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Mr. Fix It

It's a brutally competitive climate for multifamily investors hunting for assets these days. Just about anything with walls and tenants has unsolicited bids on it. In the first 11 months of 2006, apartment sales transaction volume reached $78 billion and was on track for the year to easily surpass the record $88 billion total notched in 2005, reports Real Capital Analytics (RCA). The heavy deal velocity continues to drive up prices and lower capitalization rates, a troubling situation for yield-hungry investors.

From the end of 2003 through November 2006, average cap rates for stabilized assets, as tracked by RCA, fell from 7.4% to 6%. In scorching markets like Manhattan and San Diego, average cap rates in November ranged between 4% and 4.5%.

Unwilling to outbid the competition for core assets that offer little upside potential, a growing percentage of well-capitalized private investors, institutions and even REITs are buying underperforming properties and embarking on a major capital improvement program.

If executed properly, this value-added approach that relies heavily on debt financing stands a better chance of providing double-digit returns in the long run, say industry experts. But these deals also are riskier because they are highly sensitive to economic swings, in addition to project cost overruns or delays.

Searching for value

“Many real estate investors believe that you make your money on the buy. But if you're spending a fortune to lock in a core apartment property, the growth is already baked into the deal,” says Daniel Steinberg, managing director of Manhattan-based The Prescott Group LLC, which owns a $150 million apartment portfolio scattered across the nation.

As of late December, The Prescott Group owned 17,000 apartment units, primarily acquired as value-added deals. The company invests in commercial properties on behalf of several wealthy families and trusts. In 2004, The Prescott Group forged a partnership with the London-based Gordon P. Getty Family Trust to invest in all major property types.

“We believe the best way to play this market is to acquire older or tired properties and renovate them. Investors are aggressively looking at creating this kind of value in a deal,” Steinberg says. Typically, the company will buy assets and hold them for five to seven years. The company also prides itself on generating outsized returns in excess of 20% on the back-end of an investment.

Just what constitutes a value-added deal? RCA defines it as a property with higher than 12% vacancy, or one that requires major capital improvements upon purchase. With the average age of apartment buildings now 30 years in major U.S. markets, the inventory of potential value-added deals is growing, reports real estate research firm Reis Inc.

Yet just 7% of all investment sales volume in the multifamily sector in 2006 qualified as value-added deals, according to RCA. In 2005, these deals accounted for 10% of all sales, proving that the lion's share of capital is still piling into stabilized assets.

Judging by pricing trends in the marketplace, however, it appears that a growing number of investors are competing for these non-core deals. Average cap rates have dropped more than 200 basis points — from 7.7% to 5.6% — over nearly a three-year period ending in November 2006 and are now slightly lower than cap rates on core properties.

Voice of caution

Renovating and repositioning tired assets at a substantial cost means that investors are banking on future growth. But when apartment units are upgraded, will tenant demand be strong enough to absorb those units? What will be the overall health of the economy and state of the delicate balance between supply and demand locally?

“It's so competitive out there for value-added deals right now that many investors are making aggressive assumptions about projected rent growth,” says Dr. Sam Chandan, chief economist at Reis Inc., who warns that extreme optimism may be clouding some investors' judgment.

Chandan expects a flood of condos-for-rent to dampen rental growth in 2007. He's also calling for a jump in new completions to slow the pace of rent growth. While he expects the final tally on 2006 asking and effective rents to show 4.1% and 4.2% growth respectively (year-end figures weren't available in late December), he anticipates slower growth in 2007. Chandan predicts that asking and effective rents will grow by 3.4% and 3.6% respectively in 2007.

The trend in lower cap rates for non-core deals is something to monitor, says Chandan. “You just can't ignore capitalization rates. It's really one of the most critical issues in the apartment market today, so we're telling our clients to be careful with these deals if the economy softens.”

But Doug Poutasse, chief investment strategist at Boston-based institutional real estate advisory firm AEW Capital Management, believes that it's only natural that cap rates on value-added apartment deals today are lower than cap rates on core properties.

“When the amount of capital exceeds the supply of available properties, investors are forced to take on more risk,” says Poutasse. “This is an opportunity to take a low cap rate and grow it as high as 7% after a renovation or repositioning.” AEW manages more than $34 billion in commercial real estate assets for large pension funds and endowments.

Ultimately, timing is everything for value-added deals. If the economy continues to post modest growth in 2007, then the wisdom behind many of these apartment deals would be validated. Rather than muddling through a soft economy with a core asset generating decent rents, value-focused investors could be in a position to sell their upgraded properties into a rising tide of demand.

