Arsenal Real Estate Funds is putting its money where the market is. The Morristown, N.J.-based real estate investment manager has dedicated $152 million to investments in workforce housing, a segment of the real estate market it sees growing rapidly over the coming decade.

“We think this is a wonderful time to provide workforce housing,” said John Maurer, a partner with Arsenal. “In terms of the current economic climate, there's no better investment.”

The firm expects the broadest segment of multifamily demand to come from renters who earn between 80 percent and 120 percent of the area median income (AMI). Maurer and his partners see much of the job growth in cities where they're actively investing coming from professions paying mid-range wages, such as retail work, nursing, and teaching.

Renters make up almost 34 million of the nation's 109 million households and earn less than half the median income of owner-occupied households, data from the Census Bureau shows. Researchers project that as the rate of immigration into the United States accelerates and the ranks of “echo boomers”—the kids of baby boomers—enter the rental market, the demand for moderately priced rental housing will rise.

Arsenal is in the process of raising a second workforce housing fund of $200 million to $250 million, which it expects to close in mid-October. That fund, like the first, would provide equity of between $5 million and $10 million to developer partners who agree to take on the construction risk of new apartment projects between 200 and 400 units.

Typically, the developers with whom Arsenal partners provide recourse as well as completion and cost-overrun guarantees, said Joe Margolis, a partner at Arsenal. “We agree on a budget with them, and if the property costs more to build than that budget, then the developer pays for that out of his pocket,” he added.

Terms are negotiated on a case-bycase basis, but Arsenal typically asks for an equity contribution from its partners, provides the bulk of the equity itself, and receives a preferred return on the invested equity. Developers secure the construction financing, which usually amounts to about 75 percent of the project cost.

Arsenal prefers that its partners have a track record of developing workforce housing in the area where it's looking to invest, and it likes to create long-term relationships with developers, rather than funding deals on a one-off basis.

“We find that it's difficult and time-consuming to find the right match and to get to know each other and to go through the dating process,” said Margolis. “Once you do that and you have your documents done, and all your experts and consultants know each other and work together and know the process, it's very efficient then to do a whole series of transactions together.”

Given the high cost of land in many cities, building new apartments that can offer rents affordable to median-income households is a big challenge for developers. Arsenal and its partners overcome that hurdle with a combination of several strategies.

First, most projects built under the Arsenal umbrella are garden-style apartments built in the suburbs, where land tends to be less expensive. Infill locations only work if they can be bought cheap.

And although its apartments are typically built as Class A or A-minus units, “We don't have all the bells and whistles in terms of finishes,” said Margolis. “We have a nice amenity package, but it's not over the top.”

Living without granite counters

Renters don't get granite countertops and may have to make do without Sub-Zero refrigerators and other high-end appliances. The faucets and light fixtures may be standard-issue items instead of featuring high design.

“You can go to IKEA and get something less expensive that still looks good,” said Bill Bollwerk, a managing director with Atlanta-based Alliance Residential, which has worked with Arsenal on several projects.

In addition, renters have to squeeze into spaces that are a bit tighter than they might find in the luxury units up the road. Arsenal shaves about 100 to 150 square feet off its apartment sizes compared to competitors, said Margolis. That, in addition to limiting the scope of amenity packages, allows its developer partners to charge rents about $100 to $150 lower than comparable apartments can offer.

For their part, the developers that partner with Arsenal aim to reuse tried-and-true floor plans and layouts. “We've built so many floor plans over time that we know how to be efficient yet provide the best environment for the resident,” said Bollwerk. “Good design doesn't have to cost more money,” he added.

Alliance's latest project for Arsenal, the Broadstone Jacksonville Beach in Florida, is being built on the site of a former mobile home park. Arsenal injected $8.3 million into the 228-unit complex, where site work began this summer. It's expected to be complete in November 2009.

Does mixed-income count?

Atlanta-based Wood Partners, which in late August was set to close on its fourth deal with Arsenal, uses similar strategies to keep costs down, in addition to taking advantage of taxexempt financing.

“We consistently use the same square footages and layouts,” said Bernard Felder, a principal with Wood Partners. “And having a great network of contractors and subcontractors allows us to build more efficiently than our competitors.”

The company, which operates in the South, West, and Midwest, has about $1 billion in projects in the pipeline right now, with 20 to 25 percent of that product being workforce housing, according to Felder. By that, he means mixedincome housing developments that dedicate 20 percent of the units to residents earning up to 50 percent of the AMI and the remaining 80 percent to market-rate units.

Such projects qualify for taxexempt financing, which can be claimed when they partner with a municipal entity that can issue bonds. They are also typically eligible for what are known as 4 percent lowincome housing tax credits, but Wood Partners doesn't take advantage of this option. Instead, it raises equity from private partners, including both Prudential and JPMorgan as well as Arsenal, said Felder, who pegged the internal rates of return on such developments to percentages in anywhere from the high teens to the low 20s.

Being able to use tax-exempt financing saves the company big on interest payments, slicing the rates it pays on its debt by anywhere from 150 to 200 basis points, Felder said. “The overall capital budget is lower than we think our competitors can deliver,” he added, pointing out that one big reason is the tax-exempt financing.

Plus, providing workforce housing has helped Wood Partners gain support from local officials. One site where the company wanted to build in Chesapeake, Va., required rezoning. “By virtue of the fact that we were providing workforce housing, we had a much better opportunity to bring a compelling case before the city council to have the rezoning approved,” said Felder.