It’s a good thing Pettinella is so optimistic. In his 26-year career, he’s had three professional lives—all in sectors that have been hammered during this recession. He spent a couple of years in the treasurer’s office at Ford Motor’s headquarters when double-digit interest rates and oil shortages were pummeling the auto industry. He spent 25-plus years in banking. And, in 2001, as the multifamily industry was suffering from the tech collapse and post-9/11 job losses, he came to Home Properties as the heir to co-founders Norman and Nelson Leenhouts. These experiences have given him confidence that the company he took over almost five years ago can weather this storm. Home’s strategy is simple but distinct in the public apartment sector: Take older, inexpensive Class C apartments. Renovate them to B class units. Add high barrier-to-entry markets that are still relatively strong compared to the rest of the country. What do you have? Early in a recession, it’s a recipe for success. “They were one of the best-performing REITs through the last downturn, and I suspect that they will do well this time,” says Caleb Piper, assistant vice president for Delaware Investments, a Philadelphia-based investor in Home.

While many REITs are taking impairment charges for pulling the plug on massive projects, Home has a meager two developments (668 units) underway. Where other companies have leverage ratios hovering between 65 percent and 70 percent, Home has a comparatively low level of around 60 percent, according to a recent report by Newport Beach, Calif.-based Green Street Advisors. Despite these advantages, however, Home will face challenges strategically and financially in the next few years.

Worlds Collide

In 1967, the Leenhouts brothers founded Home Leasing, the predecessor company to Home Properties, by investing in single-family homes and renting them out. In the early 1970s, they began buying properties in partnerships and buying garden-style units in upstate New York and renovating them. “We hardly ever developed anything from ground up,” says Norman Leenhouts, who now serves as the company’s co-chairman of the board. “We found upgrades more profitable for us.”

Through the ’70s and ’80s, in good and bad times, the Leenhouts pushed the company’s growth. By the early ’90s, apartment firms such as Equity Residential in Chicago and Houston-based Camden Property Trust were going public. At the time, the Leenhouts had about 400 limited partnerships with a mix of office, retail, and multifamily properties. By going public in 1994, they were able to merge these partnerships and provide liquidity for their partners.

Even though Home was on the public stage, it retained its family feel. But the Leenhouts brothers knew they needed to bring someone in to run the company who had a more institutional perspective. That’s where Pettinella came into play. “He had spent his time on operational matters,” Norman says. “We had grown to the size where we needed more emphasis on that area. He was a solid financial guy, and he had significant experience in real estate for a banker.” Pettinella worked under the brothers as executive vice president and a board member for almost three years prior to taking over. “Norman and Nelson deserve a huge amount of credit for being extraordinarily generous with their time and mentoring of Ed in teaching him things about the real estate business that he couldn’t have known when he walked in the door,” says Clifford Smith, a longtime board member at Home. “They were also willing to give him the elbow room to make changes in the organization as it continued to grow, expand, and mature, so we could capture the benefits of his public company experience.”

Pettinella used those experiences to make just such changes. He upgraded the company’s systems; brought in five new regional heads; implemented a new incentive plan; developed leasing revenue optimization (LRO) systems; standardized purchasing; and re-evaluated departmental staffing. These changes helped lower the company’s general and administrative costs as a percentage of revenue from second-to-last in the REIT space (5.1 percent) to third-best (4.7 percent).

“They were public but more like a family business,” Pettinella says. “My background is running companies, tweaking them, and pushing the bottom line.”

Core Values

When Pettinella took control of Home, he didn’t mess with what worked at the company—buying older properties in good markets and fixing them up. The strategy helped Home avoid the risk and cost of new construction (the firm does have two current developments, mainly density plays, in the Washington, D.C., area). “The D word is a dirty word in a recession,” Pettinella says. “In a booming economy, it’s the best place to be.”