Leveraging to the hilt

For The Prescott Group, its investment strategy goes beyond simply buying, refurbishing and operating rental units. Last summer, the apartment owner bought three townhouse communities in Greenwich, Conn., that were only 25% occupied at the time. The new owners financed more than 80% of the acquisition through debt financing.

Instead of simply renovating the units, The Prescott Group began converting all 34 into high-end condos. Approximately $2 million of the $55 million acquisition cost was earmarked for renovations.

The owner's game plan? “Our value-add here will be taking these rental units and upgrading them into condo units. We know it's late in the game to be doing condo conversions, but we like the Greenwich market,” says Steinberg.

He expects to generate returns in excess of 20% upon selling the former apartment properties in Greenwich. Some of the units will continue to be rented during the renovation, allowing The Prescott Group to generate some cash flow from the units before they are ultimately sold.

Private buyers like The Prescott Group typically use loads of debt to finance their deals, and their exit plans typically involve selling the property within three to five years as a core asset. “You definitely see the value-added players seeking the most debt on these deals,” says Andrew Weiss, managing director at Meridian Capital's Maryland office. In the Maryland region alone, the New York-based lender has financed roughly $75 million in deals so far this year. Weiss says that most of those were non-core plays.

“On a value-added deal, many of these investors are getting 80% leverage plus mezzanine debt to fill the gap,” says Weiss. Thanks to enthusiastic mezzanine lenders, Weiss says it's not uncommon for borrowers to place as little as 2% of their own equity into one of these deals today.

As risky as that may sound, Weiss doubts that lenders will foreclose on many value-added apartment buildings in the coming years. He believes the weight of capital pressing into the market isn't about to dry up at the first sign of distress.

“There's just so much money out there. I think more investors will see the upside of levering up to do value-added deals, too,” says Weiss.

Who's buying?

Private investors gobbled up 65% of all apartment acquisitions through the first 11 months of 2006, reports Real Capital Analytics, and they are also leading the charge into value-added deals. Undertaking a major renovation or repositioning can take several years, so closely held sponsors bearing patient capital gravitate toward these deals.

But some large institutions and publicly traded companies also are embracing this investment strategy. Two of the biggest are pension fund CalSTRS and apartment REIT AvalonBay Properties.

REITs that own and manage commercial real estate have historically shied away from pure value-added deals. But last year, apartment REIT AvalonBay Communities (NYSE: AVB) launched its $950 million AvalonBay Value Added Fund LP.

The goal: buy and refurbish tired rental properties, and then apply AvalonBay's well-regarded management discipline to each asset. The company has generated 21% average annual returns to shareholders over the past five years, and analysts credit AvalonBay's expertise as an owner and developer of Class-A rental properties as the main reason.

“AvalonBay's core strategy is ground-up development, but it has done value-added deals on the side in recent years,” says analyst Alexander Goldfarb of UBS Securities' REIT group. Goldfarb says that AvalonBay has used joint ventures to complete several large non-core deals.

As of mid-December, AvalonBay's Value Added Fund owned 10 properties, all of which were garden-style or high-rise properties located in the Midwest or Mid-Atlantic regions. The strategy harkens back to the mid-1990s when AvalonBay bought several Class-B and Class-C apartment properties and upgraded them into Class-A units.

“Most of the apartment REITs have focused on core assets in coastal markets,” adds Goldfarb. “They also can't apply 75% to 80% leverage toward a value-added deal the way that a private player can.”

New entrants

Private buyers may dominate the value-added arena. But some large institutional players such as pension funds also are testing the value-added waters. Why now? With market growth on the upswing, the strategy makes sense to pension funds.

“The fundamentals are very positive for value-added deals,” says David Schwartz, managing member of Chicago-based Waterton Associates LLC. His firm invests on behalf of large institutional clients such as CalSTRS, the nation's third largest pension fund.

Earlier this year, Waterton launched its second joint venture fund with CalSTRS: a $1 billion vehicle that invests in value-added apartment properties throughout the nation. Schwartz says the fund had deployed roughly $430 million into such deals as of mid-December.

Waterton likes to buy properties and upgrade them to core status before unloading them. Lately, however, demand for value-add has been so strong that Schwartz sold a property that was halfway through a $27 million renovation. “We're selling the half-finished dream property to the buyer. We've done this on more than one occasion, too,” says Schwartz.

Institutional investors like CalSTRS are increasingly looking beyond core apartment deals. Migrating up the risk spectrum in search of greater future yields requires that these formerly conservative players tolerate minimal upfront yields. To Schwartz, however, yield compression is nothing more than the added cost of doing business in today's market.

