadelphia 201 Hotel. Downey cautioned that projects valued at anything less than the top of the market have been rendered all but impossible, especially with the city's property assessments rising quickly and unpredictably.

"In Philadelphia, we’re underwriting no discount whatsoever, meaning that what we think the building is worth, that’s the taxes we’re anticipating paying,” Downey said. “That’s killing us right now. It’s killing us.”

The investment market is singing a happier tune than the development side, as 2018 has seen a significant increase in deal velocity over 2017, CoStar Commercial Real Estate Philadelphia Market Economist Adrian Ponsen said. Even though absorption has been slow in the wake of a surge in deliveries, rents have climbed faster than they did last year after a dip in the winter months.

“Household incomes are rising at a faster rate, which allows families to pay higher rent,” Ponsen said.

A deeper and broader pool of investors is looking at Philadelphia, and a lot of new faces have been foreign capital and institutional funds. They tend to look for safe investments, and are willing to pay a premium for them. Coupled with the fierce competition that has defined the value-add space for years, that has created an environment wherein new or recently renovated assets have grown in popularity in the city.

“People might not have expected this, but what we’re hearing from clients is that with interest rates rising, core properties are a higher percentage of what’s getting traded,” Ponsen said.

Of all the multifamily transactions that have closed so far this year at over $10M, half of them were sold by the initial developer and the other half had been held for five years or less by landlords that had added significant value. Among the highest-profile of those deals was Southern Land's disposition of 3601 Market St., which it completed in 2016 and sold in July.

HFF recently closed on the sale of a new-construction multifamily project in the Philly suburbs right after it stabilized for $100M, according to Senior Managing Director Mark Thomson. Though he could not disclose details due to some tax issues that are still being ironed out, he said the buyer was a core investment fund.

“That sort of flies in the face of Philly’s inferiority complex, where people think that core funds don’t see here as a gateway market,” Thomson said.

But as more capital attempts to find deals in the city and fewer are available, aggression has increased on the financing side to fund acquisitions. Construction loans have remained cautious, but otherwise warning signs are flashing.

“I don’t want to be Chicken Little, but we’re nine years into a cycle right now, and cycles are inevitable," KeyBank Senior Vice President Christophe Terlizzi said. "We don’t know how long this one’s going to last, but it’s one of the longest ones. In my experience, what we have on average is seven-year cycles and five-year memories, and we might be falling for that trap right now.”

Walker & Dunlop Managing Director John Banas said among the more worrisome parts of the market are players who were not active during the Great Recession, and thus didn't learn its harsh lessons.

"One of the main things we do with our younger developers who didn’t go through the 2007 and 2008 is to protect them from their own worst enemy — themselves," Banas said. “We’re taking deals away from ourselves by giving five-year fixed rates just to protect these developers in the market.”

On the capital side, debt funds have become the most dangerous element to the health of Philadelphia real estate. While banks remain cautious and prefer not to overleverage properties, they are losing out on deals to private sources that are indulging some potentially self-destructive investors and developers. Downey went so far as to call debt funds "the last of the dumb money out there."

The Federal Reserve has indicated that interest rates will continue to rise, and although Thomson said such hikes have not affected dealmaking so far, Terlizzi warned that future spikes could lead to developments failing to hit their pro forma agreements, preventing borrowers from being able to pay off those aggressive loans.

“That could precipitate a liquidity issue, which has happened in the past," Terlizzi said. "So if you see that happen, that will affect prices and values across the board.”

Downey speculated that some debt funds are structuring deals aggressively with full knowledge that they may not be paid back, saying such capital sources "[are] loan-to-own, and they’re happy to own.”

Although the capitalization rates for multifamily transactions this year have dipped below 5%, panelists agreed that the individual deals themselves caused the dip rather than overarching market conditions. 

Since most of the growth that has created these conditions has been in Center City, most of the concerns have been focused there. But one response to the shifting landscape has been looking farther away from the heart of the city for new development.

According to CoStar data provided by Ponsen, the vast majority of multifamily completions between 2015 and 2017 were focused between western Center City and University City. A much higher portion of completions this year and developments still under construction have been in the North Broad Street corridor, South Philly, West Philly and into Northern Liberties.

Post Brothers is among the most aggressive developers in the city in terms of blazing trails into areas without previous track records of development. Its next project, a warehouse conversion at Ninth and Poplar streets, is an example.

The company's strategy is to buy large tracts of land or buildings and use its vertical integration to keep construction costs low, Director of Acquisitions Zak Klinvex said. With ambitious projects filled with amenities, Post Brothers believes in its ability to charge Center City-level rents.

For those seeking new frontiers in development, the creation of opportunity zones in the new federal tax code is an encouraging sign. Though their parameters are vague enough to give most in real estate pause, it has "brought attention to areas that people might not have looked into before,” Hankin Group Chief Operating Officer Michael Hankin said.

But the current market conditions have also put a damper on enthusiasm for those projects, Klinvex said. He estimates that as much as $6 trillion in capital could be waiting to invest in opportunity zones, but as little as 1% of that could wind up being deployed. In many cases, the areas in question are simply too destitute to justify new development, or do not have enough local construction labor that understands the neighborhood, or in Philly specifically, simply can't achieve the rents that construction costs would demand even with the tax incentives.

Developing in opportunity zones remains a secondary problem to the worrying capital market. Optimism is still out there, as with Thomson, who believes the cycle has years left, but that could spell trouble.

“Things are pretty upbeat for the economy right now, but the inevitability [of a downturn] is out there," Terlizzi said. "When it happens, it happens quickly and with very little warning.”