The Chicago skyline is seeing more office and apartment developments from 2017 well into 2018 thanks to a significant boost in firms re-locating to, or expanding their presence in, the city. Industry watchers are observing significant inventory growth as well as a year-over-year increase in apartment and office rents. In this commentary, DBRS, Inc. (DBRS) looks at how these market metrics compare with properties within multifamily commercial mortgage-backed securities transactions across the greater Chicago area.
To understand the rapid office and housing development across the city, it is important to look at a variety of factors, including employment, new development and general population changes. Real estate brokerage and research firm Marcus & Millichap recently reported construction and demographic highlights in its Chicago Office Market Report and Chicago Multifamily Market Report for Q2 2018. According to these reports, new office construction activity in Chicago is projected to increase by approximately 37.5% in 2018 to 3.3 million square feet (sf ) from the 2.4 million sf delivered in 2017. The projected increase in new office development is largely driven by large firms looking to increase their presence in and around downtown Chicago. According to the Chicago Tribune, Facebook, Inc. recently signed a 263,000 sf lease in the newly completed 151 North Franklin Street office building, a space that could accommodate approximately 1,000 to 2,000 employees, and many more firms are following suit, potentially bringing higher-paying jobs to the area. Additionally, employment growth in Chicago is expected to remain positive for the foreseeable future. According to the U.S. Bureau of Labor Statistics, as of May 2018, approximately 38,600 positions were created, resulting in a 0.8% increase in jobs year over year. Household growth is also projected to remain positive, with approximately 104,860 new households projected to be created through 2023.
As a result of employment and household growth in the Chicago metropolitan area, new office development in the downtown core and firms looking to increase their presence in Chicago, there has been an increase in demand for more housing developments. According to Reis’s Q2 2018 research report, roughly 6,853 units were built in 2017, with approximately 8,110 units planned for completion in 2018, increasing submarket inventory by 1.5% and 1.7%, respectively. The inventory growth will not have a negative impact on rents. Effective rents have increased by 5.8% in 2017 and are projected to increase further by 1.7% in 2018 and 1.6% in 2019, leaving the market at a reported average effective rental rate of $1,352 and $1,393 per month, respectively. The inventory growth will put pressure on market vacancy rates; however, new inventory is projected to be fully absorbed by 2020. Properties observed within DBRS-rated transactions in the greater Chicago area have almost always exhibited a high occupancy, demonstrating that the need for housing in the metropolitan statistical area (MSA) has been an issue for some time even before the office boom.
There are 283 loans secured by 663 properties that have been securitized since January 2011 through August 2018 within the Chicago MSA. DBRS looked at the metrics of the loans, including average occupancies, which remain quite strong and likely support the current new inventory pipeline. A key measure of risk is the loan’s debt yield (the net cash flow of the property divided by the loan amount). DBRS notes that the debt yields have come down in the recent 2018 originated loans to an average of 8.4%, indicating that the absolute leverage on these multifamily projects has gone up compared with the past. However, the appraised values are resulting in lower loan-to-values. This is an indication that the returns investors are seeking for multifamily properties have reduced over time and could be a result of the favorable outlook for the Chicago multifamily market.
Although Chicago will have to deal with the tax and public service implications of decades of rising public debt, pension increases and pension underfunding, DBRS projects that new office and multifamily development in the Chicago area will stay positive as long as firms continue to expand their presence in the city and job and new household projections continue to increase. Credit metrics for new issuance loans within the Chicago MSA have remained relatively stable over the past eight years, with a recent lowering of debt yields in 2018 originations. DBRS also notes that there is a much higher percentage of full or partial interest-only loans securitized in 2018 through August 2018 compared with loans securitized in 2011 through 2017, indicating a more competitive lending market as well.