John W. Tomac

When Matt Lester bids on a property in one of his core markets These days, he has to fight a little bit harder to be heard.

Four or five years ago, the silence was deafening throughout much of his company’s footprint, which stretches from the Midwest to the Southeast. But in those same markets where he once pursued deals without competition, Lester is now trying to cut through the noise and fend off bigger investors coming in from New York and other well-heeled locales.

“In 2009, you could be a solo hunter anywhere, even in some pristine markets like Buckhead in Atlanta,” says Lester, founder and CEO of Bloomfield Hills, Mich.–based Princeton Enterprises. “There was a window of about 120 days with no competition for assets that were REO [real estate owned] assets.”

Times have certainly changed. The third quarter of 2014 saw $27.5 billion in apartment transactions, a 28 percent increase over the third quarter of 2013 and the second straight quarter of sales exceeding $26 billion, according to New York–based commercial real estate research firm Real Capital Analytics (RCA).

The apartment market’s recovery has been robust, with rents and occupancies growing stronger each of the past five years. That, combined with weakness in other commercial real estate sectors, brought a flood of investors—from foreign capital to American office owners and single-family builders—into the apartment market.

RCA reports that more than 3,000 new investors have entered the apartment space since 2010.

“There is a significant amount of capital pursuing good real estate opportunities because investors (pension funds, family office capital, and wealthy individuals) are in search of yield and are not finding many options to place their money,” says Keith Harris, chief investment officer for Chicago-based Laramar Group.

The full array of lenders has followed, with community banks and commercial mortgage-backed securities (CMBS) originators storming back into multifamily to give the insurance companies and government-sponsored enterprises (GSEs) a run for their money. The GSEs, in fact, have seen their market share fall to just 37 percent, after holding things together for the industry during the credit crisis, according to RCA.

The end result of all this cash? Returns are shrinking. In the third quarter of this year, cap rates fell to 5.9 percent, an all-time low, says RCA.

“Everyone is looking for their niche of driving higher returns in a low-yield, low-return environment,” says Bobby Lee, president and COO of Los Angeles–based JRK Property Holdings.

With many observers wondering how much further rents can be pushed, finding spots to generate solid returns will get even harder in 2015. But that doesn’t mean apartment owners won’t take a shot.

In this low-yield environment, investors are literally looking at everything. Here are five ways they’ll try to move the needle in the year ahead:

1. Assume Development Risk

Even with 238,143 units expected to hit the market in 2015, developers are still loading up their pipelines for more, according to ­Axiometrics. Trammell Crow Residential, for example, expects to start 9,000 units next year, and Phoenix-based Alliance Residential plans 8,500 starts.

“All indications are that developers and their investors are positioning for more,” says Carl Frinzi, senior vice president and business unit leader for multifamily at Dallas-based Balfour Beatty Construction, which has 2,400 starts planned for next year. “Early investors are finding buyers for their current portfolios and reloading their pipeline for another solid round of development.”

But developers may have their eye on markedly different locations than they did a few years ago. After investors spent a few years telling themselves they were safer in the urban core, Axiometrics says starts in suburbs are outgaining those in cities. Others agree.

“Suburban is far less risky and has higher returns, but it’s something that has taken awhile for institutional capital to focus on,” says Mark Alfieri, CEO of Plano, Texas–based Monogram Residential Trust. “That’s where the focus will change. Suburban is less risky from a construction perspective.”

Monogram is also open to assuming risk from other developers’ projects, including Vara, a 202-unit project in San Francisco. “We bought it at CO [certificate of occupancy] and look to do more of that going forward—buying properties that were just recently completed, taking the lease-up risk to obtain that yield, instead of waiting until the property is leased and stabilized and paying those [low] cap rates,” Alfieri says.

2.Pursue Value-Add

As in the last cycle, investors are continuing to move to the increasingly crowded value-add space as the upturn matures.

“Competition has heated up for investment opportunities with a value-add component,” Harris says. “In our mind, when there are new players entering this space, it is the sign that stable returns are getting too low. In an effort to chase higher returns, investors are often disregarding or, at the very least, underestimating the execution risk associated with these types of investments.”

In some cases, these new entrants are players who stayed in the core during the last cycle.

“As core has been priced to perfection, we’re seeing pension fund advisers and other institutional-type investors pursue a strategy of value-add to core where they’ll buy an old building in a really good location and reposition it into a core-plus asset,” says David Schwartz, CEO of Chicago-based Waterton Associates.

Much of the recent development pipeline has been tilted toward luxury deals. So, with more than 275,000 new units (and more sure to follow) expected to hit the market in the next two years, there are valid reasons to look to Class B and below.

