Resilient Twin Cities apartment market faces big test ahead

The record number of new apartments coming online in the Twin Cities has yet to produce a glut of vacant units. But with an even bigger batch of rentals headed toward the market in the coming months, property managers in some parts of the metro are preparing for a chilly winter.

During the first half of year, about 2,245 new market-rate rentals hit the market, but by the end of June the average vacancy rate was just 2.2 percent, according to Marquette Advisors. Even factoring in new buildings still being leased, the vacancy rate was just 2.8 percent, well below the 5 percent point where the market is considered balanced.

But an estimated 3,500 units are expected to hit the market during the second half of the year, posing a new test for the depth of the market, especially in Minneapolis and St. Louis Park.

Signs of a market shift have already emerged in those cities: Buildings are taking longer to fill, incentives are on the rise and at least one developer canceled plans to build a market-rate apartment building in downtown Minneapolis.

"New projects are still absorbing, just a bit slower," said Brenda Hvambsal, vice president of marketing and communications at Steven Scott Management.

She said the M on Hennepin, a 67-unit apartment building that replaced Nye's Polonaise Room in Minneapolis, has been fully leased for several months after opening in November 2017, but she's concerned about bigger projects that will hit the market later this year.

"Overall, our portfolio is doing quite well," she said. "There are a few pockets of vacancy and a handful of concessions."

By several measures, the rental market in the Twin Cities is one of the nation's strongest. In its seventh year of expansion, the vacancy rate in the Twin Cities is less than half the national average and rents are at record highs, according to Marcus & Millichap, making it a darling among national real estate investors.

The firm's third-quarter report showed that the number of building acquisitions in the Twin Cities has doubled over the past two years and that per-unit prices have increased 13 percent over the past three years.

Concessions were offered on about 7.2 percent of Twin Cities apartments in the second quarter, even with the same period last year and about half the national rate, according to RealPage. The discounts equal about a week of free rent.

A combination of factors is driving the robust market, including an increase in the number of people who rent by choice and a healthy economy that's producing thousands of new jobs every year.

During the first half of the year, demand outpaced supply. Renters absorbed 2,800 units while developers delivered only 2,245 new units, according to Marquette Advisors, which only tracks market-rate units.

Demand for income-restricted apartments, however, has been off the charts with yearslong waiting lists in many buildings.

But with thousands of units coming online during what's normally the slowest time of year for new rentals, developers are watching St. Louis Park and several Minneapolis neighborhoods including downtown, the University of Minnesota and Uptown where leasing activity is already slowing a bit.

In downtown Minneapolis, the average vacancy rate increased slightly to 2.9 percent, and in downtown St. Paul it increased to 3.8 percent during the second quarter. That's why construction is shifting to the suburbs, where the average vacancy rate has hovered below 2 percent in many communities.

There's also growing concern about an oversupply of large and expensive units. In downtown Minneapolis, for example, the average vacancy rate for two-bedroom-plus-den units was 4.2 percent compared with 0.8 percent last year.

Building owners are also facing higher financing and construction costs.

With some projects getting more risky and borrowing costs on the rise, the lending market is getting more competitive. And some lenders are asking developers to take larger equity stakes.

Tim Larkin, senior vice president for Dougherty Mortgage, said that lending production is up again this year and unless there are more substantial movements in the capital markets, he doesn't see that changing.

"The underwriting works and the returns for the borrowers are still there," he said. "That said, increases in construction costs can start to erode those returns and that in and of itself can slow down development."

One concern could be the depth of the higher end of the market. "There are only so many people willing or able to pay over $3 per square foot, and based on the large number of units being constructed, it can't be a 'build it and they will come' mentality," Larkin said.

As hundreds of new units open in the Minneapolis downtown core, the depth of the market will emerge.

That's especially true, he said, in Stadium Village and the adjacent Prospect Park neighborhoods near the U, where nearly 1,400 market-rate units are under construction or proposed for delivery between now and 2020.

"We will be closely watching these particular areas, and all of the U submarkets, in the coming years," Larkin said.

Developers are also facing rising prices of steel, wood and labor, putting pressure on developers to complete projects soon.

"From a development perspective, we're feeling pressure to get things closed as quickly as possible," said Shane LaFave, director of multifamily development for Sherman Associates. "Any delay in closing also opens you up to potential construction cost increases."

Such uncertainty prompted Sherman Associates to pull the plug on a 12-story, 152-unit apartment building and a 10-story, 133-room hotel it had proposed on the southern half of a parking lot on 7th Street between 5th and Portland avenues in downtown Minneapolis.

"A project of that size gets quite expensive," LaFave said. "We don't yet know the full effect of the new tariffs on construction pricing, but we're hearing rumblings of substantial price increases on materials coming from overseas."

The company has several large projects in the pipeline and recently completed construction on the East End apartments near U.S. Bank Stadium in downtown Minneapolis.

The project, which includes a Trader Joe's store on the main level, is approaching 50 percent leased about three months from the date of first move-ins. Still, the company is offering $500 and $1,000 Trader Joe's gift cards with leases on some units.

LaFave said the offers are intended to highlight the fact that there's a Trader Joe's in the building and to help support the new store.

"We are very pleased with the lease-up progress so far," he said. "I think you'll see a fair number of properties offer some kind of promotion or concession as we transition into a slower leasing season.

jim.buchta@startribune.com 612-673-7376