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January and February drove volume before March problems arose.
January and February started off as strong months for apartment transactions. Overall, the first quarter was flat from Q1 2019 with stable prices. “The economic crisis brought on by the new coronavirus, however, is moving faster than quarterly figures can measure,” RCA wrote in its Q1 report.
Then came March and the full-blown arrival of COVID-19. Deal volume fell below $10 billion in the month, according to RCA. In studying first quarters from 2001 to 2019, RCA found that, on average, March represented 36% of all quarterly deal volume. In 2020, March represented only 25% of quarterly deal volume with a sharp slowdown at the end of the month, according to RCA.
In fact, without two entity-level transactions involving Steadfast Apartment REIT, March would have looked even worse. RCA sales entity-level transaction were down 12% year-over-year, but slumped 38% in March.
Garden-style apartment sales were flat in Q1, but mid- and high-rise sales fell 7% YOY. However, in March both segments saw sales fall more than 10%.
As the economy took a sharp, historic turn downward, 10-year Treasuries hit record lows. While investors may have hopes that low rates will push cap rates even lower, RCA warns that they shouldn’t get too excited. It noted that the relationship between cap rates and treasuries “widened and narrowed based on changing expectations for growth and appetites for risk.”
Right now, the spread between the 10-Year and cap rates is at 450 basis points. The average since 2001 is 315 basis points.
“Conditions needed to shrink this spread just are not in place,” RCA wrote. “If investors suddenly expected more growth in the economy and subsequent stronger growth in property income, many would be willing to accept a narrower spread to the risk-free rate to capture some of this growth.”
In the last downturn, demand for apartments from former homeowners helped narrow spreads. This time, questions about rent payments, along with rent control threats, could potentially push spreads further apart, according to RCA.
“In response to the GFC [great financial crisis], apartment cap rates across the U.S. climbed 130 bps,” RCA wrote. “Doing some scenario analysis that generates a cap rate 100 to 150 bps higher than the current 5.5% is not outside of the range of possibility given these historic moves.”
Single-asset sales continue to increase as investors chase yield and safety in a potential recession.
In September 2018, Greystar closed its $4.6 billion purchase of student housing REIT EdR. This year’s third quarter didn’t see a comparable transaction, which is a big reason why deal volume fell 7 percent year over year (YOY), according to the most recent Real Capital Analytics (RCA) US Capital Trends apartment report.
Despite the decline in sales volume and the fact that only one entity-level transaction closed in the quarter (Cortland’s $1.2 billion purchase of Pure Multi-Family REIT), RCA still sees a healthy apartment-transaction market ahead.
For one thing, single-asset sales are growing. In the third quarter of 2019, deal activity rose 8 percent YOY in the segment. “Single-asset sales are up as recession fears are stoking further investor demand for investments in the apartment sector,” RCA said in the report.
With a potential recession coming, investors want to find properties where capital expenses won’t be as challenged in a downturn, according to RCA. Citing the National Council of Real Estate Investment Fiduciaries (NCREIF) data, RCA says the apartment sector has the lowest ratio of capital expenses costs relative to other commercial sectors.
Regardless of buyers’ motivation, apartment executives are still seeing strong interest in their assets. James A. Bloomingdale, Senior Vice President and Head of Acquisitions for JRK Investors, says transaction volume is holding steady YOY. “There’s a lot of money chasing deals,” he says. “Rates are staying low, and we’re seeing a lot of deals getting done.”
Johnny Gregorio, Senior Associate, Eagle Rock Advisors, sees a lot of competition for deals in the Northeast and Mid-Atlantic. “There’s a lot of capital in the market ready to be deployed in value-add deals, and you see that reflected in purchase prices,” he says.
The data back up Gregorio’s observations about apartment costs. Apartment prices rose 7.7 percent YOY in September, according to the RCA CPPI (Commercial Property Price Indices). While that’s slower than the 11.4 percent pace set in September 2018, it’s stronger than that for all other property sectors.
In this low-return environment, investors are chasing yield. Right now, value-add apartments serve this need. “It’s a very challenging environment to acquire any properties that have a value-add component—all the upside is already priced in,” says Robb Bollhoffer, a Managing Principal and Director of Acquisitions at 29th Street Capital (29SC).
With so much interest in value-add, 29SC has changed its strategy. “Transaction volume has definitely decreased for 29SC on the acquisition side but has picked up on the disposition side,” Bollhoffer says.
Bollhoffer detects excess leverage in the market, which he says feels similar to 2007, which is also driving his decision to sell.
“On the properties we’re selling, there’s a common theme of bridge debt; then, preferred equity and mezzanine; and, then, a small amount of equity,” Bollhoffer says. “Now is a great time to upgrade the vintage of our portfolio.”
As it sells older assets, 29SC sees more opportunity to develop core-plus properties. “We’ve opened a development business unit in Sacramento [Calif.], since this market is underserved on the supply side, and our cost basis will still be below some of the older-vintage assets that are trading in the market,” he says.
A respected industry analyst says those who succeed in picking, buying, financing and managing properties during a downturn will be set up to thrive when the economy improves.
While no one knows when the next recession will arrive, Ryan Severino, Chief Economist at JLL and an adjunct professor at Columbia and New York universities, is seeing signs that a downturn is getting closer.
“Growth will decline from ’18 to ’19 and ’19 to ’20, and we’re going to have to see if things hit the fan in 2021,” Severino said at NAA’s Maximize Conference, Sept. 23–24, in Atlanta.
Indeed, he’s already seeing some trouble on the horizon. “Objectively, [interest] rates are still low by historical standards,” Severino says. “Yet, investment is starting to pull back.”
When the recession does come, Severino thinks global political instability or unwise policy decisions will likely be the cause.
“We’ve entered a place where policy is starting to become a very big part of this economic outlook,” Severino says. “Most recessions are caused by policy errors.”
Specifically, Severino points to the trade war as a potential cause of the next recession. “[The trade war] isn’t doing very good things,” Severino says. “Trade is the linchpin on which a lot of this stuff hinges right now.”
