#1 Expect Meager Portfolio Trades.
Even coming off one of the larger multifamily portfolio transactions of 2010, Tom Toomey doesn’t hold much optimism for bulk apartment buys in 2011. “We’ll all have to take our cue from the banks and the GSEs on that,” says the president and CEO of Highlands Ranch, Colo.-based REIT UDR, which bought out Houston-based developer The Hanover Co.’s share of a 26-community, 5,748-unit joint venture with New York-based MetLife back in November. “The lenders all say volume will be up, but whether or not that means portfolio-level financing is available, we’re still going to see tight underwriting and slow processes. So I don’t see any portfolio transactions getting done. One or two, fine, but no big tidal wave.”
In addition to the lack of finance availability preventing execution by anyone without a multimillion-dollar equity fund, buyers seem to be finding better pricing on one-off deals, and solid operators are content to enjoy cash flow as rent fundamentals and NOI growth go into overdrive. “There are players in the market with an appetite for portfolios,” says Jeff Morris, managing director of Chicago-based real estate investment firm Jones Lang LaSalle. “It’s just a pricing issue for sellers who want to sell based on a list of market criteria—and it is hard to make a portfolio fit that list of criteria.”
Still, bidding closed in late 2010 on a 3,427-unit portfolio of assets being sold by Houston-based Camden Property Trust, with a buyer likely to be announced in the first quarter of 2011. NOI growth—even if it means attractive cash flow—will also boost asset values, which could make a block trade possible, despite a limited universe of buyers. “Logical portfolio buyers and sellers will be traded and non-traded REITs, pension funds, and other traditional institutional investors, as a result of increases in allocations to this sector,” says Mark Alfieri, executive vice president of Dallas-based real estate firm Behringer Harvard, which was the No. 2 buyer of multifamily properties through the third-quarter of 2010, according to New York-based Real Capital Analytics.
Asset quality among those refinancing portfolios, however, might be another roadblock to bulk deal activity. “Some of the CMBS pools have cross-collateralized portfolios,” says Dave Woodward, CEO of Greenwood Village, Colo.-based Laramar Group, which assumed management of a distressed portfolio of San Francisco assets in early 2009. “Some of those portfolios might be coming out of special servicing, but it is not core product. Most of these deals are tough stuff—[they were] marginal deals five years ago and even more challenging now.”
If distressed portfolios do come out of the cycle of CMBS maturities via special servicers, many in the sector expect that the assets are still out of reach for a couple of years. “We don’t have any large portfolios on our watch list,” says Bill Hoffman, president of San Diego-based receiver Trigild, which successfully sold the Irvine, Calif.-based Bethany Group portfolio out of receivership to foreign investors in 2010. “If similar portfolios of that size were coming out in 2011, I expect we would have heard rumblings about them before now.”
#2 the B Market WIll Get a Boost.
With plenty of money nevertheless chasing apartments—and the first round of core-plus trophy asset buying coming to a close—demand for both Class B and value-add assets will advance in 2011, particularly in cities that saw less deterioration in market fundamentals or are experiencing better job growth relative to the rest of the country. “The players in the 2010 market were large, well-capitalized pension funds and REITs, who were throwing darts and picking up trophies. The difference this year is in the cycle,” UDR’s Toomey explains. “If you look at 2010, all markets were somewhat improving with one or two shooting stars. In 2011, substantially all the markets will be [better], creating the opportunity for more buyers going down the curb to buy Bs and Cs.”
That doesn’t mean dealmakers won’t discriminate. When it comes to value-add opportunities, development veterans such as Atlanta-based Wood Partners are looking for more than a quick bump on lipstick improvements. “I am more interested in significant rehabs of properties in excellent locations: Strategic redevelopment is what we are calling it,” says Jay Jacobson, Wood Partners national acquisitions director. “We will focus on location-driven deals rather than traditional value-add ‘let’s fix a kitchen and charge $20 more a month’ deals. We’ve never been big believers in that model.”
Keep in mind that Class B assets don’t usually have a purchasing process that is any easier—or more cost effective—than Class A deals. Alfieri of Behringer Harvard expects cap rate spreads to tighten between asset classes as more purchasers seek out choice deals in the B sector, and firms leading the way in the buying blitz aren’t exactly turning deals on a dime. “As A properties get absorbed, people are continuing to start looking at the Bs,” adds Randy Fifield, vice chairman of Chicago-based developer Fifield Cos. “We closed out 2010 with the purchase of 1,300 [Class B] units in Texas, and they were still difficult deals to close from both a lending and due diligence perspective.”
#3 Buyers WILL spread out geographically.
