A YEAR AGO, THE TERM “CAUTIOUS OPTIMISM" was a popular forecast for 2011, a middle ground between the hangover of a nasty recession and the hope inspired by improving fundamentals.
As values and access to capital continue to improve, however, multifamily professionals are starting to drop the caveat from that forecast. New developments seem to break ground every day; value-add deals are returning to vogue; and acquisition activity is heating up well in advance of the typical fourth-quarter busy season.
“We're obviously bullish that we're at the beginning of a development cycle, so we're putting a lot of time, energy, and resources there,” says Jay Hiemenz, CFO of Phoenix-based Alliance Residential. “And the cap rate compression, coupled with better fundamentals, has made deep renovations feasible again."
It's no wonder, then, that Alliance has a development pipeline of around 5,000 units and expects to acquire about 2,500 more this year. And the company's value-add business is growing as well: It's currently working on a $45,000-per-unit rehab of a 40-year-old community in Rancho Palos Verdes, Calif., looking to move rents by $750 a door.
Alliance isn't alone in its optimism. About 44 percent of multifamily firms are increasing their acquisition appetite, while nearly 38 percent plan to start more development projects over this coming year (see “Expansion Traction"), according to a survey of 138 senior-level multifamily finance professionals conducted in August by Apartment Finance Today.
“You haven't seen any new supply added for the last two years and that really creates a lot of bullishness for early-cycle development,” says Derek Ramsey, CFO of Charleston, S.C.–based Greystar. “We feel like there's pent-up demand, that even with lackluster job growth, the earlycycle deals coming out of the ground should perform extremely well."
Indeed, what the data, along with interviews with active industry players like Ramsey, indicate is that multifamily firms are chomping at the bit, ready to feed these growing appetites more aggressively than at any point since the Great Recession. And as this optimistic bunch forges ahead, they are all too cognizant of the following five market factors influencing their every decision.
#1. Price is what you pay; value is what you get.
Many CFOs have been taken aback by the swift rebound in values this year and are selectively pruning their portfolios to fuel an ever-growing investment appetite—more than 36 percent of survey respondents plan to enter new markets in 2012. Couple that with improving capital markets, and it's a great time to sell, prompting many firms to reconsider their hold periods. At the beginning of 2011, UDR wasn't planning any dispositions for this year. Yet the REIT recently revised that forecast significantly. “Cap rates compressed much quicker than anybody expected, and it's become the new norm,” says David Messenger, CFO of the Highlands Ranch, Colo.–based firm. “It hasn't changed our acquisition strategy, but it's one of the reasons we are marketing between $400 million and $600 million [in sales]."
The assets that UDR is marketing—in markets such as Sacramento, Calif., and Fredericksburg, Va.—speak to a broader recovery. The cap rate compression that began last year with Class A assets in primary markets has trickled down to B assets and smaller metros, as more investors chase yield in unexpected places.
The impact of this cap rate compression on investment strategy has been profound. Many firms have been inspired to restart their development pipelines based on the ever-declining yields in the acquisition market. In fact, in some high-barrier coastal markets, it often makes more sense for investors to build core product now rather than buy.
Driven in part by this ever-improving pricing, Atlanta-based Wood Partners has sold more than 7,000 units since the beginning of 2010, recycling the proceeds into high-barrier coastal markets such as Boston, Los Angeles, and Washington, D.C. The company acquired 3,200 units last year for $400 million and expects to buy about the same volume this year. But it's the firm's development pipeline that's expanding at a huge clip—Wood started 2,000 units last year and expects to double that figure this year. “Relative to Class A core acquisitions, comparable development starts are generating 100 to 150 basis points [bps] more yield,” says Joseph Keough, CFO and COO of Wood. “We believe this spread justifies ground-up development."
#2. Turning down leverage is probably smart.
Development yields have also been helped by the improving construction debt market, which offers another indication of just how quickly the industry has moved from fear to exuberance.
A year ago, national, regional, and community banks were quoting spreads of 325 bps over LIBOR and instituting underwriting floors, and were often unwilling to go beyond 60 percent loan-to-cost (LTC). Today, spreads are around 225 bps, underwriting floors have disappeared, and leverage levels seem to rise a little more every month. And while the Federal Housing Administration dominated the construction market last year, nearly 50 percent of survey respondents plan to use traditional bank construction loans in 2012, while only 24 percent anticipate using the FHA. In fact, many of the industry's largest developers are beating back offers of additional leverage from banks—a dynamic that probably didn't happen too often during the last boom period. “In some cases, we're turning down leverage from our construction lenders,” Keough says. “We want to be sure that we are not overlevered and still have the ability to take out the lender if we decide to hold the asset long term."
And the way Wood Partners approaches leverage varies depending on the market—and the projected yield. The firm will be at 55 percent to 60 percent LTC for deals in high-barrier markets like Washington, D.C., where yields are lower. But that leverage level can reach 70 percent in states like Georgia, Texas, and the Carolinas, where deals are higher yielding (and at lower construction budgets).