In addition, political and economic tensions around the globe could spark a problem. “There’s no shortage of political risk in the world today, especially [regarding] policy,” Severino says.
When the next downturn does come, Severino isn’t sure there will be the political will to increase spending. “Spending is a lever that the government pulls to get the economy going. I’m not sure how many people are going to want to pull that lever next time,” he says.
The apartment industry is fairly well-positioned for the next downturn, though Severino does have some concerns about supply.
“Supply will start ramping up again,” Severino says. “If the economy goes into a recession, absorption may be more difficult with more supply.”
While supply could cause problems in the Class A space, other locations and asset classes could thrive. Severino thinks suburbs to primary markets are poised to do well as millennials leave the urban core. He also likes older product. “I like B and lower product in a recession,” Severino says. “The demand there is incredibly stable, and supply has gone down.”
As a sector, Severino says, the apartment industry has some advantages going into a downturn. “There’s still a lot of demand out there, especially with for-sale housing being so expensive,” he says.
Even in a sector positioned to weather the downturn, there will be winners and losers. When the recession comes, the skill will be the most important factor in determining success, according to Severino. “Companies will rely on skill—picking, buying, financing and managing properties—to succeed,” Severino says.
The good news is that those who succeed in the worst of times are often set up for success when the economy improves. “The most successful people I know in real estate made their way in times of trouble,” Severino says.
As supply fills up some major cities, secondary and tertiary markets are thriving.
As cap rates have fallen in the major metros over the past decade and more money has moved into the apartment sector, investors have begun looking to markets they wouldn’t have considered in the past.
“We have groups of investors who want to invest in secondary markets, and now they’re even looking at tertiary markets,” said Alexandra Jackiw, CAPS, COO at Hayes Gibson Property Services at the session “Does (Market) Size Really Matter?” at Apartmentalize this past June in Denver.
But these markets come with risk compared with larger cities. “Tier-one markets have great economic diversity and less exposure,” says Alan King, Managing Director and President, Property Operations, at Berkshire Residential Investments.
Many smaller markets often rely on one employer. If that company downsizes or closes shop, the ramifications can be felt throughout the area.
“One of my former employers bought a 324-unit property in Peoria [Ill.],” Jackiw says. “The day we took over, Caterpillar announced a reduction in workforce. We had 60 apartments occupied with their employees.”
But even with those cautionary tales, Jackiw sees why investors are clamoring for apartments in secondary and tertiary markets. “Secondary markets are less prone to big shifts [when the economy turns] than primary markets,” she says.
Secondary markets are also usually less prone to having huge amounts of supply. In contrast, King cites concessions of two and a half to three and a half months in Houston and South Florida.
“I’ve seen a lot of new construction in high-profile submarkets,” King says. “The absorption has been tough in some of them, such as Houston and Charlotte. In the worst of these [places], concessions have impacted the A-minus and B-plus markets.”
As that supply hits some large markets, a lot of smaller markets are posting staggering rent increases.
“In 2018, national rent growth was 3.3 percent,” Jackiw says. “The secondary markets had astronomical rent growth.” In Midland–Odessa, Texas, for example, rents rose 21 percent in 2018, according to Jackiw.
That market isn’t alone. “The secondary markets across Texas are doing well,” says Hugh Cobb, a Partner and one of the Owners of Alpha Barnes Real Estate Services
If these markets continue to thrive, developers will find their way in. Alpha Barnes recently opened a project in Frisco, Texas—roughly 30 miles north of Dallas—that’s renting 40 units a month.
“Building Class A products that are well located in small markets is a very strong business model,” King says.
When going into smaller markets, Cobb says investors and developers need to be on the lookout for permanent job drivers, such as Walmart distribution centers, prisons and colleges and universities.
But there are also hazards awaiting developers in these markets. “Secondary markets see developers with deep pockets as a way to add streetlights and other things,” Jackiw says.
Despite the concessions, there’s still a lot to like about big markets. “The tier-one markets are getting population growth,” says Jordan Brooks, Analytics Specialist at ALN Apartment Data. “The others are stabilizing or declining.”
The main reason for this is jobs. “Tier-one markets have diverse job drivers,” King says.
King adds that outside of some high-profile problems in markets such as Houston, Dallas and Charlotte, absorption has been strong in most large markets.
“In our revenue management system, we saw the best four-month lift through May that we’ve seen in any four months since 2013,” King says.
Apartment deal volume set a record in the first half of 2019, but rent control poses valuation issues moving forward.
Driven by strong growth in secondary markets, apartment deal volume posted record highs and topped total commercial property sales growth statistics for the first half of 2019, according to Real Capital Analytics (RCA).
In all, $80.5 billion of apartments sold in the first half of 2019, beating the previous first-quarter record set in 2016. More than half of that volume, $43.2 billion, occurred in Q2, which posted a 19 percent year-over-year (YOY) increase and 7.3-percent YOY price change.
“Record highs this late in the economic expansion are all the more meaningful given how the market achieved this level of sales activity,” RCA said in its “US Capital Trends” report. “Back in 2016, the combination of portfolio and entity-level sales were [the foundation] behind 29 percent of all deal volume in the first half of the year. In 2019, only 23-percent of sales volume was tied up in megadeals.”
Only 2 percent of 2019 sales were entity-level deals (sales of entire companies), compared to 4 percent in 2016. Sales of individual assets, which RCA calls the “bedrock” of the market, struggled in Q1, but rose in Q2.
“It [the interest in single assets] is people making a decision one building at a time that, given all the other investment options; apartments are the place to be,” says Jim Costello, Senior Vice President at RCA.
The RCA CPPI, which tracks apartment value, increased 7.3 percent in Q2, compared to 11 percent a year earlier. Partially driving down prices was the performance in the six major metros: Boston, New York, Washington, Los Angeles, San Francisco and Seattle. The RCA CPPI only rose 4.5 percent YOY in those markets, versus an 8.3 percent gain in secondary and tertiary markets.
