It's a common refrain, sometimes uttered through clenched teeth,heard in every primary market.

“If we're in a bidding situation against REITs, nine times out of 10 we're going to lose," laments Aaron Hancock, director of acquisitions for Laguna Niguel, Calif.–based Raintree Partners. “That's why we're not buying core assets."

Muscled out of high-barrier, Class A markets such as Washington, D.C., and San Francisco by well-heeled institutions—REITs, pension funds, and life insurance companies—many multifamily investors have fixed their sights on riskier plays outside the core in search of higher returns.

This shift seems to happen at this point in every cycle: The cream of the crop recovers first, followed by a trickle-down into secondary markets, Class B assets, or value-add deals. But this year feels diff erent. As more investors increase their risk tolerance and cast a wider net in search of yield, that trickle may feel more like a flood.

“It's happening faster this time; there's more capital floating around at this point in the cycle than usual,” says Dan Fasulo, managing director of New York–based market research firm Real Capital Analytics. “Secondary markets are certainly picking up steam. The promise of extra returns really gets investors to venture out along the risk spectrum."

That spectrum is getting wider every day, as firms rush in to act on opportunities that others fear. “If things are going well in a market right now, that means we're not a buyer,” says Kevin Colard, senior acquisitions manager for Kirkland, Wash.–based Weidner Apartment Homes. “And the only way we're going to acquire Class A assets in strong markets is to build them ourselves."

The Narrowing Spread

The increase in riskier behavior is a far cry from last year's environment, which off ered many investors the opportunity to play it safe. The ultra-low yield on the 10-year Treasury produced a wide spread between cap rates and interest rates. The ability to borrow at 4.25 percent covered many sins, allowed many deals to pencil out, even given a low cap rate.

“What happened in 2010 was unprecedented. It was nirvana," says David Gardner, CFO of Rochester, N.Y.–based REIT Home Properties, which owns about 39,000 units across Northeast and Mid-Atlantic markets. “We've never seen that much spread between first-year cap rates and debt costs. That's why we were so gung ho in getting as much as we could."

Home Properties, which focuses on Class B assets in suburban markets, spent $339 million last year to acquire nine properties totaling 2,614 units. But interest rates have risen at least 100 basis points (bps) since November, and there's much less of a margin for error now.

“You didn't have to be as perfect on the underwriting last year, but you've got to sharpen your pencil now, because there's a much slimmer spread,” Gardner says. “There are going to be deals that, a year ago, we would've said yes to but today we'll have to say no to."

Most investors feel that cap rates will stay relatively flat or rise this year due to the higher yield on the 10-year Treasury. At the same time, institutional investors are getting tired of sitting on their equity—there continues to be a mountain of pent-up demand, and limited supply, in the transaction market, particularly in core markets.

“It's going to be an interesting clash between the impact the higher interest rates will have versus how much capital still wants to get placed,” says Hancock. “Which one of those two turns out to be more powerful is a big question mark."

After all, the spread between average cap rates and the average mortgage rate is still high, historically speaking. And with a growing number of players jockeying to place capital—bolstered by the assumption of some rent growth—investors are willing to accept a lower cap rate.

“It's not unreasonable, given how historically high those spreads are, that the 10-year Treasury could rise and cap rates could still go down,” Fasulo of Real Capital Analytics says. “We're forecasting some heavy cap-rate compression for secondary markets this year."

Given the attention now being focused on secondary markets, many investors are finding success with contrarian moves, whether buying at low cap rates in Phoenix, acquiring bulk condo deals in Miami, breaking ground in Detroit, or pursuing acquisition-rehabs in California's Inland Empire.

Here's a look at five multifamily investors that are growing more and more contrarian in their approach, zigging where others zag. We reveal their strategies for finding value off the beaten path.

STRATEGY: Target Flyover States

Village Green Cos.

Village Green Cos. wants to forget about cap rates, says Jonathan Holtzman, chairman and CEO of the Farmington Hills, Mich.–based firm.

“In the apartment business, we talk about cap rates and not about people,” Holtzman says. “But it's the companies with high customer satisfaction that outperform the market. If you have that, you have lower turnover, lower operating expenses, and higher occupancy. Those companies will get a construction loan and attract equity."

