Equity investors are increasingly chasing yield in new development and value-add opportunities, while waiting for an expected bonanza of recapitalization deals, said panelists at the recent Apartment Finance Today Conference.
Given the frenzied bidding wars on Class A assets in core markets, cap rates have been driven so far down—compressing 250 basis points in the last 18 months—that it often doesn’t make sense to buy. Equity investors will look at acquisitions in secondary markets, but ultimately see much better returns in the new development or value-add space.
“A lot of investors find it less risky to invest in a high-quality development deal in a core market than they do to invest in an existing deal in a secondary market,” said Frank Marro, managing director of multifamily equity for Norwalk, Conn.-based GE Capital Real Estate. “So traditionally risk-averse investors, ironically or anti-intuitively, see development as having less risk than investing in secondary markets or older assets.”
The focus from large equity investors is mainly on infill or transit-oriented development. And to achieve the kind of returns they’re looking for, equity investors are much more apt to back merchant developers rather than long-term holders.
“You can’t hit any kind of yield expectation holding it for 10 years, so most of the money ends up being a merchant build strategy,” said John Fenoglio, senior vice president at Charlotte, N.C.-based Grandbridge Real Estate Capital. “There are some investors on core deals that will take a longer horizon, and they’ll price that money accordingly. But unless you get some big rent growth, you’re going to have to sell.”
Most of the money coming to the marketplace today is value-add money, looking for returns in the mid-teens or higher. The lower-return money—the core and core-plus strategies—are being rationed for true infill, true high-barrier markets.
“We just looked at a development deal, and our client was looking for total average returns in the 15 percent to 18 percent range,” said Dan McNulty, co-chairman and co-CEO of New York-based Rockwood Real Estate Advisors. “Their view is, it’s better to move into development, where you can build to a 6.5 percent or 7 percent cap rate, rather than buying something at a 4.5 percent cap.”
GE Capital Real Estate also has an appetite for development. The company is currently raising a Multifamily Recapitalization Program, which, as the name suggests, mainly targets Class A and B assets in need of being recapitalized or de-leveraged. Yet, a full 25 percent of the fund will target new development in infill locations and value-add opportunities.
The focus of GE’s new fund is three-fold. Beyond recapitalizations and new development, the program sees opportunities down the road in acquiring REO or non-performing loans as banks and special servicers get serious about cleaning up their balance sheets, Marro said.
Indeed, equity providers see a growing opportunity in the recapitalization market. About $95 billion in multifamily debt will be maturing in the next three years, according to the Mortgage Bankers Association. More than 40 percent of that debt will somehow need to be resized. “At least 15 percent to 20 percent of new capital will have to be added to that pool of debt,” estimated Dave Valger, a partner at New York-based equity investor RCG Longview. “That’s about $6 billion-plus that has to come from somewhere.”
The Class A properties shouldn’t have any problem finding that capital—REITs, sovereign wealth funds, and even some debt providers will find those deals desirable. But the B and C assets will largely be on the outside looking in. “That bifurcation will create an even greater opportunity, and hopefully a better yielding environment for new equity to come back in,” Valger said.
For the acquisition of a newer-vintage construction deal in a core market, equity providers are looking to achieve a leveraged 12 percent return. “And if this is an A-plus location, you might find a capital provider that has an even lower expectation,” Fenoglio said.
For example, some infill properties in Fenoglio’s hometown of Houston are trading at 4.5 percent cap rates, and the unleveraged internal rate of return expectation is 8 percent. “People think that 4.5 percent will be a 6 percent cap in 18 months,” he said. All-cash deals are much more common with such low cap rates. “Your competition for those kind of deals are unlevered funds—they’re having such a hard time putting money out; they don’t want any debt,” he added.
Whether it’s an acquisition, refi, or new development, equity investors are focusing much more on quality of sponsorship. While sponsor scrutiny is at an all-time high, investors realize that pretty much anybody in the business had some economic hiccups throughout the downturn. “How the person handled themselves, what the ramifications were, and how they are capitalized going forward are the first things we answer on every transaction,” Fenoglio said.