Cap rates averaged 5 percent in the six major metros in Q2, which is a 20-basis point increase from a year ago, according to RCA. “The increased deal volume in Q219, along with the cap rate movement, suggests that owners have capitulated a bit on price expectations,” RCA said in the report.
RCA determined that cap rates were up in 11 out of the 15 submarkets that are within the six major metros but increased in only 15 out of 43 remaining markets in the non-major metros.
“People are looking at some of these [six major] metros and making the decision that, given rent control and a host of other factors, they are just stepping back from their [return] expectations,” Costello says. “There is a little bit of uncertainty around what’s going to happen to the rents and apartment income of these markets.”
Dallas led the way in deal volume for the first half of the year, followed by Phoenix, Los Angeles, Atlanta and Houston. Manhattan, which had held the top position for years, fell to No. 8 on the list.
“Again, cap rates are extremely low and a change in rent control regulations have chilled investor optimism [in New York],” RCA wrote in the report.
New rules cap cash for rehabs, guts underlying asset values.
One-third of the apartments that make up New York City’s residential real estate market—valued at more than $2.6 trillion as a whole and worth as much as the gross domestic product of the United Kingdom—just lost 20 percent of their value.
That’s the consensus of apartment market watchers who are trying to quantify the fallout from New York’s recently passed rent control measures, which dramatically limit the dollars owners can spend on renovations at rent-regulated buildings, and thus how much they can increase rents to enhance the value of their assets.
“The law disincentivizes owners from making improvements at their properties because they can no longer recoup those costs through increased rents,” says Robert Dremluk, a real estate attorney and Partner at law firm Culhane Meadows.
That, in turn, is pummeling the valuations of properties caught in the crosshairs of the new rules.
While it will take time for transactions to emerge and actual price discovery to occur in the market, “you’re looking at devaluation of at least 20 percent, or more,” says Paul Mullaney, Senior Loan Originator at New York-based Pembrook Capital, which provides bridge financing to multifamily rehab projects. “Cap rates are going to rise from the 3’s to the 5’s. That’s an enormous value erosion.” (In rental housing arithmetic, when capitalization rates go up, prices go down.)
That stark downward revaluation is happening now because rent control puts one of this industry’s most successful and fundamental investment strategies – value-add rehabilitation – in its crosshairs.
With value-add rehab, buyers seek underperforming buildings with deferred maintenance where rents are currently low. They buy those buildings, make improvements, and then raise rents to reflect the higher quality living standard they’ve built into the apartments. It’s a foundational strategy for rental housing improvement that’s now been eliminated for New York’s 1 million rent-regulated apartments.
Scenarios such as this could play out nationally in any markets that pass rent control legislation.
“Owners who bought rent-regulated buildings that had low rents and the potential to raise them by making improvements don’t have the incentive to add value anymore,” says Jamie Heiberger Harrison, a real estate attorney and President of real estate law firm Heiberger & Associates. “There’s just no more room to grow.”
No More Improvements in Stuy Town
One major institutional apartment owner already announced it won’t be making any but the most-needed fixes at Stuyvesant Town and Peter Cooper Village apartment community. An iconic landmark of affordable housing in Manhattan originally championed by New York power broker Robert Moses and built after World War II to house returning GIs, the 11,000-unit community was purchased by the Blackstone Group in 2015 for $5.3 billion dollars.
But according to Crain’s New York, Blackstone is now halting any improvements it had planned to make at the community. “In light of the recent legislation, we are in the process of evaluating capital investments at Stuy Town,” a Blackstone spokesperson told Crain’s.
It’s also not the only example of plans to improve the city’s housing stock that has been cut at the knees by Albany’s rent control package.
“We have clients who were already under contract when rent control passed and who are now going back to try to renegotiate those deals, because the original numbers just don’t make sense anymore,” says Mullaney.
Squeezing Investors Out of New York
Together, the new limits put a squeeze on two interrelated measures of rental housing worth – net operating income and net asset value – at rent-regulated buildings. The result is a real estate environment that just two months ago would have been unimaginable in New York: Real estate investors reportedly leaving the Big Apple for locales like Cleveland to put cash to work.
“Investors who would typically be buying and developing properties in the New York metropolitan area are looking to Texas, Florida, Cleveland and other markets to put their money into residential properties there,” Dremluk says. “They’re abandoning the New York market because they don’t think they can make money here anymore.”
What Rent Control Does
The changes, passed in June, limit how much owners of rent-regulated apartments – or approximately 1 million of the 3 million total units in New York – can invest and recoup for improvements at their buildings.
Previously, upon vacancy of a unit, owners could make improvements and then increase the rent by as much as 20 percent. If that pushed the rent over a certain threshold, the apartment could then be de-regulated, and return to being classified as a market-rate unit.
But the new rules eliminate that provision, as well as the 20 percent vacancy bonus, while limiting how much owners can spend on improving individual units to just $15,000 over 15 years.
Previously, there wasn’t a cash limit on upgrades, and owners could raise rents by 1/40th of the cost of improvements in buildings with less than 35 units, and 1/60th in building over 35 apartments. Those ratios now change to 1/168 and 1/180, respectively, under the new rules.
“You can do paint and carpets for $15,000 in New York,” Mullaney says. “It doesn’t buy a lot.”
For major capital improvements that affect an entire building – such as common area renovations, a new roof or central air conditioning system – owners previously were allowed to increase rents by as much as 6 percent per year for all residents to recoup added costs. But that type of increase is now capped at just 2 percent per year.
For owners who want to forgo running rental housing altogether and convert their building to a co-op or condo, the new rules made that significantly harder, too: Owners will now need 51 percent of residents to sign off on a proposed conversion, versus 15 percent under old rules.
“Having worked on many of those transactions during the last 20 years, that is an extremely high threshold,” Mullaney says. “If you need 51 percent of tenants, you’re basically not going to see any more co-op or condo conversions in New York.”
