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Apartment market: Too good to be true?

Times are good for most of the players in the nation's apartment marketplace. According to industry observers, supply and demand are in balance in most local markets. Financing is readily available for development, acquisition, refinancing and renovation. Buyers continue to come to the marketplace in search of adding apartment product to their portfolios. Meanwhile, owners and managers are coming up with new and successful ways to squeeze revenues from their properties.

The performance of the nation's apartment market, especially during the past two years, has further strengthened apartments' well-established reputation as being the most stable performer of all property groups, according to Jack Goodman, chief economist for the Washington, D.C.-based National Multi Housing Council (NMHC).

Due to the nature of supply and demand in the apartment marketplace, apartments do not have the volatility found in other real estate sectors, Goodman says. "On the demand side, apartments are much more attuned to demographic change than other property types, and the number of people who occupy apartments has increased about 1% annually for the past decade. [On the supply side], the relatively short production time from initial conception to occupancy is less than other product types, which allows developers to react more quickly when there is too much or too little product in the marketplace."

A preferred investment Today's investors like apartments, according to Georgia Murray, senior vice president of Boston Financial, a Boston-based real estate investment adviser. "Because of the lower level of risk and continuing demand, investors continue to want apartments in their portfolios," she notes.

Some investors like what Murray calls the "steady-state" yields offered by this product type, while other investors look to buy and reposition in the market.

"Apartments, along with industrial product, are the most favored real estate investment type in today's market," says Craig Butchenhart, executive vice president of Philadelphia-based Legg Mason Real Estate Services. "There are a lot of investors and institutions that want to make loans on apartments [as well as execute] bridge and mezzanine financing, and some cases enter into joint ventures as well."

There is no shortage of funds available for apartments these days, according to Frank Baldasare, managing director in the Florida office of Chicago-based Cohen Financial. "There is a tremendous amount of capital available for apartment properties, both on the debt and equity sides," he reports.

"Credit crunch? What credit crunch?" asks Robert D. Page, president and COO of Dallas-based developer JPI. "Both the debt and equity markets are open for business."

Among the lenders that have returned to activity in the marketplace since the global financial hiccup of late-1998 are the conduits. But Page notes that conduits are no longer as aggressive as they were in early 1998.

There is also no shortage of buyers in the market looking for apartment product. One of the more active buyers today is Chicago-based Equity Residential Properties Trust, whose nationwide portfolio contains approximately 195,000 units.

"We are buying apartments - maybe not quite as many as in the past, but we are still in the market," says EQR executive vice president Ed Geraghty. "Pricing moves around, so we are getting a bit more discriminating about where we will buy now. We think the best opportunities for us - and we primarily like in-fill locations - are in the Northeast, the northern portion of the Midwest, and California."

Business is brisk at Calabasas Hills, Calif.-based ARCS Commercial Mortgage Co., the nation's largest originator of loans under Fannie Mae's Delegated Underwriting and Servicing (DUS) product line. "Business is better than good - it is fabulous," says company president Howard Levine. "A new kind of buyer is emerging in today's apartment marketplace. What I'm seeing a lot of this year that I haven't in the past are people buying apartment houses with the strategy of doing a significant amount of rehab and eventually repositioning the property to achieve higher rents."

There are a couple of reasons behind this trend, according to Levine. "For one thing, a significant portion of the apartment stock in this country is now 25 to 30 years old," he says. "What has also happened is that a lot of the owners of this kind of product, both the mom-and-pops and even the partnerships, have not been putting in the dollars needed to bring these properties up to 1999 standards and enable them to compete in the marketplace. [As a result], we are now seeing new owners put in $10,000 per door as part of a total rehabilitation - new kitchens, landscaping or upgrading other building features - to essentially create a new project."

Baldasare also sees this as a growing trend. "We are seeing a lot of activity in the Class-B and Class-C apartment sectors, with opportunistic investors buying, renovating and repositioning properties," he notes.

Because the stock market has not treated REIT share prices favorably, NMHC's Goodman says there has been a recent and significant change in the profile of institutional/investment grade apartment buyers.

"Through mid-1988, REITs were the dominant, high bidders for institutional and investment-grade apartment properties," he says. "Since then, though, the market has flip-flopped considerably, with private buyers, pension funds and their advisors being the dominant buyers in most markets for the past two or three quarters."

The slowdown in REIT activity has opened up the apartment investment marketplace somewhat, according to Chuck Brewer, director of operations for Memphis-based LEDIC. "Now that the REIT activity has slowed, prices are not spiraling upward as much," he says. "We have seen a lot of our institutional clients, after staying on the sidelines for the past five years or so, re-enter the market and start acquiring properties again."

However, REITs are still active buyers, says Legg Mason's Butchenhart. "But the pension funds have indeed become more active in the past six to 12 months because of their need to allocate money into real estate, and the fact that the markets and the economy have been so solid," he says.