A run on B assets, coupled with perceived overbidding on what deals are still available in coastal markets, will have apartment buyers moving beyond core metros and into secondary markets, notably in the Midwest and South, with the diaspora of dealmakers again likely to follow rent fundamental improvements and market-to-market job growth.
“Even some of the big buyers are saying cost-per-unit purchases on the West Coast are getting bid up,” says William Ross, executive vice president of Bloomington, Minn.-based NorthMarq Capital, a commercial real estate investment firm. “We are seeing some buyers consequently move back inland to the Chicago and Texas markets looking for opportunities, especially if they are by-the-pound buyers.”
Indeed, UDR’s portfolio deal with MetLife brings the REIT new communities in Pennsylvania, Colorado, Maryland, and Texas in addition to adding heft to the firm’s portfolios in Washington, D.C., California, and Washington state. “The markets that have thus far improved the greatest are those with the most transparent NOI growth, and that appears to be Northern California and Seattle,” Toomey says. “As more markets come online, the number of buyers will spread out. Instead of winning an auction of 30, you’ll only have to win an auction of five, [creating a competitive climate] which in turn brings more players into the market.”
#4 Rents Will Beat Pro FormaS.
One of the primary catalysts to deal flow in 2011 will be continued rent growth, supported by an unremitting flow of households back into apartments from single-family homes and condos. “The growth in rent rolls isn’t a lovely little increasing graph—it is a major spike,” Ross says. “And that’s where we’re seeing—and expect to see—the most purchasing activity: in markets where occupancies are good at 90 percent-plus, but [also] where rents have been crushed and are poised for substantial, year-over-year, $50 to $70 rent increases.”
Certainly the institutional set is anticipating massive rent gains, which might restrict trading in the upper echelons of the market, concentrating additional deal flow away from core investments but offering new business to third-party fee managers. “On the management side of core and core-plus, we feel there is still opportunity for the more institutional client accounts,” Laramar’s Woodward says. “They have deep pockets and staying power and are hanging in for the long haul.”
#5 Property HolD PEriods May TIGHTEN.
Or not, if asset values continue along their current stratospheric growth trajectory. In October 2010, Irvine, Calif.-based multifamily owner/manager Sares-Regis Group—which still considers itself a net buyer looking to deploy capital into apartment transactions—was able to sell the 231-unit Bella Villagio Apartments in San Jose, Calif., to Palo Alto, Calif.-based Essex Property Trust for $54 million and realize its pro forma return expectations after an ownership period of only 16 months.
“Some enormous profits have been made by buyers who were active in 2009, so there will be some long-term holds that sell into the market to maximize returns with a shorter holding period,” Alfieri explains. “Given the rent and NOI expectations of the next few years, I would say that holding periods have the potential to be shorter, but if the NOI growth does not materialize, then a typical seven- to 10-year hold will be the average.”
Just how short could holds get? Ross speculates that there are more than a handful of buyers who have already bought on a pro forma of five to seven years who could possibly sell in 2011 and take profit. “I think you will see a lot of people end up with a 24-month hold,” Ross predicts.
Players familiar with broken deals nevertheless caution buying into those types of accelerated dispositions and argue that the current economy is not a conducive environment to asset flipping. “Anyone who is planning from the outset to flip something, whether it is a single property or a loan portfolio, is taking a heck of a risk,” says Hoffman of Trigild.
#6 LevereD PlayerS MAY TAKE an Encore.
Still, the opening of the B markets and the availability of financing from the GSEs and other lenders, coupled with interest rates, makes a return of the leveraged arbitrage player to the apartment sector inevitable. “The levered player has been stymied, and I think he is coming back,” Toomey forecasts. “As you look to the future, I think you’ll see more bulk purchasers borrowing on spread, scooping up all of the Bs that they can. That part of the market will come back.”
Alfieri agrees: The domination of the all-cash, institutional buyer is likely to wane in 2011 as capital moves into the secondary markets. “As the value-add and Class B product becomes a larger share of the market, financing will become more of a requirement,” Alfieri says. “This will be a different type of investor, more highly leveraged and return-driven.”
Jones Lang LaSalle’s Morris explains that interest in financing Class B asset buys and value-add plays is about market psychology. “There’s simply less fear in the markets today than there was 18 months ago. As investors become less fearful, they are ready to take on risk,” he says.
#7 Banks and Life Companies respond to the GSEs.
While recent increases to the yield on the 10-year Treasury rate have been pushing up rates on five- and seven-year loan interest rates from the GSEs, borrowing for multifamily acquisition still remains at historically low costs. The dramatic return of life insurance companies—and to a lesser extent, banks—to the apartment debt arena at the close of 2010 is also juicing up deal flow, with market watchers saying there is still plenty of room in the spread between interest rates and cap rates to satiate the yield expectations of investment committees.