Bronx and Harlem: The Ghost of the 1970s
The result, say apartment financiers and dealmakers, is likely to be a calcified deal market – Bloomberg is already reporting sales at a standstill -- where owners of rent-regulated buildings stop investing in anything but the most basic and immediate maintenance needs required by law, such as health and safety issues, leaking pipes or clogged drains.
“The unintended consequences of this means the quality of the apartments is going to decline due to deferred maintenance or a lack of incentive to improve them,” Dremluk says. “These buildings are going to get worse.”
The final outcome, many say, could be a return to 1970s-era images of hollowed-out buildings in disrepair, especially in the Outer Burroughs – the very circumstances that led to prior reforms to allow owners to make improvements to buildings and raise rents in the first place. “The Bronx was finally getting better, and now it’s going to fall apart,” says Heiberger Harrison.
Adds Dremluk, “We may go back to what Harlem looked like 20 years ago.”
Forcing Owners to Sell
Aside from owners pulling back on improvements at their properties, the changes could also have some drastic effects on deals that have already been done.
For instance, in a typical rehab deal, a borrower might be able to secure as much as 65 percent to 70 percent of an asset’s value to buy it and make improvements.
Those loans are typically made by short-term bridge lenders, who hold the note at a higher rate until the improvements are done, usually two to three years. Then, when owners raise rents and increase the value of the asset, they can seek permanent re-financing on the building at a lower interest rate and lower loan-to-value (LTV) ratio based on the new, higher valuation of the property.
But with that mechanism now effectively dismantled by rent control, many owners who recently went into rehab deals are now sitting on short-term debt that will eventually need to be paid off. Whether they’ll be able to secure longer-term financing without getting a boost in asset value from improvements is anyone’s guess.
“For portfolios that were acquired using short-term, floating rate debt, my feeling is they may have a very hard time refinancing or getting out whole, without forcing the owner to sell,” says David Eyzenberg, President of New York-based investment bank Eyzenberg & Company, and a finance professor at New York University’s Stern School of Business.
Indeed, market jitters over existing loans already played out when rent control was first announced in June. Immediately after the new rules were adopted in Albany, several community banks that lend to apartment companies saw their stocks take a hit. The reason why, observers explain, is because the basic premise behind the existing loans on banks’ books had effectively been erased overnight when values on underlying assets tanked.
“The senior lender who was at 65 percent leverage may find themselves at 85 percent to 90 percent leverage when these deals trade,” Eyzenberg says. “They’ll make it out, but at a similar or worse LTV than they signed up for. That’s why the banks take a hit. There’s now a heavy preponderance of these loans where there’s no clear view of how you’re going to exit in a better position than you are in today.”
That means, just like the owners who took out the loans, the banks who made them may have a hard time finding another, long-term lender to replace them in the deal stack. Much like single-family homeowners who were unable to re-finance subprime teaser mortgages when housing collapsed in 2008, rental housing owners of these assets could now be in the same spot.
Cash Buyers, Less Lending
Going forward, that means banks are likely to lend less, based on an asset’s existing cash flow, or only at rates that won’t be sustainable for apartment owners.
“Instead of being able to get a 70 percent loan to value, you’ll only be able to get a 50 percent cost to loan,” says Mullaney. “There just won’t be any cash flow there to underwrite.”
That means owners – if they enter into new deals – will need to make up the difference with so-called “hard” money at higher rates.
“If you are used to borrowing 70 percent of your costs at 3 percent interest, now you can only borrow 50 percent of your costs at that rate,” Mullaney says. “You’ll now pay 9 to 12 percent for the financing that covers the portion of the loan from 50 percent to 70 percent of LTV. Your blended rate is going to go up significantly.”
The outcome of those deals would likely be cash buyers taking out assets at depressed values, and then simply managing the existing cash flow, without making any improvements to the property.
“Cash-rich companies will come in and scoop it up at 60 percent of the value of the building, and say take it or leave it,” says Dremluk. “It turns the process of valuation into a situation where you have a focus on just the cash yield of the property. The business will turn into just managing occupancy.”
Beyond New York City, the real concern now is that other cities in New York State will adopt similar rules, which is an option under the new law from Albany. Owners groups are currently fighting the new regulation in court.
“They left the window open that this can creep into other markets where it’s not currently enacted,” Eyzenberg says. “This could spread.”
Apartment deal volume came in at $36.4 billion, which was only a 1 percent increase compared to Q1 2018, according to Real Capital Analytics (RCA).
While Q1 deal volume stalled compared to last year, the apartment market still posted the second most active first quarter ever (behind Q1 2016). RCA considers any growth at all a positive for the apartments.
“The paucity of growth for the apartment sector in Q1’19 was in some respects a positive sign,” RCA writes in its U.S. Capital Trends report for the apartment market. “Deal activity for commercial property overall fell in the face of turmoil in the financial markets. So, the limited growth for the apartment sector is a case of outperformance relative to other property types.”
Portfolio sales drove volume in the quarter while single-asset sales struggled. Portfolio sales in Texas represented 35 percent of deal volume.
Matt Ferrari, Co-Chief Investment Officer, Head of Acquisitions and East Coast Asset Management for TruAmerica Multifamily, says he has not seen as many portfolio sales as he saw last year. “The few portfolios that we have seen are certainly smaller and perhaps more regionally focused than a year ago,” he says.
Additionally, there were no entity-level deals (sales of entire organizations) in the quarter. While RCA says it is not unusual to get a quarter without these kinds of deals, they did represent 25 percent of all deal volume in 2018. Volume in the mid- and high-rise segment grew 7 percent, while sales in the garden segment fell 2 percent.
Prices continued to increase in Q1 as RCA CPPI for the apartment sector rose 7.3-percent YOY. As values rose, cap rates continued to decline, falling 20 basis points to 5.2 percent.
Competition for assets drives price increases. While Ferrari says competition for deals abated in Q4 and early in Q1, things soon heated up again.
“Since rates have dropped, it has been ultra-competitive to win deals, which seems to be a similar dynamic at the same time last year,” Ferrari says.
Others agree. “It is as competitive as ever,” says Doug Root, Co-Founder and Managing Partner of Blackfin Real Estate Investors.