Home has always focused on older, cheaper properties with at least 150 units. That gives the REIT an interesting advantage. In that sphere, it mainly competes against small, regional operators, but the firm offers the technology, platform, and training of a public entity. “They have a nice strategy in the B class of buying lower quality assets, applying an institutional model to that, and creating a competitive advantage,” Piper of Delaware Investments says. “They have sophisticated rent optimization strategies and a good operating system, which they apply to a sphere that is less touched by institutional players.”

Historically, Home would seek a 15 percent cash-on-cash return under the Leenhouts brothers, but now it’s down to 10 percent. “When we buy a property, we buy it with all cash,” says John Smith, a senior vice president and chief investment officer at Home. “We’ll either assume the existing debt, if there’s any to assume, or shortly after closing, we’ll look to put financing on that. Typically, we might leverage 65 [percent] to 75 [percent], pull that cash back out, and keep churning it.”

Usually, that financing is from Fannie Mae. The agency’s mission is to support affordable housing, and Home’s properties, which have an average age of 37 years, fit the bill. But like everyone else, Home has slowed its acquisitions, making its last purchase in December 2008. It bought $360 million in assets in 2006 but only $162 million in 2007. It estimates spending $102 million this year. “We can still make deals,” John Smith says. “The question is, do you want to buy them in the economic climate we’re in?”

Right now, the answer is no. But when Home does buy, it has a rehab recipe. First, the firm tackles aesthetic issues and deferred maintenance, taking time to spruce up sidewalks, landscaping, and signage. It will also replace roofs and windows if necessary.

Home makes its interior renovations as residents leave, giving it an average of five to seven years to turn a typical property. The company doesn’t tend to do the same upgrade in each unit, often spending between $5,000 and $15,000. “It may have a certain number of high-end upgrades, while the majority of the units are getting the basic upgrades,” says Scott A. Doyle, senior vice president and head of property management at the company. “If the take rate on the high-end upgrades is greater, we’ll throttle that up.”

Home’s standard upgrade includes new cabinets, countertops, appliances, light fixtures and door hardware. It may also include an interior trim package. If there’s room in the market, it may renovate bathrooms, install washers and dryers, or elevate the level of finish in the kitchen renovations.

Home is not doing as many upgrades as it used to, but it hasn’t stopped altogether. It usually gets an increase of between $250 and $300 in monthly rents (it can be up to $500 if the property is rent controlled)—along with a noticeable change in the quality of the residents. “Pretty soon, you start to see the cars [in the parking lot] change,” Pettinella says. “And the delinquencies go down.”

Such a drastic shift in the resident population makeup has its challenges. There is a longer period of time where newer residents mingle with existing ones, particularly if existing residents live in rent-controlled apartments. What’s more, even after the initial rehabs, the average age of Home’s apartments requires keeping more maintenance staff than its peers—Doyle says the firm generally keeps one maintenance person per 65 to 70 apartments.

In many ways, these challenges are well worth it, though. Home’s same-store revenue growth of 5.3 percent from 1997 to 2007 tops the industry. However, those numbers are deceiving, according to Green Street Advisors, a Newport Beach, Calif.-based REIT consulting and research firm. “When they spend additional dollars, they don’t take the assets out of the same-store pool,” says Taylor Schimkat, senior associate for Green Street. “When they report those numbers, they reflect the benefit of the dollars they spent on the assets.”

In a Good Place

Home can do all of the rehabs that it wants, but if its properties aren’t well located, it doesn’t matter. “If you go buy a property with a cornfield across the street, as soon as you get it going well, someone else will come along and build in the cornfield,” Norman says. “In urban areas, there just isn’t any room to do that.”

The firm started in upstate New York but ventured into cities such as Baltimore, Philadelphia, Washington, D.C., and Detroit after going public. Pettinella has changed that footprint—since 2006, it sold 5,000 units in Detroit and 4,000 units in upstate New York.

It used the $600 million from those depressed markets to expand its presence in the Washington, D.C., corridor. “That’s given us a shot in the arm and strengthened our ability to have good same-store returns,” Pettinella says. “Baltimore and Washington aren’t Detroit or Las Vegas. They’re more protected.”