Village Green owns and operates more than 40,000 units primarily in the Midwest, an area home to fundamentally strong metros such as Minneapolis, Indianapolis, and St. Louis. But it's an area that's largely ignored by large institutional investors.

“We have this classic dynamic in America that pension funds and life insurance companies and REITs all go into the same places, such as Washington, D.C., and Boston," Holtzman says. “But Village Green has always been a contrarian. We don't go where everyone else goes."

Consider that about 545 new units among three projects have come on line in downtown Minneapolis in the past five years—all built by Village Green. The company's latest development in the city, the 175-unit, Class A Mill District City Apartments, was started in 2009, in the depths of the recession, with a construction loan from U.S. Bank.

And if that's not enough, the company plans to break ground later this year on a new, 156-unit development in downtown Ann Arbor, Mich. In Holtzman's view, nearby Detroit will soon become a growth city again, driven by a now profitable Ford Motor Co. and a focus on green automobile engineering.

“We're looking to expand in Detroit,” he says. “Everybody laughs at the Midwest, and Village Green says, ”˜Really?' There are 65 million people here—did we all suddenly disappear?"

STRATEGY: Get Bullish in Distressed Markets

Weidner Apartment Homes 

Phoenix may have been the poster child of distress, with its crumbling single-family home sector and high rate of foreclosures.

But that hasn't stopped Weidner Apartment Homes, which is bullish on the Sun Belt city, recently swooping in to acquire deep discounts with a long-term focus.

The company's actions aren't without merit: While Phoenix lost more than 224,000 jobs in 2008 and 2009 combined and had a metrowide vacancy rate of nearly 12 percent in early 2010, the past few months have seen the city take a turn for the better.

Job growth and rent growth modestly resumed last year, and market research firm Reis is now forecasting rent growth of 2.6 percent in 2011 and more than 3.5 percent annually through 2015.

That strong pace of recovery jibes with Weidner's outlook. Among its Arizona investments, Weidner has a 95- plus percent occupancy rate.

“It will just be a matter of time before Phoenix is as strong as it was a few years ago,” senior acquisitions manager Kevin Colard says. “Since March 2010, when we began buying the properties, we've already seen 10 percent growth in our income there."

The company entered the Phoenix market in March 2010 with the purchase of the 340-unit Trillium Villas in Peoria, a $27.5 million all-cash transaction on a short sale from KeyBank. From there, the company went on a tear—it now owns about 2,600 units in Phoenix and another 500 units in Tucson.

A long-term holder with 27,000 units in its portfolio, Weidner isn't necessarily driven by three- and five-year yields. “We were buying cap rates at 5.5 percent to 6 percent in Phoenix over the past year, but we're buying Class A assets at $70,000 to $80,000 a door,” Colard says. “We're not seeing Class A assets go for that pricing anywhere else in the country where we're involved."

Thankfully, Weidner has a lot of experience making the numbers pen out in secondary and tertiary markets.

It began investing in Midland- Odessa, Texas, in 1996, buying properties from $9,000 to $12,000 a door. The values on those properties are now closer to $50,000 or $60,000 a unit. The company owns 3,300 units in West Texas and is currently building another, 320-unit property in Odessa.

Why Midland-Odessa? Because the price of oil continues to rise. In fact, of the six markets in which Weidner is active, three are oil-based economies, including Texas, Anchorage, and select Canadian metros. Its nonoil markets—Washington, Colorado, and Arizona—are seen as a hedge against being too dependent on the fate of the oil industry.

“Typically, we're not a developer,” Colard says. “But in markets that we can't buy in because there's nothing left to buy, like Odessa or Anchorage, we're building Class A product.

And in higher-barrier markets, our nonoil-based markets, such as Seattle, where it's too expensive for us to buy, we're going to start building as well."

STRATEGY: Buy When You Can't Build

Raintree Partners 

When Raintree Partners was formed in December 2007, it fashioned itself as more of a boutique development firm than an acquisitions player. Its business model changed, however, when it saw assets trading for significantly below replacement costs. Despite this, the Laguna Niguel, Calif.–based firm didn't actually buy its first asset until April 2009, patiently biding its time until the capital markets returned. And last year, when the gates began inching open, it bolted out, acquiring 1,179 units across eight deals. “Ultimately, we'd buy a core asset, but we're looking for midteen-level internal rates of return,” says Raintree's acquisitions director Aaron Hancock.“And in this market, core assets without some sort of value-add execution aren't going to deliver those returns."