“The banks are stepping in softly with their top-tier clients and customers, but life companies on the permanent side are becoming a fairly significant source of capital for people and have become a good alternative to the GSEs,” says Wood Partners’ Jacobson. “Even if something [dire] happens to Fannie and Freddie, I think the life companies at least on the acquisition side will probably make up the void, which means, of course, they’ll be able to charge more and rates will go up a little bit.”
On the banking side, Northmarq characterizes almost a club mentality among lenders who will ask clients to run a vigorous underwriting gauntlet upfront but will tend to increase the offering of financing vehicles to those TLC clients who have made muster. “You have to act like a public company with a certain amount of transparency, liquidity, and net worth,” Ross says. “But once a firm has been blessed, that bank will then do a lot for the client—land loans, bridge loans, a lot more things.”
#8 Distress will Disintegrate.
One thing that banks seem continually unlikely to do in 2011 is stage a distressed asset dump on the market. With NOI improvements and a competitive deal space throttling asset values, the workout of troubled loans seems destined to continue. Even CMBS maturities, set to begin in earnest this year with volume increasing into 2013, aren’t likely to result in RCA-era fire sales.
“I think the distress has already been sold off to the market—that business ran its course in 2010,” Jacobson says. “If a bank is still holding a note, it’s because they have likely worked out issues with the sponsor or they just decided to wait out the recovery. The banks that waited over the past year have seen their valuations increase and have seen the markets save them. Likewise, you’d think some of these huge CMBS servicing companies are going to get tired of asset managing the portfolios they have, but I have not seen anything but B and C product come out of that sector. They are holding on to the really good stuff because they can make money off of it for themselves and their clients.”
#9 The Privates might Go Public.
With distressed asset dumps and major portfolio buys out of the picture, market watchers asked to identify the biggest apartment deal of 2011 almost unanimously pointed to an IPO—or even several IPOs—hitting the multifamily REIT space. “I wouldn’t be surprised if there is a very significant multibillion-dollar deal that goes from private to public,” Jacobson says. “The REITs are flush with cash, their stocks are trading great, and their yields are great. I can’t name names, but there are plenty of private companies that control 20,000, 30,000, 40,000 units in markets such as New York or San Francisco that seem poised for an IPO.”
Toomey agrees. He says increasing NOI and the absence of distress have several players interested in IPOs as an exit alternative to big portfolio sales unlikely to occur in 2011. “There is probably room to get three IPOs out, and one or two of them might be a re-IPO of a prior public company,” Toomey says. “I’m not aware of anyone that has any sentiment of selling into a big deal. I see companies going public as much more likely.”
#10 Development will Make a Command Performance.
Also increasingly likely in 2011 is a return to full-on apartment development and construction. With firms such as Wood Partners and Phoenix-based Alliance Residential launching major development initiatives in 2010, the race is on to get new product out of the dirt in time for deliveries in the 2012 to 2015 window of expected rent and NOI surges.
Unexpected absorption of the few complexes that opened last year also has several operator/developers looking to push groundbreaking dates forward. “All of our lease-up volumes are probably 50 percent better than pro forma, and our rents are 10 percent better,” Toomey says. “The concessionary levels are burning off quicker, and that’s why people are figuring they can be a lot more aggressive about development starts.”
Equally important, financing is suddenly available again from lenders, making the prospect of apartment building all the more real. “Wells Fargo, Bank of America, US Bank—all of these guys are back in business, even if they are only looking at opportunities in Washington, D.C., Boston, San Francisco, and the like,” says Fifield of Fifield Cos. “Some life companies are even looking at financing new construction. I think the big story a year from now will be that development is back.”
#11 Deal Volume Cranks, especially in the second half of 2011.
The result of all of these trends, of course, is a robust industry that, while not fully mended from economic recession and job loss, has matured from cautious to opportunistic optimism. As a result, the demand for apartment assets, the capital availability to purchase them, and the asset values that guarantee horizon returns for sellers will all culminate in the acceleration of deal volume, particularly toward the second half of the year. “I expect transaction volume to increase 30 percent to 40 percent in 2011, and that volume should increase as the year unfolds,” Alfieri says.
Toomey agrees and keys in on job growth as another major catalyst to deal flow during the latter part of 2011. “There is job growth out there, and the second half will be even better as more and more sectors of the economy start finding their job numbers,” he says. “When the jobs picture improves, then I say we’re off to the races again, meaning lots of volume, strong NOI growth, and lots of available financing. This industry is in good shape, and I think we’re going to have a damn good year.”