The higher leverage levels offered today—and the pushback by borrowers—is a good microcosm of where we are. It's a measure of both how far the capital markets have come and the lessons learned by finance professionals during a bitter recession: Before the downturn hit, Camden Property Trust typically kept its volume of floating-rate loans to no more than 20 percent of outstanding debt. But over the past three years, the company has beaten that figure down to around 9 percent. “With the lessons learned in the last downturn, we have been going through a de-levering process,” says Dennis Steen, CFO of Houston-based Camden. “And we learned to fund a significant piece of the development equity up front."
#3. Value-add and trending rents are back.
If the shell shock of the downturn has made some strategies more conservative, the health of the multifamily industry is doing just the opposite.
The idea of “trending rents” was viewed as a deadly sin during the downturn. Over the past year, though, value-add rehabs came back into the spotlight as rent growth resumed in earnest. In fact, 38 percent of survey respondents see more value-add opportunities coming in 2012.
Home Properties spent $339 million in acquiring nine communities last year and underwrote them at a blended 6.1 percent first-year cap rate. The company is seeing a 6.7 percent first-year yield—in aggregate, those deals are showing a run rate that's $500,000 higher per quarter than was anticipated. “We've seen a huge ratcheting up of increased new-lease rates, higher renewal rates—it's been a very steep climb from January until now,” says David Gardner, CFO of Rochester, N.Y.–based Home. “We're also seeing the opportunity to layer in a lot more upgrading of units at a much faster pace."
UDR has been the industry's most active buyer, spending more than $1.9 billion over the past year alone as it chases an urban core growth strategy. Much of that activity centers around New York and Boston, two markets UDR had no presence in a year ago. Since January, the company has acquired 1,916 units in Manhattan, while investing in 2,721 units in Boston.
UDR's focus away from the suburbs and onto urban cores also signals a larger trend. About 53 percent of survey respondents say city center population growth is the main demographic trend informing their investment strategy. No wonder, then, that on one of its Manhattan assets, the 706-unit Rivergate, UDR intends to pump in $40 million to $60 million in rehab costs—or $70,000 a door. In fact, even before it started the Rivergate rehab, the company increased rents by $500 over in-place rents.
#4. Distress has not gone away.
Far away from New England, other investors are finding ample value-add opportunity in some of the nation's hardest-hit metros. That explains why 50 percent of survey respondents expect to see more distressed properties hit the market.
Of the 1,800 units that Alliance Residential acquired last year, about 80 percent were distressed, purchased either through bankruptcy sales, REO, or short sales. But this year, the flow of distressed-priced assets has slowed. “It's definitely a different dynamic now—in most cases, you're not dealing with the lenders anymore, you're dealing with the borrowers,” Hiemenz says. “The opportunities now are more in that renovation capital play versus the distressed acquisition."
Alliance is still uncovering some great deals, particularly in Las Vegas. In April, the company spent $3 million on an unfinished condo project called The Pueblos in North Las Vegas, a deep discount when you consider that the outstanding balance on the construction loan at the time of foreclosure was $8.7 million. In May, the company picked up a nonperforming note on the brand-new, 524-unit Fountains at Flamingo in Las Vegas for just $89,000 a door. “That's been our strategy: Go where it's the scariest,” Hiemenz says. “Vegas has been so shunned by institutions that we see it as a great value play, a market you can still buy distress."
While Vegas still inspires fear, multifamily finance professionals once again chose South Florida (28 percent) as the distressed market with the most upside in this year's survey, ahead of Phoenix (16 percent) and Atlanta (14 percent). And some investors continue to unearth opportunities in South Florida. Wood Partners purchased Terrazas River Park, an empty, broken condo deal, in Miami last year for around $44 million, or 50 percent of replacement cost. The property is now more than 90 percent occupied at pro-forma rents.
#5. The bottom line can always grow further.
While many firms wrung every last dollar out of cost-cutting maneuvers in the downturn, some still saw ways to reduce costs last year.
Increasing the collections on utility billing is one popular strategy. In fact, passing utility costs on to residents was the top NOI-boosting strategy among finance execs, with about 42 percent of respondents signing on. Greystar, which manages nearly 190,000 units across the nation, moved to one vendor, National Water & Power, to standardize and maximize its water rebilling efforts over the past year. “We've taken our rebill recovery from 67 percent to 85 percent,” Ramsey says.
And now that concessions have burned off in most markets, many owners are focused on recapturing that lost income, one fee at a time. “Whether it's administrative fees, application fees, pet rent, pest control fees, or renter's insurance, a lot of those items were concessed during the downturn,” Ramsey says. “Though they're fairly small as a percentage of gross potential rent, they all drop to the bottom line of a property's financial statements, so they can have a material impact on NOI."
