Challenges with Appraising in the Secondary/Tertiary Multifamily Rental Market.

Author:Kimball, William J.


This article concerns the valuation of investment-grade and non-investment-grade apartments within secondary/ tertiary markets. Despite access to increasing amounts of statistical data via the internet through national data sources, values still are primarily derived by local market activity. Outside information, however, can be supportive in some cases in valuation in secondary/tertiary markets. In this article, both local and national trends and patterns are analyzed to demonstrate how trending values and rates can be used to augment the typical valuation. Similarities and differences in local and national data are discussed as well as specific statistics. In the end, opinions of value can recognize both local and national indicators to better understand real estate values in local markets.


The apartment market has been white-hot throughout most of the United States since 2010. The statistics are plentiful--from local newspapers, REITs, brokerage firms, accounting firms, and appraisal firms. Nationally, capitalization rates have steadily decreased and per-unit pricing has increased significantly. What is harder to quantify is the market activity in secondary/tertiary markets. Do non-primary markets parallel activity in major cities? And if so, what type of premium or discount is demanded from the market?

Appraisers may be faced with resolving such issues in a local appraisal assignment. For example, suppose an appraiser receives a call from Megga Bank about an appraisal that is needed as soon as possible. A local borrower has a 160-unit apartment complex under contract of sale and the only thing reportedly holding up the sale is the appraisal. The complex is one of the nicest buildings in the local market, and it is located in an area where most of the new commercial activity has occurred lately. The buyer has done his homework; he has gathered market studies and capitalization rates from the region, which point to a capitalization rate range just below 6%. Regional sales are as high as $185,000 per unit. With an indicated price of $ 190,000 per unit and a capitalization rate of 6.15%, the buyer believes he has a good deal. The bank wants to support this customer and asks the appraiser if he agrees with the buyer's evaluation of the property in this market. The banker asks the appraiser point blank, do you think this deal will fly? This is certainly not an easy question to answer, but it can be a considerably less daunting task with the proper data in hand. Keep in mind that it is not just the data itself, but the nuances that come with the data that are key to providing a meaningful answer to the client.

The national apartment market contains approximately 11.1 million units, with about 200,000 to 250,000 new units added annually. (1) Vacancy levels have remained at 4.5%+/- for several years, with rents increasing 3% to 5% per annum. However, according to the Emerging Trends in Real Estate 2019 report, (2) vacancies could surpass 5% in the near future.

In many larger cities, apartments are the most prevalent housing. Construction and demand have increased in markets but to different degrees. New single-family housing development has gone by the wayside in most urban and suburban markets, though recent hints of its return are evident. The millennial cohort has firmly established demand for upscale housing with uber-amenities, high walkability, and interconnected urban-chic housing in high-energy neighborhoods. This demand continues despite full employment with improving wages, which historically would have redirected young adults toward home ownership and the American dream. (3)

In the current real estate cycle, apartment construction peaked at 386,000 unit starts in 2015 nationally. (4) According to Dodge Data and Analytics, the volume of commercial and multifamily construction starts in the United States was approximately $200 billion annually from 2016 to 2018. (5)

At the same time, the apartment market is a solid investment relative to alternative investment vehicles. The multifamily sector remains popular, with about $153.0 billion in sales in 2017, ahead of the office sector at $132.3 billion in sales for the same year. (6) Only the industrial market of late has shown increased levels of transactions nationally (+22% according to Real Capital Analytics); all other real estate sectors have shown slight declines from peak levels. As the primary markets become saturated with new development, value-added activity, and investments, the secondary markets have seen increased investment activity.

Local and National Data Comparison

The appraisal of an apartment building was once confined to research on local comparables within the same metropolitan area. This task has been transformed, however, into a complex financial analysis. It has been supplanted with the never-ending gathering of new and improved information. Web-based national data sources--such as Reis, CoStar, and Real Capital Analytics--easily provide information that brings investment options in Dallas alongside those in Buffalo. Readily available national data provides another tool for the appraisal of a local apartment building.

Local Valuation

In terms of the local valuation of multifamily property, the analysis is both simple and complicated. Simply put, the national statistics are not directly applicable. Do they support trends in the property type and give direction of local indicators? Absolutely yes. Can they be directly applied to the local property? Absolutely not--a secondary/tertiary market has economic dynamics that do not compare to those of larger, more active markets.

The national overall capitalization rates summarized within surveys have varied as much as 235 basis points during the past two real estate cycles, while the local capitalization rates have varied by only 134 basis points. The national data reflects hundreds of sales and depicts a more detailed picture of the larger market. The local sales data has a more limited base, resulting in a more scattered representation. Clearly, the sales must be dissected individually to create credible comparisons. Those sales with similar-sized complexes and having similar ages, locations, and amenities must be investigated. A 50-unit complex built in the 1960s with a common boiler is obviously not comparable to a modern 200-unit project with pool, dog wash station, in-unit washer/dryer hookups, and individual HVAC units. Data representing average pricing typically includes all types of sales with such amenities; and the smaller the data sample, the greater the impact of a divergent sale.

Despite these differences, the urge to compare numbers is great, especially in the current environment where investing in real estate has gone beyond trendy. Data comparison is critical to facilitate transactions. Although the data can be plentiful, the application can be complex. The vast majority of the data pertains simply to capitalization rates, which investors strongly rely upon. At the same time, appreciation has become not only investors' friend, but their crutch. National purchasers are rarely satisfied with current cash flow returns for the long term. Regardless, the combination of strong historical trends and appreciation and little recognition of irrational exuberance has become the norm in the current cycle.

Comparison of Capitalization Rate Data

The most common means of apartment valuation is the income capitalization approach to value. The Appraisal Institute describes the income capitalization approach as "specific appraisal techniques applied to develop a value indication for a property based on its earning capability and calculated by the capitalization of property income." (7) Investors are typically concerned with the future income potential of a property and the reliability of that income stream. Considerations include the durability, variability, and stability of the income. In addition to supply and demand, the analysis examines risk factors such as vacancy increases in the market, anticipated capital expenditures for the subject property, tenant turnover in the market compared to the subject property's history, changing tides of investors (both local and national), interest rate fluctuations...

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