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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   February 2019

Smaller Cities Have Big Potential

Capitalize on multifamily-housing needs in lesser-known markets

Smaller Cities Have Big Potential

The past decade has ushered in a new age of the American city. Economics, demographics and lifestyle preferences have fueled this shift, which has afforded many small and midsize cities the chance to reinvent themselves. These changes can be seen in places like Birmingham, Alabama, where the decades-long trend of a languishing downtown has been reversed. The 2020 U.S. Census could mark Birmingham’s first net population gain since the 1950s.

Several other Southeast cities are in the midst of a population boom and the accompanying maturation of their multifamily-housing markets. As commercial mortgage brokers and their clients align their business goals with financing in a few of these secondary and tertiary markets, they also should explore why roughly 80 percent of the U.S. population lives in a city.

The American dream has long been intertwined with visions of homeownership. But things have shifted. For many of the younger members of the U.S. workforce, the American dream is now a downtown view with a short walk to the office, gym, restaurants and nightlife.

Millennials began flocking to cities to chase work during the Great Recession. So, developers responded with lifestyle assets flush with amenities in urban neighborhoods. This positive feedback loop resulted in more companies realizing that cities were attracting their desired workforce.

Amazon’s recent decision to split its second headquarters between Long Island City in Queens, New York, and Crystal City, Virginia, outside of Washington, D.C., is just the latest demonstration of the power of growing metroplexes. The growth of cities — and their apartment markets — is not based on sentiments alone, however.

A rise in renters

Economic factors such as student-loan debt, a lack of entry-level single-family homes and rising interest rates have stifled homeownership. College graduates in the Class of 2018, for example, walked off the stage with a diploma and an average of $39,400 in student-loan debt.

If the headline of a recent Trulia research piece, “The American Starter Home: Expensive, Small, Broken Down, and Hard to Find,” doesn’t make the case clearly enough, the data points certainly do. From 2012 to 2018, the inventory of starter homes declined 49 percent while prices rose 58 percent. There also is the fact that we are in the midst of a rising interest rate environment, with the average 30-year, fixed-rate mortgage increasing by about 90 basis points from November 2017 to November 2018.

Demographic factors like delayed parenthood mean that traditional triggers for home-purchase decisions are occurring later in life. On average, women are having their first child at age 28, compared to as recently as 2014 when 26 was the average, according to the Centers for Disease Control and Prevention. Furthermore, the fertility rate — the number of births a woman is expected to have during her childbearing years — has declined to an all-time low of 1.76.

This decrease is weighted toward cities, with fertility rates dropping 18 percent in large metro areas, 16 percent in small and midsize cities, and 12 percent in rural areas from 2007 to 2017. Smaller households mean that new parents might be comfortable in a two- or three-bedroom apartment for the long term, rather than fleeing to the suburbs for more bedrooms and a yard.

When we combine all these factors, it’s easy to see why many think a mid-60 percent homeownership rate — 64.4 percent as of third-quarter 2018 — is the new normal. It could actually be a return to normal, since a mid-60 percent homeownership rate was standard from the mid-1960s to mid-1990s.

Competitive small cities

Untethered by homeownership, a younger professional workforce is converging on cities and is generally staying longer. This phenomenon is not limited to gateway cities or primary markets. Secondary and tertiary cities are expanding as well.

Commercial mortgage brokers should refer to the chart accompanying this article that features select Southeast U.S. cities that lenders are closely watching to ensure that their maturing multifamily markets are well capitalized. These cities are ranked by percentage changes in population from 2010 to 2017. Note that with the exception of Charlotte, North Carolina; Jacksonville, Florida; and Atlanta, many would be classified as “small cities.” Each market has its own unique growth story.

Charleston, South Carolina, for example, continues to grow as a tourist destination and has seen recent investments from Volvo and Mercedes-Benz.  In Greenville, South Carolina, companies like BMW, Michelin and Fuji have created a manufacturing hub at the midpoint between Charlotte and Atlanta — two of the fastest-growing cities in the country. As a result, downtown Greenville is booming with mixed-use developments and some residents are commuting out of the city for work so they can take advantage of the draw of city life.

