If you were to take a drive with Home Properties president and CEO Edward Pettinella, you’d be surprised by the type of apartment properties that appeal to him.
He’s not interested in the prettiest assets, the newest communities, or the luxury apartments that achieve the highest rents. The properties that catch his eye are the ones that everyone else considers eyesores.
“You’d probably think they were a little beaten up, a little run-down, but that’s our sweet spot,” Pettinella says. “Our primary expertise is rehabbing and repositioning a C portfolio into a B portfolio. That allows us to raise rents in a substantial way, which drives our revenue and same-store NOI.”
It’s a time-tested strategy upon which the company has built its empire. Rochester, N.Y.–based Home Properties owns nearly 43,000 units in 121 properties primarily located in the Northeast and Mid-Atlantic. The REIT boasts a total market cap of $6.6 billion and membership in the S&P 400. And its strategy seems to be gaining momentum. Home has posted an 11.4 percent average annual total return over the past 10 years. And in the near term, the company outperforms its peers: Home has posted a five-year compounded annual return of 11.7 percent, compared with 11.5 percent for apartment REITs and 5.7 percent for all equity REITs.
Last year proved to be something of a banner year. In 2012, the firm achieved 15.9 percent FFO (funds from operations) per share growth, the highest in the REIT’s history. And it achieved same-store NOI growth of 8.1 percent last year, the third-highest rate in its existence.
“Those numbers beat the go-go years, and we’re extremely proud of that,” Pettinella says. He attributes the record-breaking numbers to expense control and revenue growth from rehabbed rent increases against a backdrop of low interest rates.
“I’m a strong believer in the saying, ‘If it ain’t broke, don’t fix it,’?” he adds. “We’ve worked for years to perfect and tweak our business model. We like our geographic footprint—we have the ability to grow in our markets—and we’ve produced great results.”
Close For Comfort
Since its founding in 1994, Home Properties has focused on repositioning Class C and B- assets into Class B+ assets. But over the past nine years, the REIT has experienced a lot of changes.
Pettinella took over as CEO in January 2004, and one of his first initiatives was to shift the firm’s market makeup. It turned its back on its own backyard—upstate New York—as well as Detroit and Pittsburgh, and moved instead into high-barrier-to-entry, high-growth markets.
Ninety-seven percent of Home Properties’ units are located in close-in suburban submarkets of major East Coast cities, and its four largest markets account for 84 percent of its portfolio.
The suburban Washington, D.C., market is where the firm has its biggest concentration, accounting for roughly 31 percent of its portfolio, with 13,161 units. Baltimore represents 24 percent of the REIT’s portfolio, with 10,477 units. Suburban New York City and Philadelphia make up 17 percent and 12 percent of the portfolio, respectively.
“We feel comfortable where we are,” Pettinella says. So comfortable, in fact, that the company’s future growth will be focused primarily within those same close-in, suburban submarkets where it has already established a presence.
Sexy is as Sexy Does
Compared with its apartment REIT brethren, Home Properties is performing well, even if the company is something of a contrarian.
The REIT tends to outperform its peers during a down market and underperform during strong periods of economic growth, according to Michael J. Salinsky, director of REIT equity research for RBC Capital Markets.
“Their strategy isn’t sexy, but we think Home Properties can deliver over a long period of time,” he adds. “With that said, I wouldn’t expect them to outperform during this cycle.”
Home Properties’ 8.1 percent same-store NOI growth last year was toward the higher end of that of its peers (the range was 6.4 percent to 9.2 percent). Over a 10-year period, the REIT looks even more impressive, leading the pack with the highest same-store NOI growth of 3.7 percent.
Paula Poskon, a senior research analyst with Robert W. Baird & Co., describes Home Properties as a stable, defensive REIT due primarily to its tenant base. The REIT’s focus on older, close-in B+ product caters to blue-collar and service employees, as well as immigrants and seniors.
“There is a perception that Home Properties houses low-quality, low-income tenants, and that isn’t really true,” Poskon says. “I’d say they provide workforce housing for the folks who can’t pay $4,000 a month for an apartment. There are a lot of folks who fit that description, and it’s easy for the investment community to have a negative stereotype of who the tenant is.”
These “renters by force” don’t have the option of buying a home because, in many cases, their income doesn’t allow for it. And it’s a demographic sweet spot for retention.
“Sixty percent of our residents either have never owned a home or have no intention of doing so,” Pettinella notes. “Moreover, they generally can’t afford to move, which means that we have the lowest resident turnover among all apartment REITs.”
In fact, just 38.9 percent of Home Properties’ residents leave when their leases roll. That turnover is significantly lower than the average of 54 percent. The low turnover has a positive impact not only on Home Properties’ occupancy rates, but also on expenses, since the company doesn’t have to spend as much money on unit make-ready.