The company's purchase of the 264-unit Boulder Creek Apartments in Riverside, Calif., last August illustrates this approach. The Riverside market—one of the anchor cities in California's Inland Empire region—is among the hardest hit in the nation in terms of single-family oversupply and job loss, and meaningful rent growth hadn't occurred there since 2007, according to Reis. “It was a contrarian play, but we thought the market had at least stabilized at the bottom,” Hancock says. “We were buying at a cap rate that was over 200 bps above our cost of debt, so the cash-on-cash returns were outstanding." Raintree paid $24.6 million for Boulder Creek at a 6.75 percent cap rate, and by the end of the year, there were comparable transactions going down in the same market at a 5.75 percent cap. The company sees “terrific value-add potential” and plans both interior and exterior renovations at the property within the next 12 to 18 months.

Still, even though the company's 1,551 units across Northern and Southern California markets have all come exclusively from acquisitive activity, “that may not be the case anymore,” Hancock says. “We're looking to start with land acquisitions this year."

Raintree wants to develop in the Bay Area, Los Angeles, Orange County, and San Diego, despite intense competition in those core cities. “We're finding some opportunities on 75- to 150-unit development sites in A locations that are below the REIT radar,” Hancock says.

STRATEGY: Focus on Fractured Condo Deals

Southwest Properties 

Buying a fractured condo deal, where a minority of units has already been sold, can scare off even the savviest of investors. Often plagued by homeownership association issues and back taxes, fractured condo deals can be more trouble than they're worth. But Southwest Properties is among a handful of companies that is making the broken condo deal pencil out.

“There's a limited time for these kinds of deals, and in South Florida, that time has passed,” says Omar Del Rio, vice president of acquisitions for Halifax, Nova Scotia–based Southwest. “You're still able to purchase below replacement value, but you're no longer getting 50 cents on the dollar or below. Right now, the prices are almost like retail."

Southwest Properties, which owns and operates 1,250 rental units in Halifax, began investing in U.S. multifamily properties in 2009. The company targeted new construction bulk condo deals and has purchased four so far in Florida for a total of 628 units, operating them as rentals until the for-sale market returns.

In February, Southwest acquired 224 units (out of 240 total units) in Tower II of the Oasis Grand project in Fort Meyers, Fla., a market the company went into because it couldn't find better prices in larger metros. “It wouldn't have been our first choice two or three years ago,” Del Rio says, but the company estimates that it received a discount of 33 cents on the dollar in terms of construction, land, and soft costs.

Southwest has had success in stabilizing its previous broken condo deals, including Downtown Dadeland in Miami, The Place at Channelside in Tampa, and The Sage in St. Petersburg. The occupancy rate on those 404 total units is nearly 100 percent, and the company has already increased rents in Miami since buying 158 units there at the end of 2009. All told, Southwest now has a total of 1,878 units across its Florida markets and Canada.

Obviously, investors need to tread cautiously into fractured condos. One of the biggest considerations is financing, or the lack thereof. Many national and regional banks will issue recourse bridge loans for the acquisitions, at fairly high prices. But finding perm debt for a fractured condo acquisition is difficult, even once a project is stabilized— Fannie Mae, Freddie Mac, and the FHA have little or no appetite for them.

“We go into these deals saying it's great to get financing afterwards, but you have to make sure they can work without it,” Del Rio says. “We were able to put financing on the deals in Tampa and St. Pete, but they would've worked without it."

STRATEGY: Downshift When There's Demand

The Kislak Organization

Like many multifamily firms, the Kislak Organization has been taken aback by the cap rates at which some high-profile deals have traded over the past two years.

“It sometimes feels more like 2005 than I ever thought it would,” says Tom Bartelmo, president and CEO of Miami Lakes, Fla.–based Kislak. “What we see happening out there, with some assets with 5 percent caps on them—that's not for us. Frankly, I think the risk of those purchases outweigh the reward."

The company, which owns nearly 3,200 units spread between Dallas, Las Vegas, and several major Florida markets, focuses on adding value to Class B assets that are 20 to 30 years old. Recently, however, Kislak has been priced out of many major metros. “We're still looking in primary markets, but the reality is that we're not likely to be the highest bidder for a deal,” Bartelmo says. “So that leaves our focus more on secondary markets, such as Tucson, Ariz., and Pensacola, Fla."

