Chicago: Apartment building sales headed for record year

Sales of major apartment buildings in both downtown Chicago and suburban areas are headed for another record year, but beyond that it’s been a tale of two markets.

Over the past five years, annual sales of apartment buildings in Chicago’s suburbs have increased more than fivefold, reaching a record $1.1 billion in 2006, according to market studies conducted by two Chicago firms. This total was nearly double the volume of sales in Chicago proper, which reached $610 million last year.

Now the two market sectors may be headed for a role reversal, with sales of apartment buildings in downtown Chicago picking up and suburban sales flattening. For 2007, the suburbs look to equal last year’s $1.1 billion, while sales in downtown Chicago appear on course to easily pass the former $1.1 billion record, and possibly even reach $1.5 billion.

John Jaeger, first vice president at CB Richard Ellis and author of its “Chicago Apartment Market Transaction Trends” report, said that while demand for downtown Chicago apartment buildings has always remained high, it has been a lack of available properties that tempered sales recently.

But with several major projects in downtown Chicago announced or in the early planning stages, Jaeger foresees a significant infusion of new apartment buildings coming to market over the next few years.

“I expect at least 1,500 [total] new rental units a year through 2010, including this year,” Jaeger said. That means several rental buildings will come on the market every year in Chicago, where it is a common practice for developers to erect a building and sell it in short order.

Projects include a mixed-use high-rise development of 650 rental apartments as well as condominiums, hotel rooms and 1 million square feet of retail space on a vacant site at the downtown fork of the Chicago River. Another project — the nearly 500-unit Streeter Place — is under way in the Streeterville area just east of Michigan Avenue.

It’s a different story in the suburbs, said Ron De Vries, vice president of Appraisal Research Counselors and co-author of his firm’s “Benchmark Report,” which tracks sales of major Chicago-area apartment buildings. The suburbs frown on developers coming in to build rental apartment buildings, De Vries said. “Their preference is condos. It’s incredibly difficult to get a site zoned for multifamily rental use. The developers want to build it, but they just can’t get the sites.”

In a transition that may mark a sea change, institutional investors have replaced condo converters as the main buyers of apartment buildings in both downtown Chicago and suburban areas. That’s because the condo market, except for very high-end units, has been overbuilt.

“Because the condo conversion market has slowed down so much, we’re not seeing the number of buyers out there [for conversions] like we were seeing a year or two ago,” De Vries added. “The income buyers have really taken up the slack.”

Key suburban markets include Naperville-Aurora in Du Page County to the west and the Schaumburg-Arlington Heights area in northwest Cook County. North suburban Lake County also remains solid. Those areas have traditionally been strong rental markets because of their proximity to large corporate headquarters and major office buildings.

Pete Evans, a partner with Moran & Company, a brokerage firm based in Chicago that specializes in selling apartment buildings, said that institutional investors are increasing their allocations for real estate because rental buildings represent an attractive risk-adjusted return with relatively low potential for problems. Whereas only several years ago the real estate allocation within institutional investors’ portfolios was only 2 to 3 percent, recently it has increased to as much as 10 to 12 percent.

“This is the strongest market the Chicago area has seen in six years,” Evans said. “Operations are improving; there’s been real effective rent growth over the past 24 months.” That is creating something of a virtuous circle, at least for the owners of rental buildings.

The scarcity of rental apartments, De Vries said, has led to higher rents, the end of such concessions as a month of free rent, and occupancy rates that remain in the mid-90 percent range.

Substantial reductions in real estate taxes in Cook County are also working to increase the returns on apartment buildings. This is motivating owners to shun condo conversions and boosting the interest of pension funds and other institutional investors in the buildings.

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“The institutional investors are now looking for more real estate [and] accepting lower returns,” De Vries said, noting that acceptable capitalization rates have dropped to the 5.5 percent-or-lower range from 7 percent a couple years ago.

That also has led to owners of apartment projects to offer their buildings for sale. Many of them had previously shied away from marketing their properties because they thought the high interest rates and the condo downturn would depress the value of their buildings.

“We’re seeing a lot more Class A and B-plus buildings coming on the suburban market now,” De Vries said.

Condo conversions had such a negative impact on the availability of rental units in Chicago and nearby suburbs that Cook County Assessor Jim Houlihan convinced the county board to lower the assessment level for larger apartment buildings. He became alarmed as a decade-long wave of condo conversions reduced the number of rental apartment buildings by 27 percent. In a process that began in 2002, Houlihan proposed lowering the assessment level on apartment buildings to 26 percent of market value from 33 percent. Early last year, the County Board approved his plan to phase in further reductions to 20 percent by 2008, for a total reduction of nearly 40 percent.

Evans said the slow absorption rate of recent condo conversion projects has also discouraged condo converters from paying the high prices that they were willing to pay for rental buildings in the past. Still, he added, institutional buyers have kept bidding activity strong and the market attractive to sellers.

“It’s been very aggressive,” Evans said. “When you have a good-quality Class-A product, there’s a lot of money chasing after it.”

Evans recently brokered the sale of the Streeter, a 481-unit rental apartment building in downtown Chicago. That building fetched $212 million from the Ohio State Teachers’ Retirement System. The Streeter drew plenty of bidding activity, almost exclusively from institutional investors.

Another large deal downtown was for the 2,346-unit Presidential Towers in the West Loop area, which was bought for $470 million by the California State Teachers’ Retirement System and Chicago-based Waterton Associates.

And in a key development, London-based real estate investment adviser StratREAL purchased the 56-story Grand Plaza East Tower apartments in the River North area of Chicago for $262.5 million earlier this year. The deal, completed for investors in the Middle East, marked the first major Chicago apartment property to be sold to offshore investors.

That, Jaeger said, signals foreign investors may be entering the Chicago-area apartment market for the first time and creating additional competition for prime apartment properties.

“[In the past] they didn’t understand the market,” Jaeger said, “because apartment [rents] are highly regulated in Europe and elsewhere” where they’ve previously invested.

But in the Chicago area rents are expected to continue their upward trend, with an increase of 5 to 7 percent this year, making the potential for healthy returns for investors far greater.

In addition, Jaeger said, the number of 20- to 30-year-old buildings on the market offer substantial potential for “value-adding” — major upgrades to properties that can inflate rents even further.

Figures compiled by Jaeger bear out the increased value of investments in apartment buildings.

During the first six months of 2007, the average sales price of a unit in the Chicago area rose from $113,000 to $164,000, an increase of about 45 percent. The average price per square foot also rose, from $125 to $198, an increase of almost 60 percent. Total transaction volume rose by more than two-thirds to $1.5 billion from about $870 million. And it is headed toward a projected $2.5 billion.

The market for rental apartment building sales has been so strong and condo market so slow, in fact, that Jaeger sees potential for condo “reversions” — the return of buildings or parts of buildings to rental units from condos. Just another turn in the virtuous circle.