Moving south, Toyota and Mazda last year announced a $1.6 billion plant in Huntsville, Alabama, a move that should add roughly 4,000 jobs. Further toward the Gulf of Mexico, places like Gulfport, Mississippi, continue to bounce back from Hurricane Katrina and the Great Recession.

With a federal mandate to create 1,300 jobs by 2021 in exchange for $570 million  in grants from the U.S. Department of Housing and Urban Development, the Port of Gulfport recently secured a significant win. A new compressed gas liquid (CGL) production and export terminal operated by SeaOne Holdings is set to bring hundreds of jobs to the area.

Regardless of which program makes sense for a given market, it is always worthwhile to explore green-incentive programs that can reduce interest rates and increase loan proceeds.

Multifamily owners and operators are welcoming renters in all locations. For lenders, however, running a portfolio in a smaller city comes with its own set of challenges. Take Murfreesboro, Tennessee, as an example. Located about 35 miles southeast of Nashville, Murfreesboro is one of the fastest-growing cities in the country.

After permitted multifamily developments increased from 445 units in 2016 to 1,233 in 2017, a concerned city council adopted a moratorium to limit apartment construction to certain areas and cap new developments at 100 units. Although cities of all sizes face these growth restrictions, multifamily owners and investors — and the mortgage brokers representing them — face unique challenges when providing financing in some of these smaller, yet growing, cities.

Financing that fits

Although the economic and demographic factors cited above certainly present a strong case for multifamily investors who are looking to expand into a new market, these smaller metro areas can be capital-constrained when compared to larger cities. A national bank or lending institution, for instance, may not be familiar with the robust higher-education and health care market dynamics in a place like Tuscaloosa, Alabama. A community bank may be willing to look at a deal, but only if there is an existing relationship with the potential borrower.

On the other hand, the government- sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, as well as loan products from the Federal Housing Administration, work on a national basis, regardless of market size. Because smaller markets typically feature smaller developments and a lower price per unit than major metros, many deals can be served by loans in the small-balance range of $1 million to $7.5 million.

Multifamily owners in these markets are often surprised to find that a $5 million deal fits within a nonrecourse “small loan” program. Such programs typically offer reduced upfront costs, streamlined servicing reports and competitive terms for both acquisition and refinancing purposes.

Mortgage brokers and borrowers should pay close attention, however,   to the subtle differences between Fannie’s and Freddie’s small-balance loan programs when consulting with  a commercial mortgage lender on a  customized financing solution. Although  both agencies have good programs, one may be a better choice for a  particular investment strategy based  on requirements for the debt-service coverage ratio and  market-size classifications.

Regardless of which program makes sense for a given market, it is always worthwhile to explore green-incentive programs — Green Rewards through Fannie Mae and Green Advantage through Freddie Mac —that can reduce interest rates and increase loan proceeds by 5 percent to cover retrofits that reduce water and energy use. These programs serve to improve the “triple bottom line” by benefiting the “three Ps” — people, profits and the planet.

Utility savings can be passed on to tenants, while the green improvements create jobs and make the local community more resilient. With decreased operating expenses and reduced financing costs, it’s easy to see how profits are improved. And, of course, conserving water and energy helps reduce greenhouse-gas emissions and preserves limited natural resources.

Eligibility requirements for the GSEs’ green programs increased slightly in 2019  under new Federal Housing Finance  Agency guidelines. Borrowers must now be able to project a reduction of energy and water use of at least 30 percent for the whole property, and at least half of that reduction must be in energy consumption. In previous years, the target was 25 percent, with no formal energy-reduction requirement.

•  •  •

A new era of American urbanism means that a greater portion of the population will continue to rent. As a result, national and regional multifamily owners and operators are exploring new markets. Commercial mortgage brokers and borrowers have more options than ever to secure competitive financing, but they should partner with a lender that understands how the minutiae of deal structures are crucial for obtaining the best possible terms the market can offer.


 
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