Now, most of Home’s holdings are in the Mid-Atlantic, with 92 percent of the portfolio located in high-growth, high-barrier markets. The firm has a major presence in the greater D.C. area, suburban New York, Baltimore, Philadelphia, Boston, and Chicago. “The locations are infill, and with the exception of New York, they probably are more insulated from the big job losses you will see around the country,” says Karin Ford, a senior analyst and vice president for New York-based Key Banc Capital Markets.

Not that all of Home’s moves have been great. In some cases, it’s been slow—Stephen Swett, an analyst with Keefe, Bruyette and Woods, an investment banking and security brokerage firm based in New York, wonders whether it could have gotten out of Detroit quicker. And, in some cases, it may be lucky. CIO John Smith says the company looked hard at Tampa, but passed.

In Home’s markets, the median home price is $318,000, compared to $180,000 nationally, according to the National Association of Realtors. But the firm’s average rent is $1,142. To get such mortgage payments, buyers would need to find a $160,000 home. That’s not easy in these markets. Still, Home is generally in good locations albeit not the prime spots, says Green Street’s Schimkat. “The company does have some solid assets that have reflected pretty stable rent trends so far, but their locations within those markets may be inferior on a relative basis to their peers in those markets,” he says.

There are advantages to being outside the fray in good markets. For instance, while Manhattan may be the most prime real estate spot in the country, it has seen softness since the financial markets fell apart, whereas Northern New Jersey and Long Island are holding up for Home. “While Wall Street is losing jobs, people can’t pay $2,500 or $3,000 a month, but they can come across the river to Jersey and pay $1,400 a month for a similar apartment and still be in commuting distance,” John Smith says.

The Outlook

All told, Home is in a good position, analysts say. During the last downturn, its same-store NOI growth was 13.3 percent, while its same-store revenue growth was 4.1 percent (the REIT average was 2.8 percent). “It’s a portfolio that has, in the past, proven to be fairly defensive,” Swett says. “They own moderately priced apartments in the very expensive markets. Owning moderately priced apartments in a recession, you should be relatively better off.”

That’s why Home is considered a defensive stock. Indeed, it does have a lot of things going for it right now. Most notably, it has demand from a number of sources. “Unfortunately due to the housing debacle, we’re the recipient of what goes on. There will be another 1 million to 2 million homeowners displaced before this situation is cleared up,” Pettinella says. “They’ll most likely go into some kind of apartment environment.”

Owning B-level apartments, Pettinella thinks he can capture a wave of those former homeowners. What’s more, most of Home’s current residents are staying in place. The company’s average resident stayed 2.4 years in 2008 and 2.3 years in 2007. “There are very few of our residents right now who wouldn’t qualify given the upheaval in the credit markets and the inability to get a good loan today,” Pettinella says.

Finally, Home expects to pull in renters who were in Class A units but are downsizing for economic reasons. “The B’s tend to do better at the beginning of a downturn. As people become more price-sensitive, they trade down,” says Andrew McCulloch, a senior analyst at Green Street, who adds that once the recovery begins, Home’s position won’t be as strong as it is now. “The B’s will do better than the A’s. Then the A’s will come back and do better coming out.”

When the return does come, Pettinella says he’s prepared Home to track the A’s better at the top of the market by doing some development and maybe buying higher grade properties. But with each passing month, it looks like the recovery is farther and farther off. And, until it gets here, provided their balance sheet remains stable, Home looks as well-equipped to handle the downturns as any other owner/operator in the business.