“As we look at the recovery period, the Class B apartment properties and value-add is outperforming, and is expected to outperform, the Class A market over the near term,” says Brian E. McAuliffe, senior managing director for Los Angeles–based CBRE Group. “That gets back to the supply side on Class A.”

But there are also ways to juice your rents through value-add without navigating the treacherous acquisition waters. Instead of bidding on someone else’s property in a 4 cap-rate environment, Monogram simply rehabs its own portfolio.

“Some of the best value-add opportunities that we see in the market today are in our own portfolio,” ­Alfieri says. “So, even for a property that’s 10 years old, there’s an opportunity. We’re going in and redoing the kitchen and flooring, and we’re seeing terrific returns on that investment.”

3. Return to Condos

In some markets, at least, it looks like condominiums are making a long-­awaited return.

The Washington, D.C., condo pipeline, for example, has increased for the first time since 2005, according to Alexandria, Va.–based ­research firm Delta Associates. With the 3,100 units either being marketed or sold in and around the nation’s capital, supply has grown by a few hundred units over the past six months as condo prices have jumped 12 percent year over year.

And developers are jumping back in like they did during the mid-2000s, though “the size of the projects is smaller than they were in the last boom cycle,” says William Rich, Delta’s senior vice president and multifamily practice director.

Washington isn’t alone. Earlier this year, The Wall Street Journal reported that more than 1,800 units would be completed in downtown Miami in 2015. New York has been a strong market for a while, too. And in markets like Charleston, S.C., and San Francisco, smaller projects, in the 50- to 100-unit range, are beginning to appear.

“I expect condos to be a trend with growing momentum, but only in elite AA- and AAA-type locations, and on the upper end, just because of the difficulty in financing for home purchases,” says McAuliffe.

With stringent mortgage-finance rules still limiting demand, it’s doubtful this condo boom ever grows to the disastrous mid-2000s levels, but there is growing demand in certain markets.

“Part of [the demand] is rental prices,” Rich says. “There’s also a shortage of product in the market.”

McAuliffe thinks condo conversions could soon follow in hot spots around the country. “If [this cycle] follows past ones, the next area is condo conversions,” he says.

4. Make Portfolio Buys

For the bigger players, 2015 could offer some big opportunities. For the very biggest of the public and private equity sources, there’s ­Atlanta-based operator Gables Residential, which should have a new owner in the first half of the new year.

But even for buyers who can’t take on a firm that began the year with 36,081 units (and a development pipeline of 982 units), there’s opportunity. McAuliffe expects several large portfolios to move and the sale of properties in the $200- to $400-million range to continue. “I expect numerous transactions of a billion or more going into 2015,” he says.

Big-money institutional buyers may look for even more creative ways to establish their presence in multifamily over a long period.

“The institutional world has learned the lesson that they want to associate with people who are operators,” says Albert M. Berriz, CEO of Ann Arbor, Mich.–based McKinley. “They don’t want to just have an investment conduit; they want to talk directly to the person who’s operating the asset.”

These types of arrangements aren’t anything new. In 2008, CB ­Richard Ellis Investors bought a controlling stake in Atlanta-based Wood Partners. But over the past couple of years, the business has been so profitable that few firms have wanted to sell a stake of their platform.

“Now, as there’s a pause for less growth, I think there will be more interest in having some discussions to buy some of these platforms,” McAuliffe says. “It may not happen, but there will be discussions.”

5. Head Back to Core Markets

While trades of mid- and high-rise properties in the Big Six metros recorded $10.89 billion in the third quarter, secondary, and even some tertiary, markets once again saw the largest total number of apartments move, according to RCA. Some of that activity entailed large institutional buyers chasing yield.

“There’s no question that money is chasing deals in the secondary, and even tertiary, markets,” Lester says. “The traditional buyers of New York, Boston, San Francisco, Los Angeles, and Chicago real estate are in a variety of markets that you didn’t tend to see them in.”

Partially fueling that growth is a renewed appetite by lenders to finance deals off the beaten path. In the third quarter, regional and local banks captured 17 percent of all apartment lending (after sitting at less than 10 percent before 2013), while CMBS secured 13 percent of the market (after originating almost nothing in 2010), according to RCA.

“What was holding those markets back in the first few years of the recovery was that, with the exception of the agencies, debt financing wasn’t as readily available,” says Ben Thypin, RCA’s director of market analysis. “But now, between CMBS, the banks, and the agencies, it’s fairly easy to get debt financing on a secondary-market purchase.”

But the cap-rate spread between core and secondary markets has narrowed, from 200 to 300 basis points down to 50 in some cases.

“There’s almost no premium to go to secondary and tertiary markets,” says JRK’s Lee. “My expectation is that you’ll see some migration to quality—whether it’s higher-quality assets or higher-quality markets. When you look at it, you almost don’t get paid a premium to go to Brunswick, Ga., versus Atlanta.”