Deals remain available if buyers know where to look.
“There are still good suburban value-add opportunities available in many of our target markets and we continue to be bullish on the space and our investment thesis,” Ferrari says. “There also continues to be a healthy amount of product in many of our markets and our goal is to still buy $900 million to $1 billion of apartments this year if we continue to find opportunities that we like.”
For renovations to be successful, investors need to choose the right market and community. But those are only the first steps.
Apartment investors have been attracted to “value-add investments” throughout the recovery. Year after year during the past decade, between 15 percent and 20 percent of the dollars spent to buy apartment properties have been for value-add investments, according to data from Real Capital Analytics through 2018.
Last year, investors bought more than $26 billion in apartment properties for value-add investments over the 12-month period ending March 2019, according Real Capital Analytics. During the past five years, that figure has ranged between $22 billion and $34 billion, swelling in 2016 and 2018.
“There are billions of dollars aggressively chasing value-add multifamily housing opportunities, especially with larger portfolios,” says Phil Brosseau, Vice Chairman, Multifamily, Capital Markets, CBRE.
Most domestic and foreign capital investors prefer older apartment communities built before 2010, indicating that value-add redevelopment will remain the favored strategy for raising and deploying capital, Brosseau says.
However, investors need to be careful, especially as prices rise for apartment properties and a growing number of economists worry about the possibility of an economic downturn in the next two years. Here are four ways to avoid value-add mistakes.
Pick the Right Market
To succeed, value-add investors need to make sure that the building they plan to renovate will serve a genuine need in the market.
“Failure to complete a rigorous study of all aspects of the current asset and the submarket in which it resides can cause a value-add project to fail,” says Steven DeFrancis, CEO of Cortland, a leader in value-add investment.
For example, as Cortland planned its renovation of Watermark at East Cobb, an apartment community in Marietta, Ga., it studied “population and job growth forecasts, current and forecasted market supply, rents and quality of competitive assets, school district, and nearby employers,” says DeFrancis.
Strong value-add redevelopment markets will often show a strong demand for older, nicely renovated apartments. That shouldn’t be too difficult in 2019. “Overall occupancy should hover near the 95 percent mark, with almost no product availability continuing to register in Class B and especially Class C units,” Greg Willett, chief economist for RealPage, says.
The local market should also have a growing base of residents who are paying less than 30 percent of their incomes for rent. That means they could probably pay more to live in a renovated apartments – without having to give up necessities. “You don’t want to increase the rents to be out of reach,” says Matt Ferrari, head of acquisitions and dispositions for TruAmerica Multifamily.
Pick Properties with Room to Improve
Value-add investors also carefully choose apartment buildings that have clear room for improvement.
A promising area for value-add redevelopment should show a difference of several hundred dollars between the cost of renting a new, luxury apartment and the cost of renting an older, un-renovated apartment. In a “value-add” community, the newly-renovated apartments should be able to charge a few hundred dollars more each month than the older or un-renovated apartments nearby, and still be a bargain of more than $100 a month in rent compared to the cost of new construction.
Ideally, there should also be a clear difference between the rents already being earned at nicely renovated apartments in the area and the apartments that investors plan to renovate themselves. “If an apartment property is already performing at market value, there probably is not much opportunity,” says John Daley, Senior Vice President of Design and Construction at Waterton, which just purchased Bay Village Apartments in Vallejo, Calif.
In sum, investors should be able to show why they believe renters will look at the other options in the market and choose to live at their renovated property at the rents that they propose.
Plan for High Construction Costs
Value-add investors also need to include rising construction costs in their plans to renovate apartments. The cost of labor and materials has been volatile, particularly for commodities such as steel and lumber, that have been affected by tough negotiations between the United States and its leading trading partners, according to data from the Associated General Contractors of America.
Because rents today are growing more slowly, managers cannot count on rising rents to make up for a surprising increase in the cost of labor and materials.
“In this past 12 months, we hit a point where construction cost inflation is well above rent growth inflation,” says TruAmerica’s Ferrari.
To protect themselves from rising costs, developers are increasing the amount of money in their contingency budgets.
Make Green Renovations Pay
Value-add redevelopments also often include renovations that cut the cost of energy at their apartment properties. Savvy developers make sure to choose renovations that are likely to quickly add value and save money.
“We all want to be environmentally conscious, but we have to get the return on investment,” says Daley. “We make an attempt to make our green renovations earn back their cost in five years.”
Developers make sure to balance the cost of renovations against the savings from lower energy bills and interest rates. Water-saving improvements tend to quickly pay for themselves. Energy improvements such as solar panels can be more expensive.
Borrowers who pledge to cut the water and energy used at their buildings by 30 percent can qualify for Fannie May and Freddie Mac’s popular “green” lending programs and receive interest rates by as much at 30 basis points lower than conventional financing.
“We have gotten very deep into the green programs,” says Daley.
Bendix Anderson is a freelance reporter
Ten years ago, the Great Recession walloped almost every sector of the economy. According to the U.S. National Bureau of Economic Research, which officially tracks the country’s recessions, it started in December 2007 and ended in June 2009, lasting 18 months. While many owners of apartments faced foreclosures and tighter lending regulations, demand for their product grew when homeowners lost their housing, couldn’t close or afford to buy.
Apartments became the belle of the ball, offering the best solution for a roof over residents’ heads and a good financial opportunity. Investment soared to $154 billion in 2017 from $104.6 billion in 2007, according to Real Capital Analytics. Owners and operators made their projects more appealing by debuting more downtown locations as urban living became hot and introducing new amenities, which helped fuel the current craze.
As the 10-year anniversary of the end of that meltdown has passed, many owners and operators look to a variety of strategies to preclude it from reoccurring, or at least on the same scale. For now, the market looks strong: Apartment absorption remains at its highest level in three years, according to the U.S. Census. Additionally, rental housing is becoming the favored choice for Gen Z, the cohort that follows the Millennials, says Andrew Gerringer, Managing Director of New Business Development at The Marketing Directors in New York, a real estate sales and marketing consultant.