“And there's almost no way to differentiate between core and value-added capitalization rates today,” says Schwartz. “So it all boils down to picking the right markets where rental growth will play into your strategy.”

Scattered economic clouds

If economic growth were to slow in 2007 from its current pace of 3.2% annually, apartment investors could increasingly gravitate toward core offerings. Such a scenario could also limit demand to chase value-added deals.

Projected growth is clearly a big question. Boston-based real estate consulting firm Property Portfolio & Research (PPR) is calling for slower job growth over the next 12 months.

While revisions to third-quarter job growth were upward, average monthly growth this year registered 149,000, a fairly modest pace, according to PPR research strategist Michael Cohen. Another issue is low unemployment, which is constraining growth in many markets.

The good news is many other analysts expect strong near-term demand to unfold in the apartment market. Shifting demographics and a weak single-family housing market could help buoy demand for units in coming years. And as renter households increase due to the echo boomers, homeownership is waning.

PPR calls the influx of echo boomers — Americans born between the late 1970s and early 1990s — a “demographic tidal wave” for apartment owners. As the leading edge of this group reaches its prime apartment-renting years, PPR expects annual demand growth to average 1.1% through 2011. At that rate, roughly 141,000 units will be absorbed annually through the next five years.

This past year marked the first time since 2001 that effective rental growth has exceeded inflation. PPR expects average effective rents to rise by 5.1% in 2006, and that would be the strongest annual rent growth in more than 15 years.

“The expectation is that 2007 will bring another strong year of growth to the apartment market,” says Mark Obrinksy, chief economist at Washington, D.C.-based trade association National Multi-Housing Council (NMHC).

Unlike Chandan of Reis, Obrinsky believes that a limited new supply of apartment units will sustain this recovery. If Obrinsky is right about the market, value-added players such as The Prescott Group are smart to accept tiny yields for strong returns down the road.

“It all boils down to the amount of risk you're willing to take on the front end of a deal in order to create value in the future,” says Steinberg of The Prescott Group, referring to the importance of a healthy exit strategy. “So it's not really about current cash flow. It's more about the longer-term upside potential.”

Parke M. Chapman is senior editor.

Tight supply gives landlords pricing power

Aggressive condominium conversion activity plus rising costs for materials and labor have kept new apartment supply in check for the past 18 months. Converters thinned some 174,000 apartment units from the nation's inventory in 2005, reports Boston-based real estate research firm Property & Portfolio Research. While the conversion wave has definitely showed signs of slowing, converters still managed to swallow up 48,000 rental units during the first nine months of 2006.

“During previous up cycles, land was cheaper and that allowed developers to buy up sites and build new apartment projects,” says real estate attorney Barry LePatner of LePatner Associates LLP. “But land prices have skyrocketed and it doesn't always make sense to build when it costs more than replacement.”

The cost of materials rose 10% between July 2005 and July 2006 on an average weighted basis, reports construction data firm RSMeans, which tracks materials and labor costs. Costs for concrete and masonry registered the two biggest double-digit spikes.

With little supply on the near-term horizon, apartment owners are enjoying the tightest market since the third quarter of 2001. According to real estate data firm Reis, the apartment vacancy rate in the top 25 metropolitan markets was 5% at the end of September, down from 5.5% a year earlier.

Emboldened by this tight market, landlords are gaining the upper hand. Asking rents in the top 25 metro markets increased by 1.4% during the third quarter of 2006, reports Reis. The researcher expects asking rents in these markets to rise an average of 3.1% in 2007. That would represent the strongest annual asking rent growth since the last market peak in 2000.

“The apartment market is really benefiting from the best of both worlds,” explains Sam Chandan, chief economist at Reis. “You have limited new supply and strong renter demand. Until that changes, it means that landlords' NOI [net operating income] will continue to grow with investment demand for assets.”

What effect, if any, will failed condo projects have on the rental market? Some analysts call these “repartments,” or former apartments briefly converted into condos before becoming rentals again. Deutsche Bank REIT analyst Louis Taylor says that apartment vacancy is so low that if as much as 30% of all conversions were to become repartments, vacancy would rise by only 70 basis points.

“The impact is obviously greater in markets where more units have been converted over the past year [Florida, for example], but these markets also have some of the lowest vacancy rates in the country,” wrote Taylor in a research note late last November. “Given how tight vacancy is, we believe the markets can weather some units coming back.”
Parke M. Chapman

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