How much more yield will equity sources seek on their multifamily investments in an economic climate that promises to be one of the most challenging in a century?

While it's impossible to say for certain, Bob Hart, president of valueadded specialist Kennedy Wilson Multifamily, pegs the internal rate of return (IRR) target for any given investment at roughly 50 percent beyond what it would have been when yields were at their thinnest in 2007.

And that's going to pretty much be the case across the risk-profile spectrum, whether it's core-type holdings, value-added ventures, distress-driven opportunistic plays, or ground-up development projects.

“We're talking high-teens to mid- 20s (IRRs) today depending on the risk profile, compared to low- to midteens in early 2007,” elaborates Hart.

Investor wariness may well push average going-in capitalization rates for even the lowest-risk core apartment investments into the 7 percent-plus vicinity as 2009 progresses, predicts Craig LaFollette, executive vice president with CB Richard Ellis. As he's quick to point out, that's even more than some equity managers have been yielding in the earliest years of far more risky apartment development deals.

All of which also suggests investment activity will likely remain as crunched as credit over the coming year. Few sellers will be satisfied parting with properties at those pricing levels, perpetuating the bid-ask gap that helped reduce transaction velocity dramatically in 2008.

And many previously active investors will be comfortable remaining on the sidelines in the year ahead, anticipating that deepening financial distress will help spawn even more attractive yields in 2010. While trading in core-type properties has fallen most dramatically to date, value-added and development investments look to be particularly thin in 2009.

“The potential buyers that now dominate the market are patient,” says Sam Chandan, chief economist with market research firm Reis, Inc. Those that are willing to pull the trigger expect a year or two of declining-tofl at operating incomes—and want higher yields up front to compensate for the looming income erosion.

There's not much mystery behind equity's heightened yield requirements. Equity managers fear softening renter demand will erode operating incomes over the coming year.

Investors calculating IRRs today recognize that rents and incomes may be no higher two years from now, LaFollette relates. Hence buyers of stabilized communities will drive hard bargains ahead, as they need the additional going-in yield to help boost the longer-term return, he adds.

If the recession erases 4 million jobs, net operating incomes (NOIs) at apartment properties across the country would decline by an average of about 1.6 percent in 2009, according to an analysis by Witten Advisors. Under that scenario, NOIs would likely be flat in 2010 and rebound by an average of 5.4 percent the following year, the research consultancy forecasts.

Meanwhile, today's higher financing costs likewise necessitate higher going-in yields. Not only are remaining active apartment lenders requiring higher debt-coverage ratios, leading players Fannie Mae and Freddie Mac further widened their interest rate spreads during 2008's waning weeks, LaFollette reports.

“As financing costs go up, you have to have higher cap rates,” LaFollette continues. “And when the perceived risk is greater, you also need higher IRRs.”

Core holdings

Amid all the economic and capital markets uncertainty, even lowleverage public real estate investment trusts and the deepest-pocketed, most sophisticated institutionally backed investors are challenged to determine what to bid for core-class apartment communities, laments Ric Campo, CEO of Camden Property Trust. Camden has some $1.5 billion ready for deployment, but “we don't know what to bid right now because of the uncertainty in the market,” Campo told conference callers.

LaFollette concurs with his fellow Houstonian's assessment but offers an educated guess. “If you want to get an institutional investor off the sidelines, you'll need to price even an absolute trophy property at a cap rate of no less than 6.5 percent.”

Again, potentially declining NOIs seem certain to boost IRR requirements for core assets. “It's going to have a severe impact on IRRs, so [core investors] are going to want cap rates going in maybe in the 7 to 7.25 range,” LaFollette continues. “And even at that pricing, it may be tough to find a buyer.”

At the other end of the price-point spectrum, it appears only exceptionally attractive pricing will get smallish local operators off the sidelines. Many of these investors are scared to buy in this environment with the volatile capital markets, rising cap rates, and softening renter demand, says Greg Wendelken, regional manager overseeing investment brokerage Marcus & Millichap's Seattle operations.

“People are taking money off the table because they want liquidity in this challenging period,” Wendelken adds. “There's just not a lot of urgency to buy right now.”

Value-added ventures

Fears of declining effective rents also will cut further into value-added investment activity in 2009, experts agreed. Some equity sources that had been investing in value-added ventures are waiting to pounce on distressrelated opportunities ahead, and some are migrating toward quality stabilized properties, notes veteran value-added specialist Jerry Fink, managing principal with The Bascom Group.

“They're seeing better yields for low-risk Class A properties than they've seen for quite a few years,” Fink elaborates. The net effect on equity flow into Bascom's specialty: “The value-add game is almost dead for the moment.”

It just doesn't make sense to vacate and upgrade units if the development team can't really count on high enough post-repositioning rents to justify the investment, adds Hart. “No one wants to take on that rehab risk. What's attractive today are deals immediately accretive to the equity without much risk.”

Opportunistic plays

Many opportunistic buyers looking to exploit financial distress seem set to sit out 2009, as they expect to identify truly vulturistic targets only after debt markets stabilize. “Almost all the conversations today are about distress, about prospects for blood on the streets, and picking up real steals,” LaFollette notes.

But LaFollette doubts the opportunistic equity will start flowing heavily until 2010. More normalized lending practices by then should help identify assets that are truly distressed—as opposed to those in better shape but hampered by the semi-frozen credit markets.

Development projects

Higher cap rates don't provide much incentive for equity managers to invest in new development ventures, particularly amid questions about the depth of renter demand ahead. And predictably, construction lenders are wary of funding such risky ventures in the prevailing environment.

While few markets are now considered overbuilt and Campo remains optimistic about the next decade, Camden enters 2009 deliberately “slowing down our starts” amid the erratic financing market, the CEO relates.

Higher cap rates are another factor limiting development, LaFollette notes. Development teams in recent years could earn a return of maybe 7 to 7.5 percent (of development costs) by continuing to own stabilized projects. But they also knew they could sell them at cap rates in the 5s and even lower in some cases—quite an incentive to continue building.

“But now if caps are at 7, you've just got no spread” between development yield and acquisition cap rates, LaFollette continues. So why take on development risk for the same return an investor could get acquiring an already stabilized community?

The diminished new-product pipeline has Campo expecting something of a landlord's market once the financial arena stabilizes and the economy starts pulling out of the recession— perhaps a couple years down the road. He in fact projects an apartment shortage starting as soon as late 2010, likely lasting through 2013.