Just last December, Kislak purchased nearly 500 units across three distressed assets in Pensacola, Fla., from Ocean Bank, which had foreclosed on the properties. The company plans to significantly redevelop the assets later this year, investing $4.5 million in capital improvements.

One property, the Villas at Jasmine Fields, is about 50 percent occupied, and another, the Villas at Jasmine Park, was a broken condominium deal.

Kislak purchased 130 out of the Jasmine Park's 170 units (the other 40 had been sold). “We'll be talking with the owners and lenders on those purchased units to see if we can purchase them back at a fair price," Bartelmo says.

As capital becomes more readily available, the acquisition market for value-add deals will also grow more competitive. And if the trickle-down from primary markets to secondary markets, as well as from Class A to Class B assets, proves strong, it may not be long before investors have to start considering tertiary markets and Class C opportunities to find yield. Which is why, for many, 2011 will be a year of the second tier.

“I'd like to get another 1,000 units this year, where we can either add in management or capital improvements or repositioning, or all of the above,” says Bartelmo. “We've been focusing on the distressed side of the equation. But it's been very difficult to root out opportunities that fit with the profile we've been looking for."


The time is ripe for making real strides in construction and rehab financing.

THE METRICS FOR multifamily look good. The homeownership rate is down. And the demographic outlook for the next five years is strong, buoyed by the voluminous Echo Boomer generation. Taken with the lack of new supply coming on line, this rising demand for rental properties makes a good case for investing in new construction and rehabilitation across the country. “This is a good time in the cycle to build or renovate,” says Dan Fasulo, managing director of New York–based market research firm Real Capital Analytics. “You could really put yourself in a position to catch the market on its way up. But it's still challenging to get money for those types of projects."

Once upon a time, the government-sponsored enterprises (GSEs) had a big appetite for significant levels of rehab, but those days are gone. The GSEs are now more backward-looking, shining a spotlight on the trailing 12 months of rent collections, not underwriting rent growth. Meanwhile, many lenders are still struggling with aggressive rehab deals gone bad on their books.

Most of the rehab work being done now is funded through equity or cash flows. Then, once the dust has settled and the higher rents are being paid, the owner will move to put permanent debt on a property. “It used to be that you'd spend the dollars and get the additional debt,” says Aaron Hancock, director of acquisitions for Laguna Niguel, Calif.–based Raintree Partners. “Now, it's spend the dollars, get the NOI increase, and then get the additional debt."

Still, there are other options for rehab deals. The bridge loan market has heated up in the past six months, and not just from traditional sources such as regional and national banks. “We're seeing a lot of the old bridge programs come back at the agency lenders,” says Kevin Colard, senior acquisitions manager for Kirkland, Wash.–based Weidner Apartment Homes. “And the banks are really starting to lend again."

As more banks step back into the construction lending market, prices are beginning to go down. U.S. Bank, JPMorgan Chase, Wells Fargo, and Bank of America are actively originating multifamily construction loans, while insurance companies such as MetLife and PacLife also intend to be more active this year with their construction-to-perm programs.

“The pipeline today is more active and deeper than I've seen it in probably three years now,” says Joe Griffith, who heads up the commercial real estate banking business in the South and Southeast for JPMorgan Chase.

The increased activity and competition mean that all-in interest rates on construction loans have started to drop. Construction loans are generally pricing today with spreads over LIBOR in the mid–200 basis points (bps) range.

“But it's clearly headed down, driven by competitive pressure," Griffith says. “Other banks our size are getting back in the multifamily construction market, and some of the regional banks are doing some as well."

Last year, Chase originated only six new multifamily construction loans, but it expects to more than double that amount this year. Most of Chase's construction loans are 65 percent loan-to-cost (LTC), and the company typically underwrites to a 1.25 percent debt service coverage ratio (DSCR). But given the increased competition of late, Griffith expects leverage levels to come back up to 70 percent soon.

U.S. Bank also weathered the recession well. In fact, the bank has been in growth mode since the middle of last year. “For the last two quarters, we've grown our loan book, while many banks' balance sheets are shrinking," says Kyle Hansen, an executive vice president in the commercial real estate group at Minneapolisbased U.S. Bank. “We absolutely have construction debt available, and are actively looking for deals."