Last year, the REIT’s occupancy rate of 95.6 percent was only 30 basis points off from its 18-year high of 95.9 percent. And even at its worst, the company still looked OK: During that 18-year time span, the company’s lowest occupancy rate was 92.5 percent, in 2002.
The high occupancy coupled with ongoing rehab efforts allowed Home Properties to increase its average rental rate by 4.2 percent in 2012, to $1,239 per month, compared with $1,171 in 2011.
And while running a successful multifamily business is an art form, it’s also a science. Pettinella says Home Properties tracks a ratio that measures the qualifying income for residents to unit rents. During the height of the Great Recession, that ratio was 14.2, and the highest was 20.2.
“Right now, it’s 17.1 percent, and we think we could raise rents for the next several years and not hit the upper boundary,” Pettinella says. “That stat tells us there is more room for pricing power, and if the government can control expenses and unemployment comes down, we have the wind at our back.”
Home Properties’ strategy of acquiring and repositioning mature C to B- apartment properties has been refined through astute strategy, elbow grease, and critical mass.
Since its IPO 18 years ago, the REIT has acquired and repositioned 219 communities totaling more than 61,000 units. The company targets a minimum 10 percent return on repositioned investments. And it continually reinvests, taking a long-term view of rehab, which many others in the industry see as more of a short-term play.
In 2012, Home Properties renovated 5,650 units with a price tag of $100 million in rehab work. It expects to renovate 4,000 this year.
“The philosophy in this business is to not spend money, but we spend money in an aggressive way because we think it will drive revenue,” Pettinella says. “Over the last 10 years, a third of our income has come from the $100 million we’ve put out in cap ex. We’re changing our portfolio by rehabbing assets.”
Pettinella explains the rehab trifecta: Upgrading properties from a C to B level significantly increases the rental income, net operating income, and market value. For example, a C- property Home would consider acquiring might rent at $983 per month. But after being repositioned to a B+, that same property could lease for $1,833.
But it takes the kind of patience that only a longer-term holder can provide. The complete repositioning of a Home community, for example, can take five to seven years. The comprehensive process includes a mix of interior and exterior improvements and typically begins with improvements in landscaping, signage, and common areas.
Sometimes, the improvements and subsequent rent growth are simply the result of curing deferred maintenance, which can include new HVAC systems, roofs, balconies, and windows. At many properties, community centers and swimming pools are added or upgraded, which provides an immediate bang for the buck. Then, apartment interiors are renovated as residents move out, with the most significant investments made in upgrading kitchens and baths.
Often, the renovations include more than simple cosmetic improvements. Complete remodels of outdated kitchens and bathrooms typically feature new appliances, flooring, counters, cabinets, lighting, tile, sinks, bathtubs, and toilets.
Since older properties tend to have closed floor plans, Home Properties usually removes kitchen walls to open up the units. It also replaces windows and doors, and, when feasible, adds in-unit washers and dryers.
Over the past three years, Home Properties has made more than $1.1 billion in acquisitions. The REIT averages $200 million to $300 million annually, according to Pettinella.
In fact, since 2000, the rehab king ranks as the third–most active acquirer within the apartment REIT sector, buying 1,797 units. When mulling an acquisition, the company focuses on solid floor plans and B- construction that both can be upgraded to Class B and B+ levels.
During 2012, Home acquired three large communities with a total of 2,018 units for a combined purchase price of $298.2 million, or an average of roughly $148,000 per unit. The average first-year cap rate was 5.9 percent.
The company’s geographic and asset-type strategy position the firm as a very big fish in a relatively small pond, Pettinella explains. The company often finds itself competing against local or regional buyers who have far smaller checkbooks and minimal access to capital.
Moreover, Home doesn’t run into any of its apartment REIT peers, Pettinella notes, because their markets don’t overlap.
Home prefers to acquire communities that are situated near public transportation and major highways. It also is looking for submarkets that have significant barriers to new construction and limited new apartment supply.
In suburban Washington, D.C., for example, Home acquired The Manor East, a 198-unit apartment property located 15 minutes from Northern Virginia’s Reston–Herndon corridor. The REIT paid $16.2 million for the property, which was 98 percent occupied, with monthly rents averaging $1,050.
During the first three years of its ownership of The Manor, Home will invest a total of roughly $2.8 million to upgrade individual units and reposition the Class C property, which has an “A” geographic location.
“In many cases, the properties that we acquire are the worst in the neighborhood, and the neighborhood loves it when we come in because we’re quality owners,” Pettinella says. “They know the property is going to be improved, and the quality of the tenants is going to increase.”