New development perspectives Compared to just a few years ago, it is harder to make money developing apartments, according to JPI's Page. "The easy deals have already been done, while construction costs, and particularly labor costs, have significantly outpaced inflation over the last several years," he says.

From the REIT perspective, local-market nuances determine whether new development makes more (or less) sense than simply buying existing product, says Equity Residential's Geraghty. "In many markets today, it is difficult to find existing product at prices that are not staggering," he says. "There is either not that much to buy, or the prices are very expensive for older product. So on a return basis, we can compete in those markets with new product."

In-fill sites within existing center-city areas are becoming more popular with apartment investors, lenders and developers, according to NMHC's Clarine Nardi Riddle, senior vice president of government affairs. "Profitable center-city development is a long-term trend that has been moving at a snail's pace, but it is now becoming much more visible," she reports.

A number of demographic studies project a society with a greater proportion of childless households in the not-too-distant future, says Riddle. "A number of our (NMHC's) members are tapping in on that trend and figuring out how to create places to live, work and play in the same place, which is where center cities come to the forefront," she says.

Developing in-fill sites holds several significant challenges for the apartment developer, but the rewards are also there, according to Ken Moczulski, managing director of Houston-based TransWorld Properties. "[Development] can be much more difficult to build on in-fill sites," he says. "Getting the necessary land can require assemblage of numerous smaller tracts with multiple ownerships. Because these sites are typically located in well-established neighborhoods, there are usually more government approvals to deal with."

Moczulski adds that it is challenging to build a project in the congested areas where in-fill sites are located. But when complete, in-fill apartment projects pay off. "In today's market, these projects have a bit better profit margin compared with suburban properties," says Moczulski. "The rents are higher, and when investors look at an in-fill project, the cap rate some will pay will be lower, because they recognize the high barriers to entry for competing projects."

"Generally speaking, the closer-in deals are harder to get done," adds JPI's Page. "But while they require more time and money in the predevelopment cycle, their returns justify their increased risk profile."

"There is no question that many investors will pay top dollar for in-fill projects," says Legg Mason's Butchenhart, cautioning investors to not write off sites in the wide-open suburbs. "It all depends on what suburb you are talking about - for example, Philadelphia's suburbs are strong as hell. Finding an appropriately zoned, buildable, suburban ground in a lot of markets in the East and the Mid-Atlantic is also difficult. But the economies down [in the Sunbelt suburbs] are very strong. So while there may be some temporary problems with oversupply, the economies will probably bring things back into balance pretty quickly."

"Lenders are taking a more careful look these days at where projects are located," says Ed Geraghty. "They are a lot more skittish if a deal is in an outlying suburban location with a lot of competition, while they are much more amenable to most in-fill locations."

The affordable housing sector of the apartment marketplace is also particularly active, according to Boston Financial's Georgia Murray. "Affordable housing has been a significant growth market since the early 1990s," she says. "The Low Income Housing Tax Credit (LIHTC) program has worked so well, and the market has been so resilient that investors have been very anxious to get involved, which has allowed the credit to operate more efficiently, and more affordable housing has gotten built - which is good for everybody." (For more information on affordable housing, see "IRS to modify compliance monitoring standards," p. 62).

In Washington, the pressure to raise the state-level volume limits of the LIHTC continues, according to NMHC's Jim Arbury. A bill to increase this limit from its current $1.25 to $1.75 has more than 200 co-sponsors in the House of Representatives, he reports. "Prospects for passage," says Arbury, "are 50-50 at best."

Meanwhile, state-level caps for tax-exempt bonds aimed at financing affordable housing are set to increase from $50 per-capita and $150 million annually to $75 per-capita and $225 million annually in 2003. A move is underway in the House to make this increase effective in 2000, says Arbury, with prospects for passage also pegged at 50-50.

Changing management roles Once consigned to being a care-taking function done as cheaply as possible, effective management has assumed a majorrole in maximizing the returns owners garner from their apartment investments. "The focus of the apartment business now is more on managing what you have, and less on acquiring new properties," according to Jay Harris, NMHC vice president of property management. "There is a growing recognition that the ability to manage what you have better than your competitor is going to be what distinguishes you as a good performer."

With a constant stream of new units coming online, and the self-managing REITs holding steady with a 5% to 10% share of the total market, times are good for fee apartment property managers, says Harris. "The REITs have done a good job managing what they have," he adds. "But, the vast majority of the market is still available for third-party management."

These managers are on the hot seat these days, according to LEDIC's Brewer. "As fee managers," he says, "we live or die by our ability to make apartment operations profitable."

Brewer also says maximizing profits from apartment operations has actually become easier during the past several years because of the people in the profession. The turmoil the apartment industry went through in the 1980s, engendered first by tax law changes and then by economic recession, shook the management end of the market up positively.

