New Venture

Bigger is not always better. If you don't believe that, just ask some REITs. While they have large caches of money to spend, they've had difficulty competing with private buyers over the past couple of years. So, a couple of these public apartment firms–Essex Property Trust in Palo Alto, Calif., and AvalonBay in Alexandria, Va.–have created funds that allow them to act as private players.

With so many sources of capital and buyers, such as condo converters and tenant-in-common groups–or TICs–and more already in the market, the REIT funds represent just a drop in the bucket to other buyers. The REITs, however, do have to hire extra staff or redistribute some responsibilities, not to mention face some risk, when starting these funds. But the upside seems to outweigh these challenges.

Parcwood Apartments, a 312-unit apartment community in Corona, Calif., came into Essex Property Trust's second fund in 2004.

Photo Credit: Essex Property Trust

The first two things a firm needs when setting up a fund are time and a lot of frequent flier miles. That's because senior management will be spending a lot of time traveling to meet with pension fund leaders and other investors. "We spent 12 to15 months before our first fund meeting with the pension [managers]," says Michael Schall, chief operating officer for Essex. The company sold its first Essex Apartment Value Fund portfolio to another REIT, United Dominion Realty Trust in Littleton, Colo., and is now on its second one. "We're traveling to their offices, making presentations, and developing our track record so that we can show what we've been able to do and articulate. You also have to define whether you're a core, value-added, or opportunistic fund."

Essex and AvalonBay both decided that they needed to bring on more manpower for their funds–and with good reason. Once leveraged, AvalonBay's fund could reach more than $900 million and have about 20 properties. With leverage, Essex's fund will be more than $750 million and have anywhere from 12 to 18 properties. The second Essex fund will last seven or eight years, while the AvalonBay fund is scheduled to last eight years with two one-year extensions.

Essex Property Trust added Carlmont Woods, a 195-unit community in Belmont, Calif., to its second fund in 2004.

Photo Credit: Essex Property Trust

To beef up its workforce, Essex added a senior vice president, fund manager, fund asset manager, and fund controller for its side venture. In addition, it added property-level staff to run each apartment community. "We have 10 regional portfolio managers," Schall says. "Each one of them has some fund and some Essex properties. They're divided by geography, not by who owns it."

The consumer would never know whether a property is owned by one of the REITs or their funds. While Essex doesn't do a lot of branding, AvalonBay brands its fund properties with the other apartments in its portfolio. But the properties, often of the Class B and C variety, must be repositioned. "People associate AvalonBay with the nice stuff, but we believe that we're adding a lot of value through redevelopment," says Lili Dunn, senior vice president and managing director of investments for the REIT. "When we initially acquired them [properties in the fund], they were not reflective of the AvalonBay portfolio."

If there's one central reason REITs start funds, it's the cost of capital. With low interest rates over the past few years, REITs were watching private players scoop up many of the good deals. But with funds, a REIT can use leverage. "If we can use 60 [percent] or 65 percent leverage in the fund structure, it's much more cost-effective for us to buy through the fund, because we're only a 28.2 percent interest partner versus buying on balance sheet, where we would be a 100 percent owner and we could only use leverage of about 35 percent," says Mary Jensen, director of investor relations for Essex.

AvalonBay launched its Value Added Fund to target acquisitions (something the company generally doesn't do) and to gain access to private money. "In essence, it broadens our access to capital," Dunn says. "It enhances our financial flexibility by tapping into institutional private equity. This is a source of capital we haven't tapped into before."

Both Essex and AvalonBay charge their investors fees for property, asset, and redevelopment (and, if applicable, development) management. While these fees fall behind the cost of capital as a motivation for REITs to start a fund, they are important. "A lot of times, these are performance incentives," says Christopher A. Wimmer, a chartered financial analyst and assistant vice president for real estate finance at Moody's. "If they reach a certain return, they get an increased payout."

While the benefits are undeniable, there are also pitfalls of which REITs must remain aware. Wimmer sees some potential for problems with management's workload. "You're stretching management, and it's hard to quantify how much you're giving up," he says. "To some degree, management has to spend time on this. If it's a large, sophisticated institutional investor, it may require a lot of management that gets absorbed in managing the fund. That's hard in the multifamily sector."

There's also the issue of finding properties. With so many players lining up for multifamily properties, it isn't easy for a fund to find winners, says Simon Wadsworth, chief financial officer for Mid-America Apartment Communities, a Memphis-based REIT that has done some joint ventures and side funds in the past. "There's a lot of money out there, but not many good opportunities to put it to work," he says. "That's a challenge. It's great to have a fund, but if you can't find things to invest in, it's not that much fun."

Both Jensen and Dunn admit that finding properties isn't easy–but they won't alter their requirements just to fill their funds. In fact, Jensen said Essex would return money to investors before it bought properties that failed to fit its criteria. But she doesn't expect that to happen, though. "Obviously, the buying environment is difficult," she says. "But we believe we will reach our goal."

Private buyers aren't upset about the additional competition. After seeing TICs and condo converters alter the buying landscape, the private companies are taking more of a ho-hum attitude toward REIT funds. "Because of all of the capital that's come into our industry, I don't know if there's a discernable impact of a new type of money coming in," says Todd Darling, executive vice president of Acacia Capital, a money management advisory company in San Mateo, Calif. "In our mind, it's institutional pension fund money backing operators."

Daniel Kaplan agrees. "If it's a well-located property and it's fully marketed, you will get 20 offers on it," says Kaplan, the chief investment officer for Fowler Property Acquisitions, a Larkspur, Calif., firm that buys and renovates multifamily properties. "By giving them another tool, I don't think it will hurt the market. It's just one more force to compete with."

In fact, Kaplan thinks AvalonBay's and Essex's funds make good business sense. "It makes them more competitive," he says. "It has to be pretty frustrating if you're a 100,000-unit REIT to not be able to compete with private buyers dominating market because they're using higher leverage and exchange money. It lets them still play the game."