High Hurdles

Low interest rates created an unusual paradox for the multifamily industry in 2003. By making homeownership affordable, low rates hammered property owners on the revenue side. But they also lowered the industry's cost of capital, made development more feasible, and contributed to a trend toward soaring property values, as investors sought out buildings to buy. Go figure.

Vacancies rose in many markets as renters decided to own instead. About 70 percent of the renters who left Fogelman Properties communities departed for homeownership, says Mark Fogelman, president of Fogelman Management Group in Memphis, Tenn. And David Schwartz, managing member of Waterton Associates in Chicago, adds, "The rent versus own decision is made a lot easier for people by the low interest rates."

On the upside, low rates enabled private buyers to bid for properties that were unattainable in the past. "As interest rates went down, the pool of available buyers got more aggressive in their underwriting," says Kevin Scherer, director of research for SSR Realty in Morristown, N.J. "Buyers are increasing their risk by employing more leverage." This, combined with an influx of investors who were disenchanted by the stock market, increased the flow of capital in the multifamily sector and raised property values.

That made 2003 a seller's market. And many firms took advantage of it to trim their assets, unloading smaller buildings or properties in difficult markets. "You can sell about anything and get a reasonable price," Schwartz says. "It's a good time to clean up your portfolio."

The Solutions

While high property values and cheap refinancing are nice, many firms spent much of 2003 trying to stop renters from leaving. Fogelman Management trained employees to stress the lifestyle flexibility renting provides. When residents indicate that they are moving because they've decided to take advantage of the low interest rates, managers and agents will talk to them about how renting takes maintenance costs and real estate taxes out of their hands.

Still, Fogelman admits that these arguments fell on many deaf ears. "There's a certain segment of the population that, no matter what we do, will still move out," he explains.

In some locations, the migration to homeownership caused Fogelman Management to change its target market. Focus shifted from people in their mid-20s and 30s with home buying aspirations to echo boomers just out of college, who may not have built the credit history to buy a home or condo, and empty-nesters, who may rent because they prefer a maintenance-free lifestyle.

Low interest rates provided some comfort for the vacancy hardships they caused. In a market where firms were running low on revenue and needed to find ways to cut expenses, refinancing mortgages to lower interest rates provided a way to save.

Outlook 2004

When gazing into 2004's crystal ball, most multifamily firms not only want to know if interest rates will rise but what will happen if they do. Across the board, experts predict that rates may go up incrementally in 2004, but that it won't make a huge difference. "I believe we are in a lower interest rate environment for a while," Scherer says. "We have global competition that will hold down inflation. That will allow the government to keep rates low."

Regardless of how quickly rates rise, there seems to be a feeling among multifamily developers that they weathered the worst part of the home-buying storm. "A lot of people who wanted to buy homes bought them already," says Ned Midgley, vice president of CB Richard Ellis in New York. If interest rates do go up in 2004, they also may pull private money out of the multifamily sector.

hile Scherer doesn't think this will cause a tremendous drop in property values, it may change the demographic of the multifamily investor. "As the economy recovers and interest rates go back to normal levels, the leveraged buyers will slowly retract and other buyers, such as institutional ones, will come into real estate," he says.

With interest rates allowing those renters with stable jobs to become homeowners and relatively high unemployment rates keeping other prospective renters living with their families or doubling up, apartment occupancy suffered in 2003. In some parts of the country, vacancy rates were as high as 13 percent to 14 percent.

"You take the economy, combine it with home purchases, and it has created a challenge for maintaining occupancy," says Steve Eddington, senior vice president of operations for Camden in Houston.

These high vacancies sent firms scrambling for ways to attract new renters. Most popular: One to two months free rent. Other concessions usually came off the front end of the lease. "Customers typically want lower sign-up costs to diminish the move-in fees," says Victoria Blanton, vice president of sales and marketing for AIMCO in Denver.