But because demand can quickly shift, owners and operators should know which strategies industry survivors find most useful. While shoring up their balance sheet with the right financing is important, other strategies, such as finding the right location, utilizing technology and data, hitting the right affordability sweet spot and using superior design can help apartment professionals weather the next storm.
Financing: Secure longer-term fixed and floating rates and non-recourse debt.
The excessive short-term debt that many developers and owners took on is frequently cited as one of the prime causes of the crash. But so, too, is the fluctuating nature of interest rates, especially in an industry where projects take years to complete.
“Interest rates shot up, people couldn’t pay, homeowners moved out and projects failed,” says Stuart Saft, Head of The Real Estate Practice at the law firm Holland & Knight. More lessons were learned if projects took longer than expected, says Gerringer. “They found interest rates were not their friend and could make a difference as to whether they made a profit,” he says.
Another financial lesson learned was remembering the cyclical nature of the industry and that adjustments must be made. Commercial mortgage broker Charles Foschini’s recommendation now is for apartment owners to take advantage of the current “exceptional time” and lock down long-term, non-recourse debt or financing for 15 or 20 years. It’s also important for owners to recognize that the market is now mature, says Foschini, Senior Managing Director and Co-Leader for Florida Productions in Berkadia’s South Florida office. “Growth will continue but not at the same pace,” he says.
Many owners are already doing so. Waterton in Chicago, which has long focused on investing and managing workforce apartments, has used a combination of long-term debt with a 50/50 mix of fixed and floating rates that are non-recourse and matched the term to the asset’s expected holding period. “The goal has been to have plenty of liquidity for good opportunities,” says David R. Schwartz, CEO, Chairman and Co-Founder of Waterton.
At the time of the Great Recession, Waterton had accumulated significant capital, and sat tight until banks came calling for it to help rescue other firms’ assets. “It became a fun time with great opportunities for us,” says Schwartz. “Rents were down 3 percent because of job loss but that was much less than the overall housing downturn of 25 percent,” he says.
King of Prussia, Penn.-based Morgan Properties, the nation’s 20th largest multifamily apartment owner with more than 46,000 units in 11 states, takes a different approach with its class B rental housing. During the past few years, the company has remained active in acquisitions, but has changed its financing strategy toward debt versus floating-rate financing.
“Today, 90 percent of our portfolio has long-term, fixed-rate financing, which makes us extremely well positioned for success toward the later innings of the cycle,” says Jason Morgan, Senior Vice President of Acquisitions and Investment Management for Morgan.
Morgan has also launched a multifamily debt platform during the past 14 months that focuses on Freddie Mac K-Series B-pieces (Freddie loans with various terms). “We are able to leverage off our vertically integrated platform, diversify in the capital stack and make attractive risk-adjusted returns,” Morgan says.
LumaCorp., in Dallas, another workforce apartment leader, has found that holding investments for the long term helped it survive throughout its 35 years. Because it, too, believes the cycle is at or near the market peak, it is harvesting capital gains from existing assets and reinvesting them through 1031 Exchanges.
“We want to sell strategically and reposition existing assets for long-term holds since we anticipate doing fewer deals,” says Ian Mattingly, President.
Some companies are willing to use a combination of construction loans and mortgage debt, but do so carefully. Steve Fifield, Founder and CEO of Fifield Cos. in Chicago, which focuses on urban infill apartments, keeps debt to 60 percent to 65 percent of the value in case rents drop or vacancies increase if a recession occurs. But Fifield says he learned this lesson longer ago. “It came from the 1990-91 recession when most of us developers had easy access to 80 percent to 100 percent of cost financing. Ten years ago, I had already embraced using 60 percent to 70 percent debt levels and partnering on virtually all development projects with large institutional investors or family offices,” he says.
Fifield’s other financial strategies are to get to know his bank and equity investors well, track supply and demand, keep rents in line with fluctuations in each market and hold down head-count costs by not replacing staff lost through attrition. “Numbers [headcount] fell about 20 percent over the last two years. We’re now right-sized,” he says.
Location: Know your market.
Location, location, location may still be the mantra, but the definition of what’s a prime apartment site varies by the cost of developing and operating it for different demographics that may congregate there. In uber-expensive New York City, properties are rising farther afield, says Gerringer. For many clients that has meant buildings in the Hudson Yards area along the Far West Side, in Long Island City in Queens where Amazon will locate a HQ2 headquarters and parts of New Jersey beyond gentrifying Hoboken and Jersey City, he says.
Harrison, N.J., a suburb of Newark, once had little to attract residents, but developers saw the wisdom of constructing apartments because of the low cost of land and proximity to a Path rail stop into Manhattan. “It was a good place for renters looking for the best value rather than mixed-use amenities their more affluent counterparts want,” says Gerringer.
Waterton’s favorite sites are typically in urban and suburban areas near public transportation, a highway or major road. But it has found that its renters also seek a variety of retail and employment opportunities. Currently, it sees strong demand in suburbs of Dallas, Raleigh and Charlotte.
RKW Residential, based in Charlotte, is interested in suburban markets, too, but which have a downtown-type center to attract a mix of demographics. Proof that its strategy works is its The Lowrie in suburban Charlotte, which leased up soon after opening, says President Marcie Williams.
Some owners prefer to focus on a single region that it knows well. For LumaCorp. That place is Texas. There, it finds viable opportunities as companies relocate, and desires apartment buildings close to jobs. Unlike counterparts elsewhere, walkability to mass transit isn’t a factor since it’s still in its infancy in Texas, Mattingly says. “Renters have to have a car to have a job,” he says.
London-based Balfour Beatty Communities, with its U.S. headquarters outside Philadelphia, also considers knowing its markets well part of its success, though its locations are spread apart in 17 U.S. cities and six states. Its 1,500-plus staff helps it tap into the local dynamics and adjust strategies, says Mike Price, Senior Vice President of Residential Transactions. “We feel deep local market knowledge is still key to weathering the tougher investment cycles and taking advantage of the upturns,” he says.