"Throughout the management business, on-site managers used to be people without a lot of business training, while maintenance personnel were little more than handymen," says Brewer. "What emerged from these times was a much more savvy group of on-site managers. We now have a group that knows the difference between physical and economic occupancy, realizes how important it is to be aware of what is going on in the marketplace, and is much better trained at watching the bottom line. Maintenance people are now professionals in their own right, many of them specialists with certifications."

Today's on-site managers need to have a couple of major qualities to be successful, notes NMHC's Harris. "What they need the most is the ability to look at running an apartment property, or a region, as they would a small business," he says. "They need to be able to make intelligent decisions about a variety of issues, such as when it makes sense to upgrade a property, or whether it is time to sell. Now more than ever, there is a need to sell ancillary products, which makes marketing skills more important for managers and leasing agents than ever."

Now that owners realize that good people in management roles pay dividends, they are faced with a shortfall in the availability of these professionals. "There is a definite shortage of labor at all levels of apartment property management," says Harris. "The star performers are much more likely than they were 10 years ago to be looking at opportunities on a regular basis, and moving to other companies - or other industries. Retaining these people is now more important than ever."

New services, new income streams Many apartment complex owners and managers are climbing aboard the "ancillary services" bandwagon, selling tenants a variety of outside vendor-supplied services that generate new, non-housing income streams and create a marketing advantage. This field has grown rapidly during the past several years to include a number of items, according to NMHC Housing/Finance vice president Steve Lefkovits. The term "ancillary income" now encompasses income received from cable TV, telephone, Internet, ATM, water sub-metering, vending, concierge, leasing rooftop rights for transmission antennas and, "anything else that is an operating business or revenue-generating amenity that is not traditionally linked to the payment of rent," he says.

For example, Atlanta-based Post Properties (NYSE: PPS) recently entered into a marketing alliance with Atlanta-based telecommunications firm BellSouth. Under the agreement, Post leasing agents will exclusively market BellSouth local phone service to residents of selected apartment communities. The program includes 44 communities (18,309 units in Georgia, Mississippi, Tennessee, Florida, and North Carolina) comprising approximately 60% of the Atlanta-based REIT's portfolio. BellSouth will also serve 11 of these properties with its Fiber in the Loop (FITL) product, a fiber-based broadband service enabling users to maintain continuous, high-speed connection to the Internet.

Third-party managers are finding more success in negotiating these kinds of transactions with vendors, according to LEDIC's Brewer. "We are finding that cable and telephone companies, for example, are much more receptive," he notes. "Because of the economies of scale we offer, due to the number of units we manage, fee managers can offer these vendors as good, or better, deals than the REITs can."

Apartment owners and managers need to do some homework before they rush headlong into the ancillary services arena, warns Lefkovits. "It is very important for them to have a clear idea of what services their tenants want," he says. "They need to determine exactly what kinds of services will meaningfully differentiate their properties from those around them and then they will be ready to go to the vendors and negotiate."

"With all the start-up companies in the telecommunications field, you have to be careful about the vendors you go with," says Equity Residential's Geraghty. "A lot of them are very good when it comes to ideas and marketing, but many are not yet big enough to deliver as much service as they promise."

Strong market outlook For the balance of 1999, "I think the risks are greater that we will build too much new apartment housing, as opposed to too little," says Jack Goodman in the latest NMHC Multifamily Outlook. "The production numbers for this past January and February are at the top end of the range we have seen during the past several years. This means that we are probably producing a bit more than we need. But, having said that, we are nowhere near the disastrously high levels of production that we reached in the mid-1980s. It is hard to see how to see how the next year or two could be much better for the apartment industry than the past few years have been."

Although caution may be called for during the next couple of years, the long-term view from NMHC is positive. During the next 10 years, Goodman adds, a growing group of young-adult and single-person households should favor demand for apartments and help multifamily rental housing maintain, and perhaps slightly increase, its share of the housing market.

"I think the market will remain strong," agrees Butchenhart. "In our crystal ball, we see a national economy that looks like it will remain healthy, and interest rates that will remain low. And with low interest rates and a good economy, I don't see any reason why the apartment market shouldn't remain very strong. What we see is that continuing economic growth should be satisfactory in absorbing the new units that are being put up."

"We see most markets as being very tight, very strong, with rentals that are moving up," adds Levine. "Some may be getting a little too much in the way of market-rate construction - we're watching markets that include Reno and Las Vegas, for example. The affordable market is the real growth arena and appears to be doing fine nearly everywhere."

"Look for more consolidation [in the public company arena], as those REITs that can make the most of the efficiencies and economies of size tend to distance themselves from their competitors," says Geraghty, adding that investors can expect the REIT share of the market to increase steadily over time. "This is part of the broad trend toward the securitization of all forms of real estate. This provides a more efficient means for financing, which has always been a big driver for change in the real estate marketplace."

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