The Solution

Multifamily firms didn't just lay down and offer concessions. Many looked for alternatives. In some cases, operators instituted across-the-board rate reductions. "We tried to get away from concessions and just acknowledge that we were going to lower our asking rates," says Todd Pope, president of Simpson Property Group LP in Denver. "But we continue to use up-front concessions to stimulate demand."

This strategy worked for other firms as well. In Phoenix, some property owners gave away three and four months of free rent, essentially cutting their prices by 33 percent, says Ed Lange, CFO for BRE Properties based in San Francisco.

BRE kept acceptable occupancy levels without dropping rents by 33 percent or offering concessions, says Lange. He says his company could resist these forces because BRE has good communities -- plus he thinks some of his competitors may have gone further than necessary with their concessions.

Few firms used solutions to the occupancy problems that went beyond rate reductions and concessions. Simpson did try something new. It ran a promotion where it gave away $25,000 to one lucky person who visited one of its Denver properties. "It did OK, but it was nothing as significant as lowering the price," Pope says.

Outlook 2004

In the long run, vacancy rates hinge on two critical factors: home buying and the economy. If the economy gets better in 2004, interest rates could go up, which should create more jobs -- welcomed news to multifamily firms. "I think we are totally at the mercy of job growth," Pope says. "When companies start to hire more people, our existing inventory will be absorbed and we will get back to where we were. Until there's job growth, I don't see enough people coming through our doors."

Unfortunately, other firms don't see 2004 bringing in more renters. "I don't see the overall economy changing a lot in 2004," Eddington adds. "We still anticipate concessions being a way of life for the industry."

Multifamily firms are feeling the squeeze from declining revenue and increasing insurance and utility costs, so it's only natural to look for ways to control expenses. "When the revenue line is under a lot of pressure, it just forces you to be much more attuned to your operating expense environment," says Eric Bolton, president, CEO, and chairman of Mid-America Apartment Communities Inc., in Memphis, Tenn.

The Solution

When the time comes for businesses to cut costs, most people assume layoffs will follow. But this wasn't always the case in 2003. "We have not cut the payroll category," says Steve Heimler, president of Stratus Real Estate Inc. in Sherman Oaks, Calif. "When it comes to staffing, more is more."

That does not mean other employee expenses won't be touched. Employee costs, including insurance and salary, eat up about one-third of a firm's expenses, estimates Tom Toomey, president and CEO of United Dominion Realty Trust Inc. in Highlands Ranch, Colo. In 2003, multifamily operators attempted to control these costs by reducing pay raises and benefits, he says.

Companies may also reassign their employees to cut costs. In the summer, when residents often move in or out, Mid-America traditionally uses contract workers to prepare units for new renters. But lately the company staggered the work hours of its current employees so they would be available to prepare the units during longer periods of time. "We are much more aggressive in managing fixed costs with our staff so we don't have to run up variable costs with contract labor," Bolton says.

If payroll cost cutting proves impossible or does not provide enough relief, then it's time to look at other costs. Mid-America focused on its advertising budget in an effort to find where its leads originate. This led to a cost-saving discovery: The Internet was generating many more leads than other forms of advertising. "This has afforded us the opportunity to cut our print and billboard advertising, which tend to be more expensive," Bolton says.

Outlook 2004

When looking at 2004, Toomey expects multifamily expenses to be much like 2003, rising at a 3 percent clip. But there is one very important caveat: If the nation's energy providers have to upgrade their facilities, they may send costs back to customers, he says. This would not only cost firms more, but it also will increase residents' utility bills, making them less likely to be able to stomach rent increases.

Despite Bolton's optimism about increased revenue possibilities in 2004, he does not think the expense-cutting craze will go out with 2003. "The progressive operators will continue to look for ways to squeeze costs and improve productivity," he says.

Insurance rates rose to new highs in 2003, although the problem actually dates back to the weeks following Sept. 11, 2001, when insurance companies began raising premiums. Since this time, multifamily firms have seen their rates go up at least 25 percent, according to George Klein, executive vice president with MGM Enterprises Inc., a multifamily firm in York, Pa.

The Solution

This dramatic rise in pricing forced many executives to change the way they work with insurance companies. In the past, firms called their insurer whenever there was an incident.