Avoiding losses also involves knowing when to leave a market or not enter. While LumaCorp hunts for new locations, it also trims its portfolio where growth forecasts are low, or other companies have a robust pipeline of new inventory, Mattingly says. Fifield steered clear of his South Loop Chicago backyard because of a lack of restaurants and shopping. As they were added so was apartment inventory, and now, he says, it will be three to four years before the submarket is back in equilibrium.
Technology: Harness knowledge.
Before 2008, few predicted a recession and of such magnitude. Ten years later most of the industry waits for the next downturn, though the prediction is for one far less severe. The difference, says Alfredo Munoz, CEO at ABIBIOO Studio in New York, a design and construction management firm, is the quantity of data available.
“With all the data out there, it’s much easier to track markets, opportunities and zero in where we can build and when,” Fifield says. All the data also helps companies save money since it eliminates their need for as much advertising, says Gerringer.
Some large companies, such as Waterton, have an in-house technology staff and use proprietary algorithms to track data. It also outsources research. The goal is to stay on top of 1,000 submarkets across the country and rank the best ones to invest in, Schwartz says. Recently, it added new markets to its U.S. target list, such as Nashville, Salt Lake City and Louisville.
“Nashville, for example is seeing significant growth as 100 people move there each day, some from companies relocating like asset manager Alliance/Bernstein from New York, which will provide a better labor pool and more renters,” Schwartz says. Smaller companies see the wisdom of outsourcing technology, leasing and marketing and investing in systems, so they can stick to their knitting and not support staff during slower periods, says Gerringer.
Firms use the technology for more than choosing locations. Mattingly has found data helpful to know when to pare labor costs, one of its biggest challenges.
“Last year, these costs increased at double the pace of our typical five-year trend,” he says. The result: More video conferencing and less reliance on road warriors, he says. At the same time, it won’t give up on the important human touch, which it considers critical to attract and retain renters and staff. Such steps help secure positive online reviews and maximize occupancy.
“Renters look for buildings with the best reviews. Essentially, more good reviews leads to more renters,” says David Scherer, Founder and Co-Head of Origin Investments in Chicago, a private equity real estate firm that owns and operates multifamily buildings nationally.
Williams’ RKW Residential concurs with this approach. Though her company offers virtual reality tours to generate leases, it also depends on a live team.
“One thing we are doing is adjusting hours,” she says. “This way, a team member is available for residents or prospective residents who work during the day and need service when they are off work in the evening.
The demand for this kind of quality of service stems from owners and operators knowing that many residents measure what they do against the hospitality industry. “We are seeing greater convergence between apartments and hospitality, and we expect this to continue,” says Fred Cooper, Sr., Vice President, Corporate Finance, Toll Brothers, a luxury home and apartment builder in Horsham, Penn., outside Philadelphia.
Affordability: Fill a void.
From 2010 and 2016, the number of apartments deemed affordable for very low-income families fell by more than 60 percent, according to a report from Freddie Mac. New York-based Jonathan Rose Companies has long recognized the void because of its core belief in impact investment. Doing so helped it weather the Great Recession without vacancies, says CFO Mike Arman. And President Jonathan Rose remains optimistic for any upcoming downturns. “We think we’ll continue to be pretty recession proof,” he says.
Rose plans to acquire more assets from acquisitions rather than building them, which is riskier.
“Our goal is to preserve this sector by buying and holding onto units acquired through the life of the funds we use—about 10 years—or if we sell, going to a buyer with the same philosophy,” Arman says.
Most of Rose’s 70 properties also represent project-based Section 8 housing rather than riskier voucher-based housing and are operated by the company’s own property management company rather than turned over to a third party, Arman says. Yet another reason Arman thinks that his company’s 15,000 units have become so desirable is its practice of creating “Communities of Opportunity” to bring health, social services, education and recreational programming into the community centers it constructs. A coordinator works with local organizations to strengthen residents’ lives, which, in turn, enhances neighborhood fabric. For example, residents without health insurance might receive free flu shots from a local hospital.
At Waterton, Schwartz and his team also focus on older buildings with lower rents, so it makes economic sense to add value inside the apartments and amenities, such as a fitness room, outdoor space and 24/7 accessible package room and develop underutilized features, such as racquetball and tennis courts. “We raise rents but still keep them affordable and significantly less than new counterparts,” he says.
Design: Cater to a target’s psychographics.
These days good design isn’t just about looks but inspiring the right experience. Doing so doesn’t require greater spending but better research and planning on paper before construction gets bid, says Mary Cook, a Commercial Interior Designer and Founder of Mary Cook Associates in Chicago. “What’s also important is weighing the competition’s offerings against the values and interests of the target market and differentiating projects,” she says.
Nowadays the newest recession-proof tool is psychographics research that factors in customized lifestyle choices, Cook says. “If you improve their quality of life and make it easier, they will come and stay—and encourage friends and acquaintances to join them,” she says. But it’s essential to use information to get choices right the first time rather than spend to correct problems, she says. “Fifteen percent of our work each year is ‘fixing’ projects completed by someone else who did not adequately consider the potential residents,” Cook says.
Gerringer advocates for this approach, as well as building in flexibility, particularly with an amenities program that can adapt to changing resident preferences. “Rather than have theaters with stadium seating that limit use, we suggest a screen in a room that can be converted to other purposes,” he says.
RKW Residential is converting business offices to co-working spaces, and dog parks to fitness centers so canines can do more than walk but work out on agility courses, treadmills and with tennis-ball launchers. Because of technology tools residents can be polled frequently about choices, from their fitness preferences to sponsored group events that foster community, Cook says.
Owners and operators who remember the Great Recession’s lessons and monitor what’s happening seem optimistic. “If we go into an economic downturn in 2020 as some prognosticators suggest, the rental housing industry is on solid footing and may see nominal revenue declines, but will still be supported with strong capital flows,” said Schwartz of Waterton.
Barbara Ballinger is a freelance reporter.
