There’s just no way around it. Entrepreneurial types across the U.S. can expect to keep banging heads with institutionally backed players pretty much any time a sizable multi-family acquisition or development opportunity arises in 2006.
Syndicates that combine a dozen or more smallish investors through tenancy-in-common (TIC) structures will also remain exceptionally aggressive bidders for multifamily opportunities in the coming year.
In a nutshell, 2006 is bound to see too many opportunity funds and other investors chasing too few opportunities – an environment generating far thinner returns than today’s market fundamentals would traditionally yield. “Today’s hot investment market is still driven by the availability of capital rather than fundamental underlying economics,” lamented Andy Weiss, managing director at Meridian Capital Group, a high-volume income-property lender.
Of course, as Weiss and others related, there’s a more optimistic way to view this situation: It can make it difficult to buy a property, but it also makes it a very good time to sell.
Optimists might also see Wall Street’s renewed allure pulling some of that equity from real estate back to securities. Unfortunately for would-be buyers, stocks just won’t prove attractive enough to put a dent in today’s competition for multifamily assets, which is continuing to erode yields, according to the consensus of experts.
Wall Street’s apparent late-year bull-ride notwithstanding, “I’m not hearing a sucking sound” vacuuming capital out of the multifamily arena, said Linwood Thompson, managing director overseeing investment brokerage Marcus & Millichap’s (M&M) multi-housing group. Investors remain lukewarm on corporate profit-growth prospects, “and a lot of them continue allocating even more capital to real estate generally and apartments in particular,” said Thompson.
What capital wants
Nearly 90% of the property professionals surveyed for the 2006 edition of the respected Emerging Trends in Real Estate predicted that domestic real estate markets will see moderate or substantial oversupplies of equity
capital in 2006.
That’s hardly a surprise, given that investment tracker Real Capital Analytics (RCA) estimates pension funds alone have already allocated $50 billion to real estate that they haven’t yet been able to deploy amid the heavy competition.
In the bigger-picture perspective, “we are in the middle of a great reallocation of money” from stocks and bonds to real estate, RCA founder Bob White told attendees at a Los Angeles industry gathering in late 2005. For the immediate term as the new year approached, “there is a sense of urgency for investors to get into the marketplace before interest rates rise,” he added.
That urgency implies that investors competing for promising properties will probably have to accept meager near-term yields, and then look to squeeze more income as fundamentals improve, according to Rick Wise, director of acquisitions at Waterton Associates, an active multifamily-heavy investment adviser. “A lot of buyers are demonstrating willingness to take it on the chin for a couple years” in anticipation of better operating incomes ahead, Wise said.
Entrepreneurs willing to sell out to the big guys, or looking to partner with them, might want to consider the latest property profiles that deep-pocket buyers appear to be targeting. Emerging Trends respondents recommend infill locations, mixed-use configurations, age-restricted communities and second-home resorts.
They also identified solid opportunities to buy and upgrade Class B and B-minus properties “quickly and cheaply” to the B-plus price point. Likely losing propositions are properties targeting high-income renters, and markets where a lot of recently constructed or converted condominiums seem likely to join (or rejoin) the rental pool.
Predictably, a recent RCA report noted that capital is starting to flow less into low-capitalization-rate environments in favor of secondary markets such as Indianapolis, Denver, Portland and Columbus. Also predictably – given the huge flow of institutional capital – the report identified a “large-deal premium.”
David Neithercut, president of giant real estate investment trust (REIT) Equity Residential Properties, is anticipating greater interest in markets hitting cyclical troughs or just embarking on recovery modes. Markets matching that description (such as Phoenix) might see rents rise in the “high single digits” this year, while those well into recovery – or that didn’t skip a beat during the latest recession – will probably see rents grow about 3% or 4%, he added.
M&M’s Thompson sees smart money targeting infill sites in markets with dwindling inventories of such opportunities, as demographic trends suggest ongoing resident demand with “exceptional value appreciation.” And mega-players such as Archstone-Smith are already hopping aboard the infill bandwagon. The multifamily REIT is demolishing older structures to redevelop at higher densities, and plans to continue targeting such opportunities “in expensive infill areas,” according to chairman R. Scot Sellers.
Sellers also suggested that property owners in some markets can still expect aggressive offers from condo converters. Bidding intensity has predictably cooled in some high-activity markets. But conversion specialists are shifting to viable new markets – making it pretty tough for rental specialists to compete for acquisitions in some cases.
In some of Archstone-Smith’s core markets, converters tend to be more aggressive than rental specialists in pursuing acquisitions opportunities, Sellers said. Converters likewise remain more liberal in the due-diligence process and “more willing to push the terms.”
Active conversion specialists are also tending to erode yields generally in markets such as Seattle, where regulations allow relatively quick and cheap conversions of pretty much any market-rate rentals, added Keith Guericke, CEO of West Coast apartment REIT Essex Property Trust. Hence cap rates there today are typically in the 4.5% to 5% range whether the buyer expects to convert or maintain rentals, he said.
The big players
As Essex’s 2006 plans also suggest, entrepreneurial types will likely have a very tough time trying to compete with REITs and institution-backed joint ventures when it comes to today’s emerging apartment development opportunities. Acquisition yields have become so thin in top-tier markets that REITs and institutions are now willing to reduce their yield requirements for new development ventures even as they assume greater risks.
Development cap rates now appear to be penciling at just 6% to 6.5%, but that’s still enough of a premium over acquisition yields to justify the investment and related risks, said Guericke. Essex is even taking on more development-related risks by tying up sites and pursuing entitlements for perhaps two years before closing on a land acquisition.
Archstone’s Sellers likewise sees development yields of 6.5% or so to be worth the risk in exceptionally strong marketplaces such as South Florida and Southern California, where cap rates might be just 4.5%. “That’s obviously an enormous spread of 40% plus or minus.”
With risk-adjusted yields in a historic trough, some of Trammell Crow Residential’s (TCR) institutional partners are also investing in development ventures earlier in the process than has traditionally been the case. This includes funding land purchases before entitlements are in place or specific project plans and budgets are developed, said Michael Melaugh, executive managing director of capital markets with TCR. The capital partner of course takes a correspondingly greater share of ultimate profits, but TCR is quite willing to relinquish a bit of its earnings potential to reduce its risk, he added.
With cap rates on acquisitions so low, even a growing number of today’s seemingly endless roster of new opportunity funds are focusing on multifamily development, said Jahn Brodwin, a partner in real estate advisory firm Schonbraun McCann Group. “You could realistically describe many of the new funds as merchant builders.”
And that can present partnering opportunities for entrepreneurial developers with proven market expertise, Brodwin said. Savvy veterans should also look at growth-minded REITs as opportunities to get great pricing while sheltering capital gains tax liabilities – and without having to participate in a TIC arrangement, he added.With REIT share prices generally at lofty levels, many of the trust acquisitions pros are logically aiming to use operating partnership units as currency, Brodwin said. But owners attracted to the tax-deferred benefits of selling to REITs also need to keep potential share-price declines in mind, he cautioned.Meanwhile, multifamily entrepreneurs might see burgeoning acquisitions competition ahead from yet another buyer type: offshore investors. Foreign investors for the most part are comfortable with lower yields than domestic players, according to Ross Moore, U.S. research director at brokerage giant Colliers International, speaking at the Los Angeles gathering.
David Baird, national director of multifamily at investment brokerage Sperry Van Ness, said he expects to see offshore equity pouring into U.S. multifamily markets in coming months. “Those investors feel comfortable about our multifamily sector, so I think we’ll continue to see plenty of inflow from them.”