Now that insurance rates "have become so restrictive, that instead of immediately going to the insurer, owners won't turn the claim over unless they have to because they don't want the loss on their claims history," says Jeffrey Masters, a partner in the litigation department and co-chair of the development risk management practice group at Cox, Castle & Nicholson LLP in Los Angeles.\

This is not the only reason firms seem to be avoiding insurers. In many cases, owners take higher deductibles to cut their insurance costs. This means that smaller accidents, which used to be reported, are no longer large enough to even reach the deductible, giving firms added motivation to prevent these types of mishaps. "[By] taking higher deductibles, they are looking at how to manage risk," says Jay Harris, vice president of property management and human resources for the National Multi Housing Council. "If owners manage risk well, they can save money."

Though raising deductibles was the most popular way to deal with skyrocketing insurance costs, it certainly was not the most dramatic. Some companies started to use captives, essentially insurance companies specifically for a larger business, be it a manufacturer or an apartment firm. Companies who start these entities finance their own risk by sending premiums to a captive instead of paying an insurance company.

For instance, a company with a million dollar premium sends part of the money, around $400,000, to the insurance company that administers the captive. The other $600,000 is be placed in the captive, and the multifamily firm would get back what it did not use at the end of the year. While they have their advantages, Masters warns that captives carry a lot of risk and can be expensive to set up.

Outlook 2004

Unfortunately, multifamily firms may need to continue looking for ways to trim their insurance costs because no one expects premiums to fall in the near future. Instead, owners can only hope for prices to stabilize. Masters thinks the influx of insurance companies coming into the market will make this a reality. The problem? The types of coverage for multifamily clients will not increase, meaning firms will still continue to have trouble finding insurance for higher risk problems such as mold.

Surveying Land: It's Getting Harder to Find the Right Sites

Finding quality land to develop has never been easy. Yet, in late 2002 and 2003, a phenomena appeared that made prime locations even harder to come by for apartment developers.

Low interest rates and minimal down payments converged to feed a condo craze. The sale prices condos can garner make it very difficult for apartment developers to compete for real estate. "As long as they are willing to wait for entitlements, nine out of 10 times the condo developer will pay more for the land," says J. Ronald Terwilliger, national managing partner for Trammell Crow Residential. Combine this with difficult entitlement and zoning processes, and 2003 turned out to be a hard year for developers seeking land.

The Solution

This land crunch sent developers scurrying for solutions. Terwilliger sees developers looking for different types of land than they coveted in the past. For instance, to get always-popular infill sites, developers converted old warehouses and shopping centers into apartments and lofts, which required them to take on extra challenges. "In order to get good locations, we will take on-site contamination, and we will build ground-floor retail and share more costs with the retail owners," Terwilliger says.

Sometimes securing land is only half of the battle. Developers often work with local governments to get entitlements, but many governments were cash strapped in 2003 and sought the highest possible tax value for developable land.

Unfortunately for multifamily developers, municipalities that made no revenue from property taxes, like those in California, saw commercial or industrial land zoning as the best way to restock their coffers, making multifamily developers go through even more hurdles to get entitlements. This means developers must be flexible by building for higher densities, says Tom Allen, vice president of acquisitions for A.G. Spanos in Stockton, Calif.

In localities that did collect property taxes, developers still had to fight the misconception that apartments don't make up for their fiscal impact. Educating localities that renters are much less likely to have kids than their single-family counterparts, putting less of a strain on school systems was one argument developers used in their fights, according to Sam Fuller, executive vice president of development for AvalonBay Communities in Alexandria, Va.

Outlook 2004

With land a finite resource and localities seeking more from developers, acquiring land probably won't get easier. "It's always going to be tough [to find land]," says Gerald Ogier, president of ContraVest Inc. in Lake Mary, Fla.

Terwilliger agrees, saying that low interest rates and strong demand will fuel the condo market, making it hard for apartment developers to compete. "I think [the land crunch] is going to continue well into 2004, if not go all the way through it."