In an uncertain environment, one veteran apartment executive is continuing to bet on what he knows—value-add opportunities in the Southeast. Find out how he finds assets in this competitive environment and how the end of the cycle is altering his strategy.
Joe Lubeck, CEO, American Landmark was buying and renovating Class B apartments before anyone was using the term workforce. As the crucial task of providing affordable housing to America’s workers has grown more important (and gained more attention), Lubeck has been able to turn his passion into a successful business.
In 1996, he started Landmark Residential, which then evolved into a Landmark Apartment Trust, which grew to 35,000 apartments. The bulk of that company was public (23,000 units) and he sold it to Starwood Capital Group in January 2016 for approximately $2 billion. Some people might have decided to retire and move to a sunnier locale. But the entrepreneurial Lubeck wasn’t ready to hang it up.
In 2015, Lubeck, 60, took his 12,000 units and launched American Landmark, which has grown today to 24,000 units. Last year, American Landmark was ranked No. 14 on Real Capital Analytics’ list of top apartment buyers nationally. He kept the same key people, platform, geography and business model from Landmark Apartment Trust. The company is a large and active player in Lubeck’s core market of North Carolina, South Carolina, Georgia, Florida, and Texas. It focuses on true value-add and opportunistic buys.
“As my wife says, we’re a one-trick pony, but we’ve got that trick down well,” Lubeck says. “We’ve round-tripped more than 150,000 units, we’ve renovated literally 100 percent of those apartments and, of course, we’ve done well economically and financially. But we also are proud of the mission of supplying good, clean, affordable [non-subsidized] housing with good service.”
Lubeck spent some with NAA to talk about the apartment sales market and where he sees it moving in the year ahead.
How much business did you do in 2018?
Lubeck: In 2018, we did about $1.5 billion in acquisitions, but we've also sold $800 million. We’re an opportunistic trader. We look at thigs on a deal-by-deal basis, and we evaluate where we stand with each asset on a regular basis. We both buy and sell into what we think is a reasonably stable market.
How has that market shifted during the past year or so? Has it become difficult to find assets that interest you and have you had to adjust your expectations for return?
Lubeck: That’s the key question. Certainly, it’s a more competitive marketplace than it was five years ago or 10 years ago, and certainly much more than it was when I first went on my own 25 years ago. There are many, many more investors and much more capital in the secondary and tertiary cities. There are many more people who are now value-added experts as well.
As a result, we have become more selective with what we buy. Our expectations have not changed dramatically despite the market being so competitive. We have some competitive advantages because we’ve been doing it so long and have a reputation for closing on time and in accord with our contractual terms. We get a lot of off-market and private label transactions. Probably two-thirds of what we have bought in the past few years has been off-market or has some other situational consideration, such as a seller with a time consideration, a tax consideration or a familial or estate planning consideration.
Still, the market is certainly much more competitive. There are many, many more renovators than there were when I first started. There are also a lot more of the big equity players who used to restrict themselves to the bi-coastal markets that are now finding that Sun Belt and secondary and tertiary value-added properties offer them great risk-adjusted returns.
With that entrance of those guys, has it required a strategy change or are you just simply using your connections that you've built up over the years to find apartments?
Lubeck: We have not changed our strategy. We believe that our strategy in the cities where we have the greatest experience gives us a competitive advantage, and our capital strength and the fact that we’re not entirely reliant on tying up deals and finding equity partners gives us an advantage. That said, we do not participate well in the auction environment that the brokers have managed to develop. We’re not a good bidder in the so-called “best and final types” of scenarios.
How are you making the decision on what to sell and what to hold during today’s competitive, low-cap-rate environment?
Lubeck: We evaluate every transaction based on ourselves and our investors. We have a threshold that we set internally, and whenever we pass that threshold, we’re a seller. Most of what we sell still has meat on the bone and I’ve been accused of selling too early on occasion, but I’ll take that all day long as long as we’re generating solid returns for our investors, who then typically reinvest with us.
Are you selling potentially a little early because you’re concerned you might wait too long?
Lubeck: No. We always feel that when we have accomplished our goals and delivered a solid return to the investors, then it is time to sell. We are more buyers than sellers. My view of the national market is very different than my view of the Sun Belt market, but we still have a lot of confidence in the strength of our sector. We plan on doing another $1 billion to $2 billion in acquisitions this coming year.
Are you planning to become a REIT again?
Lubeck: We are privately held under our current structure. We have been a REIT. That may be a future exit strategy, but we really evaluate it on a market-by-market basis.
There is a lot of talk about this current cycle coming to an end soon and rates increasing. Because of that, are you altering your buying strategies? Are you altering your financing strategies?
Lubeck: Well, the interest rates are certainly a key consideration. We have always assumed that the interest rates of the past few years have been below market, and we don’t base our projections for a property based on the continuation of that scenario. That said, we are certainly more focused on long-term fixed-rate debt.
We believe that even if we go beyond our typical hold time of four to five years, that selling assets with that long-term debt, with what will then be below market interest rates in place, may be an asset. We certainly are focusing more on long-term fixed rate strategies. As far as the cycle, people ask me that question all the time. What inning do you think we’re in?
Yeah. The persistent baseball analogy keeps coming back.
Lubeck: I think we’re in the 18th inning. We're way beyond where the cycles would normally be. But in our markets, we see good reason for that, and frankly, we don’t see that eroding very much during the next few years.
What do I base that on? Well, we look at fundamentals. The fundamentals for success of the value-add sector and workforce housing is based on two things—jobs and population growth. Where there is job growth and where there is population growth, demand will continue for apartments. Within those markets and within our clientele, we also see a continued reduction in their desire to own a home.
Look at Texas. One thousand people move into Texas each day. One thousand people a day are moving to Florida. The job creation is extraordinary in the major markets within those cities and that that tells us that we’re not approaching the end of a cycle -- at least not yet. Will market conditions change? Certainly. We look at interest rates. We look at new product. We look at the supply of equity, but we still feel very confident that there's going to be continued stability in the Sun Belt or smile markets.