Revenue management software continues to gain traction—it was the second-most popular NOI-boosting strategy in this year's survey (23 percent). Bell Partners started rolling out Yieldstar in 2008 and expects to have it implemented on about 175 communities by year-end. “It really helped us during the downturn. Our strategy was to push occupancy to help offset rent declines,” says John Tomlinson, CFO of Greensboro, N.C.–based Bell. “Now, clearly, the focus is on maximizing rents."
Indeed, the focus for nearly everyone in the industry is on growth. Only 7 percent of survey respondents report having no growth plans for 2012.
Armed with both the hard-earned wisdom of a survivor and the knowledge of rapidly improving fundamentals, it's no wonder that optimism— without the caveat of caution—is reigning in multifamily.
“We're looking at 2012 to 2013 as some of the best years multifamily has ever seen,” Gardner says. “We all have a couple of good years ahead."
HOW LOW CAN CAP RATES GO?
Can interest rates, and by extension cap rates, fall further in 2012?
A YEAR AGO, many borrowers thought they were facing a once-ina- lifetime opportunity when the yield on the benchmark 10-year Treasury hovered around 2.4 percent in the autumn. Yet, the benchmark hit 2.1 percent August 10, 2011, keeping mortgage rates at historic lows.
Bring together a wave of hungry capital-targeting multifamily plus surging fundamentals, and you've got the formula for cap rate compression. So multifamily finance pros aren't shocked that values have improved—it's the rapid pace of that improvement that's surprising.
Camden Property Trust, one of the industry's most active buyers over the past 12 months, closed on more than $700 million for 18 communities from July 2010 to July 2011. But a year ago, the company didn't see itself as big spenders. “We were waiting on the sidelines last year, but the interest rate environment really helped us accelerate acquisition activity,” says Dennis Steen, CFO of the Houston-based REIT. “In core markets, with interest rates as low as they've been, you can still acquire an asset in the mid–5 percent cap rate range, finance it with agency debt, and get a decent levered IRR."
Indeed, few saw this coming. In last year's CFO Strategies Survey, 78 percent of respondents believed cap rates would stay flat or rise this year—yet they have continued to compress. In this year's survey, 83 percent expect cap rates to stay flat or start rising in 2012. Still, other CFOs have been bolstered by the Federal Reserve's pledge in August that it would keep interest rates low for the next two years. And they also see the ever-improving debt and equity markets as proof positive that cap rates will continue to remain compressed, or even fall a little further, in 2012.
HEDGING AGAINST GSE REFORM
While Fannie Mae, Freddie Mac, and the FHA continue to lead the debt market, private-sector lenders are getting competitive.
LAST YEAR, ONLY 16 percent of survey respondents borrowed from either life insurance companies or conduit lenders. But more than twice that, 39 percent, expect to tap CMBS or life company debt over the next year.
As Congress continues to debate the future of the government- sponsored enterprises (GSEs), the growing menu of debt options becomes particularly critical. In fact, when it comes to housing finance reform, a plurality of senior-level multifamily finance execs (about 34 percent) favor a market with only limited government involvement targeted at affordable housing over any other options, according to the survey.
The way large apartment firms approach the possibility of a GSE-less world is telling. First, they are diversifying their debt sources by striking more relationships with life companies, banks, private funds, and conduit lenders.
Second, they are not pushing for every last dollar in leverage— most private-sector lenders favor lower loan-to-value (LTV) deals.
“The most prudent thing to do as a borrower is to not rely on a leverage point that makes the GSEs your only market,” says Jay Hiemenz, CFO of Phoenix-based Alliance Residential. “There's always liquidity at a moderate leverage point—if you structure it properly, then you're going to have debt options."
Indeed, taking a long-term strategic approach to leverage— in essence, preparing for a market without the GSEs—is critical for long-term holders like Rochester, N.Y.–based REIT Home Properties. “The idea of putting 75 percent LTV every time I get an acquisition is not going to be the story anymore,” says David Gardner, CFO of Home Properties. “We're trying to position ourselves for a number of years down the road when things change, by de-levering."
One trend causing anxiety for multifamily CFOs is the prospect of an increase in property taxes.
MANY FIRMS enjoyed steep savings by challenging tax assessments during the downturn, but there's a sense in the industry that tax increases are around the corner.
Pretty much every level of government is struggling with its budgets and eyeing additional revenue.
Last year, Camden Property Trust was able to get a 6 percent decline in its property tax bill, but the REIT wonders if the party is over. “It's going to start to revert to some degree,” says Dennis Steen, CFO of Houston-based Camden. “We're expecting property taxes to be up about 2 percent, plus or minus."
But other CFOs see room to challenge assessments. “From an expense point of view, that's one line item that could come back to haunt all of us,” says David Gardner, CFO of Rochester, N.Y.–based REIT Home Properties.
“There is still a lot of ability to reduce assessments and get reasonable tax reductions. We have a number on tap for the balance of this year."