Here are six tips for making the right investment decisions in secondary and tertiary markets.

AS PENSION FUNDS, life insurance companies, and REITs grow increasingly anxious to deploy capital, the pent-up demand for core assets in the highest-barrier metros isn't likely to go away any time soon. Unfortunately, the bidding wars and resulting cap-rate compression in primary, Class A markets throughout last year drove many multifamily investors to look beyond primary markets for higher-yielding opportunities.

Increasing your risk tolerance by looking toward secondary and tertiary markets can be tricky, however. Here are six tips to keep in mind.

1. Focus on Management.

When Raintree Partners acquired Boulder Creek Apartments in Riverside, Calif., last year, it tread cautiously given the state of the local marketplace. The Inland Empire has been one of the hardest-hit areas in the nation in terms of single-family overbuilding and job loss.

When underwriting the deal, the company knew it couldn't cut corners for a third-party manager. “We made a point of paying a top-end salary to get a high-end, on-site manager in Riverside," says Aaron Hancock, director of acquisitions for Laguna Niguel, Calif.–based Raintree. “We wanted to make sure we had one of the best people in the market, so we budgeted for it."

2. Do Your Homework.

The most important thing to remember when entering a new market is to do exhaustive research—find out everything you can and then find out more. Partnering with experienced local operators that know the market inside and out is also a good rule of thumb.

When Raintree entered Riverside, it was very concerned about the shadow market of unsold condos and single-family homes. And no data provider kept good stats on this segment of the market. But in canvassing all the local rental listings on Craigslist and, Raintree found that the amount of condos and homes for rent in a one-mile radius of its asset numbered just 10.

3. Know the Submarkets.

Most market research paints markets with a very broad brush—average rents and average occupancies across the entire metro—without breaking that data out by asset class or submarket. “What they're doing is generalization,” says Jonathan Holtzman, chairman and CEO of Farmington Hills, Mich.–based Village Green Cos.

Village Green will break ground later this year on a 156- unit, 11-story development in Ann Arbor, Mich., which is about 40 miles from Detroit. The local market there is strong, driven by a thriving university, a growing biomedical research sector, and the resurgent automobile industry.

“Macroeconomics say don't do anything in Michigan," Holtzman says. “But microeconomics will tell you that some Detroit markets are among the best in the United States today."

4. Question the Hype.

The data provided by market research firms only go so far. So it's best to err on the side of caution—if the research is spitting out numbers that appear too good to be true, they probably are.

“We're underwriting a deal right now in a market where one of the data sources is projecting 6 percent market rent growth per year through 2014,” says Mike McNamara, head of acquisitions for Philadelphia-based TRECAP Partners. “We're underwriting about half of that."

5. Be Patient.

Investing in tertiary markets requires having longterm vision. You can't depend on meaningful rent growth to generate returns—the focus instead should be on cash-on-cash returns. “Make sure you use a capital structure that allows you to be there for the long term, so you can wait out a cycle,” advises Raintree's Hancock. “You need long-term debt and patient long-term equity."

You also can't depend upon a disposition. “We're in it for the long haul, but we need to know that we can get out in a reasonable amount of time,” says David Gardner, CFO of Rochester, N.Y.–based Home Properties. “You might get a good return on the asset you're holding, but in a tertiary market, a sale is certainly not a given."

6. Focus on Employment Centers.

Secondary and tertiary markets are much more sensitive to the loss of a major employer. “The risk in a tertiary market is that it might be limited to three to five major employment centers,” says John Smith, chief investment officer at Home Properties. “So even if you're buying at a great initial yield, the resale value may not be a heck of a lot more five or 10 years out."

The other side of the coin is that smaller markets reap larger rewards when a major employer moves there. For instance, in Malta, N.Y.—25 miles north of Albany—Advanced Micro Devices is developing a $4.2 billion semiconductor manufacturing plant and is requiring many of its suppliers to relocate to the area, creating thousands of new jobs.

“Albany is a secondary market on a good day,” says Eric Silverman, founder of Newton, Mass.–based equity investor Eastham Capital. “But when a big player comes in and spends billions of dollars making a silicon wafer plant and, along with its suppliers, will employ 10,000 to 15,000 people, we're going to rent some apartments."