“These folks have to go somewhere,” Pettinella says. “In the next two years, it will continue to unravel, and the end result is it will mean more traffic for us.” [M]

t’s two weeks before Christmas at The Sycamores, a 200-unit apartment project in Reston, Va. Despite the carols playing in the background, it’s hard to feel the holiday spirit—a nasty mix of rain and ice is falling outside. Two weeks earlier the National Bureau of Economic Research announced that the country was in a recession—had been for a year. And the rental sector was beginning to feel the pinch—rents began to fall, occupancy faltered, and vacancy rates slowly started to rise. But the monotony of this Friday morning is broken up when a tall, engaging figure walks through the front door. No, it’s not Santa Claus; it’s Rochester, N.Y.-based Home Properties president and CEO Ed Pettinella. He’s been up since 4:00 a.m.; he has a Venti Starbucks in hand; and he’s ready to sell Home Properties.

LEADERSHIP LESSONS: Ed Pettinella

• Age: 57 • Title: President and CEO
• Previous Gig: President of Charter One Bank in New York
• Favorite Quote: “Learn from yesterday, live for today, hope for tomorrow.” —Unknown
• Best Business Decision: Selling our Detroit and Upstate New York properties; transferring utility costs to our residents
• Greatest Business Challenge: Restructuring a company for higher profitability
• Person You Most Admire: A former CEO because he taught me how to avoid many common pitfalls, as well as how to skillfully manage for performance
• Best Advice Ever Received: Always operate with the highest level of integrity.
• Leadership Philosophy: Treat fellow workers exactly as you would like to be treated.
• Playing on Your iPod: The Killers and Coldplay
• Last Book Read: Wooden on Leadership by John Wooden (McGraw-Hill, 2005) HOME PROPERTIES

• Founded: l967 • Headquarters: Rochester, N.Y.
• Employees: About 1,200
• No. of units: Manage 38,436; own 37,286
• Regional coverage: Largest markets by number of units are suburbs of Washington, D.C.; New York City; Baltimore; Philadelphia; and Boston  

What's the Rub?

Home waited longer to pass on cost

For years, Home Properties had built its residents’ utility costs into the price of rent. That’s understandable since many of its apartments are older and not metered. Even after ratio utility billing systems (RUBS) became popular, Home was reluctant to pass the costs onto its residents.

That led to some confusion for the analysts covering the company. They saw that Home’s public peers weren’t weighed down by energy costs and wondered what the problem was.

“Home argued that in their markets, it was something that was necessary,” says Stephen Swett, an analyst with Keefe, Bruyette and Woods, an investment banking and security brokerage firm based in New York. “Home got caught in having utility costs that they had to eat and their competitors didn’t.”

In fact, president and CEO Ed Pettinella thinks that if you compare Home to its local competitors, it was one of the first to adopt RUBS. “We compete with regular type competitors or mom and pops,” says Scott A. Doyle, senior vice president and head of property management at the company. “We took the lead earlier than most competitors in our market. In Washington others may have been first. In Philadelphia and other markets, we were the first to go.”

Liquidity Concerns

Did Home miss an opportunity?

Some analysts think Rochester, N.Y.-based Home Properties missed an opportunity. After passing on a chance to extend its line of credit in 2008, Home now has an extension due in September.

Green Street Advisors, a Newport Beach, Calif.-based REIT consulting and research firm, doesn’t see a decrease in Home’s line availability but doesn’t see an increase, either. The REIT has about $70 million in line availability and needs to spend about $70 million to complete development underway in 2009.

The company’s $2 billion in maturities average seven years, and its cost of funds is about 5.7 percent (5.4 percent for total fixed and variable loans). All told, the company is not in bad shape.

“We’re a little worried about their maturity picture and some spending they need to do, given the limited availability they have on their line,” says Karin Ford, a senior analyst and vice president for New York-based Key Banc Capital Markets. Last year, Ford ranked Home as her top apartment REIT.

“These guys know Fannie and Freddie well. But it’s a real concern that they may have trouble on the capital side if Fannie and Freddie go away,” Ford continues.

President and CEO Ed Pettinella isn’t concerned. In fact, he says the firm is currently in discussions with Fannie Mae and Freddie Mac to secure additional credit facilities. Pettinella would not disclose the details of the terms of the new agreements.