When Essex Property Trust, a Palo Alto, Calif.-based REIT, went public in 1994, it brought a distinct operating philosophy to the multifamily universe: to acquire, develop, and own apartment communities in high-barrier, supply-constricted markets. At the time, Avalon Properties (now AvalonBay Communities) engaged in similar tactics in tight Northeast markets. The companies were alone in their practices.
Less than two decades ago, most large REITs were happy with the 9 percent cap rates they saw in so-called commodity markets—Sunbelt locales such as Atlanta, Houston, and Phoenix.
For Essex to pursue its strategy, it would have to buy and build in places like San Francisco and Los Angeles, where high-priced properties typically yielded cap rates of 7 percent or less, and municipal hurdles meant entitlement timelines could span years.
“People would ask, ‘Why should I invest in California when I can go to Houston or Atlanta and get a lot better deal?'” recalls Keith Guericke, president and CEO of Essex. “What we saw, though, was that in California, we had rent growth of 5 or 6 or 7 percent every year. In the Sunbelt, you might have 5 or 6 percent rent growth for a two-year period, but then you'd have rent losses for the next five years. So you never got anywhere.”
Indeed, fir ms like Essex and AvalonBay were once seen as niche operators in hard-to-crack markets that produced lower returns in the short term. Today, they're the vanguards of where large apartment firms want to be: high barrier-to-entry, supply-constricted coastal markets where developing properties from the ground-up is a battle, and buying existing buildings at a palatable price is almost impossible. “Now, all of the big REITs are trying to get into the supply-constrained markets,” Guerick says.
The advantages are obvious—gargantuan returns and growth opportunities. But busting down the barriers isn't easy. With more and more players charging into coastal markets such as Boston, New York, and Washington, D.C., in the East and Seattle, Portland, San Francisco, and Los Angeles out West, industry insiders say it takes more than deep pockets to succeed. Equally crucial are strong development capabilities, long investment timelines, and the ability to overcome local, municipal, and community roadblocks.
A HOT COMMODITY Right now, firms that traditionally sought more middle-of-the-road (and country) markets such as Chicago-based Equity Residential and Richmond, Va.-based UDR are unabashedly pursuing markets on the coasts. During the first quarter of 2007, Equity realized 53 percent of its total net operating income from six high-barrier markets, including New York, Washington, D.C., and Seattle. Meanwhile, after a West Coast buying spree, UDR counts Orange County, Calif., as its single largest market; the region accounted for more than 10 percent of the firm's total NOI in the first quarter of 2007. “Over the last several years, we've seen an advantage to increasing our exposure to high-barrier markets,” says Mark Wallis, senior executive vice president at UDR.
The reasons behind the flight to the coasts today aren't hard to understand. Although the cost—and struggle—of getting into high-barrier markets is great, so are the rewards. “There is the very obvious element of restricted supply yielding bigger returns and better rent growth in these markets over the long term,” says Alan George, chief investment officer at Equity. “That's the simple answer.”
Those advantages are bolstered by the fact that once you're in, it's harder for your competitors to build next door. After all, the definition of a high barrier-to-entry market is that it's hard to get your foot in the door, so you don't have to worry about a deluge of new properties popping up and putting downward pressure on rents. In fact, once you're in, observers say rent growth tends to be more consistent, and comes in bigger chunks, than so-called commodity markets. At Alexandria, Va.-based AvalonBay, chairman and CEO Bryce Blair says rent growth in the company's supply-constrained coastal markets averaged 4.7 percent over the last 10 years. The average rent growth for the 50 largest metropolitan statistical areas, in contrast, has been just 3.1 percent during the same period, according to Economy.com and market research firm Reis. “At the end of the day, it's about revenue growth, which ultimately drives NOI growth and asset values,” Blair says.
And though recently some firms have successfully bought existing properties in high-barrier markets, that's becoming increasingly rare. The number of buyers chasing those properties has driven values up, while causing cap rates to plummet. With cap rates hovering between 4 percent and 4.5 percent in markets like New York and Los Angeles, yields are often lower than the cost of funding an acquisition. “The situation you see today is that entry cap rates for acquisitions of stabilized properties are well below most companies' weighted average cost of capital,” says Ed Lange, COO at San Francisco-based BRE Properties, which focuses solely on West Coast markets. “You cannot build a growth strategy around acquisitions alone.”
Indeed, BRE has been scouring the West Coast over the last several years, looking for the best sites for multi-family development. The result is a $1.5 billion development pipeline, and plenty of places to turn dirt. “This year, we are starting more than $200 million in projects, but all of those land sites were identified a number of years ago,” says Connie Moore, president and CEO at BRE. “It's taken us that long to get it to this level.”
As market dynamics have changed, even first-movers have had to adjust operations to keep up. At Essex, for example, Guericke says the firm has shifted from an 80 percent acquisition strategy to more of a 50-50 split with development. The firm has beefed up its Southern California development group staff by 300 percent over the last five years to ensure it can get in on the hard-to-find deals in that market.
BUMPY ROADS Still, the development process is anything but rosy in these lucrative markets. Land costs are often four to five times higher than in less sought-after areas. And more complex approval processes in major cities can mean sinking $1 million to $2 million into the process up front, with no guarantee of success. Given that scenario, companies need deep pockets, lots of bodies, and an investment timeline that spans decades, not just a few years.