Apartment Investors in U.S. Not Scared by Vinyl Siding in Search for Yield

Orchard Pointe, a 17-year-old, vinyl-sided apartment complex in Vancouver, Washington, wouldn’t have drawn a second look from Invesco Real Estate in early 2010, when most multifamily-property investors wanted newer, trophy buildings in coastal markets such as New York and San Francisco.

“We wouldn’t have even considered it,” Greg Kraus, head of acquisitions at the Dallas-based real estate arm of asset manager Invesco Ltd. (IVZ), said in an interview.

By December, the firm had purchased the 388-unit Orchard Pointe, located about 15 miles (24 kilometers) from downtown Portland, Oregon, on behalf of a client for more than $31 million. It plans to raise rents after spending about $4 million to renovate the garden apartments, including removing the vinyl siding, Kraus said.

As U.S. demand for rental housing surges, investors are venturing beyond class A properties, or newer, well-leased buildings in centrally located neighborhoods of big cities. Orchard Pointe was the first class B property -- older, with higher vacancy rates or requiring improvements -- that Invesco had bought in three years, before credit markets seized and commercial property values tumbled.

“It really reflected our belief that fundamentals are improving,” Kraus said.

Apartment-building sales climbed 96 percent to $33.7 billion in 2010 from a year earlier, according to Real Capital Analytics Inc., a commercial-property research firm in New York.

‘Value Add’ Apartments

“Value-add” apartments -- class B properties, distressed acquisitions, real estate that requires renovation and buildings where cash flow can be increased -- accounted for 33 percent of sales in the fourth quarter, compared with 25 percent a year earlier, said Sam Chandan, Real Capital’s chief economist. Such deals made up 61 percent of apartment transactions in the fourth quarter of 2005.

The U.S. homeownership rate is at a 10-year low, in part because the foreclosure crisis is forcing former owners to rent and discouraging would-be buyers. Foreclosure filings increased in almost three-quarters of U.S. cities last year, and the number of homes receiving a filing is likely to jump 20 percent this year, according to data provider RealtyTrac Inc.

Apartment rents climbed 4.3 percent in last three months of 2010, the most since the third quarter of 2006, according to research firm Axiometrics Inc. The Dallas-based company projects a 6 percent increase in U.S. rental revenue in 2011.

“Those improving fundamentals are driving the willingness of investors to explore value-add opportunities as opposed to paying premium prices for core properties,” Chandan said. “That is a feature of the multifamily market that we do not see to the same degree in other sectors.”

Demand for Apartments

Demand for apartments will rise further as the job market recovers and the children of baby boomers move away from home and seek apartments, Ron Johnsey, president of Axiometrics, said in an interview. Supply is tight, with monthly starts of multifamily properties averaging an annualized 112,000 units in 2010, compared with 280,000 units in 2008, according to the Commerce Department.

“The multifamily sector is probably the only commercial real estate sector that has very positive fundamentals behind it,” said Jeffrey Baker, New York-based managing director at Savills LLC, a real estate investment bank that raises capital for multifamily owners and developers. “You’ve got a demographic that is producing more households that want to rent an apartment. You’ve got virtually no new supply that’s been added over the last several years.”

Household Formation

The homeownership rate may decline to 65 percent by 2015 from 66.5 percent in the fourth quarter of last year, creating 4.5 million new renter households, according to a March 2 report by Green Street Advisors Inc. About 2 million of those households may end up in professionally managed apartments, the Newport Beach, California-based real estate research company said.

Equity Residential (EQR), the largest publicly traded apartment owner in the U.S., plans to make about $1 billion in property acquisitions this year, Chief Executive Officer David Neithercut said on a Feb. 3 earnings conference call. The Chicago-based company will seek assets with “a little bit more risk,” as the competition to buy safer properties has intensified and driven up prices.

Capital Chasing Deals

The company, which acquired three prime Manhattan high- rises in the beginning of 2010 from developer William Macklowe, turned at the end of the year to properties such as Northpark Apartments in Burlingame, California, a 40-year-old garden- apartment community of 510 units near San Francisco International Airport.

“I am not suggesting that we will never buy or won’t buy a stabilized asset, but there is an awful lot of capital chasing those,” Neithercut said on the February call. The capitalization rate, a measure of investment yield, has sunk to as low as 4 percent for the newest, fully leased properties in the coastal markets where Equity Residential operates, he said.

Cap rates are a property’s net income divided by the purchase price.

AvalonBay Communities Inc. (AVB), the No. 2 U.S. apartment owner, will increase the concentration of “B assets” in its portfolio to 25 percent from 15 percent. The move isn’t related to the growing competition for multifamily properties, CEO Bryce Blair said in an interview. Rather, the company’s research showed that class A and class B assets perform similarly in the long run. For that reason, AvalonBay, based in Alexandria, Virginia, is seeking to diversify its portfolio with properties at a variety of prices, he said.

Marina del Rey

“Conventional wisdom is that the ‘A’ asset on Central Park is always going to outperform the ‘B’ asset in Central Queens -- well, that’s not necessarily true,” Blair said. “If you’ve overpaid for an asset on Central Park or are in an area with an oversupply of other ‘A’ assets, and you have a very unique property in Central Queens, the Queens property may outperform the Central Park property.”

At AvalonBay’s class B and C properties in the Los Angeles submarket of Marina del Rey, effective rents had an annual growth rate of 4.3 percent in the 10 years through 2009, compared with 2.2 percent for its class A properties there, according to a November investor presentation on the company’s website.

Class C Properties

The declining rate of homeownership fueled creation of an estimated 700,000 new renter households in the U.S., half of which were in multifamily buildings, AvalonBay’s Blair said on a Feb 3. call with analysts and investors. That helped push the firm’s rental revenue from apartments leased at least one year up 2.5 percent in the fourth quarter compared with a 4 percent decline in the first quarter of 2010.

Nationally, effective rents at class A and B properties climbed 5.3 percent in the fourth quarter over a year earlier, according to Axiometrics estimates. By the final quarter of 2011, class B properties may see effective rent growth of 5 percent over the year-earlier quarter, compared with 4.8 percent for class A properties. Rent on class C properties may increase 5.3 percent.

Revenue from class C properties increased 5.3 percent in the fourth quarter, after bottoming at negative 8.7 percent in the third quarter of 2009, Axiometrics estimates.

The interest in value-add properties will come primarily from investors who are paying cash, or from real estate investment trusts and pension funds, which don’t need to take on high loan-to-value debt and tend to hold assets for a long time, said Mike Kelly, president of Caldera Asset Management, a Denver-based multifamily consulting firm.

Multifamily Financing

The crisis in commercial real estate was compounded by property owners who borrowed on assumptions of future rent, known as underwriting, that were too rosy, he said. These days borrowers can get a loan only against the last 90 days of the property’s income, rather than future projections, Kelly said.

“You’re going to get tremendous rent growth -- you just can’t underwrite it,” Kelly said of value-add properties. “These guys can’t underwrite the giant rent growth and not get laughed out of the room for it.”

Fannie Mae and Freddie Mac, which offer financing for multifamily acquisitions, “are much more heavily weighted to core assets since the downturn,” Chandan of Real Capital said in an e-mail. Value-add properties accounted for 12 percent of Fannie and Freddie lending by dollar volume in 2010, he said.

‘Little Less Heady’

The biggest metropolitan areas, notably New York and the suburbs of Washington, D.C., have led the apartment recovery, as their growing job markets lure investors to well-leased properties, especially trophy assets considered the best in the market. Cap rates on Manhattan properties averaged 5.1 percent in the fourth quarter, compared with the national average of 6.6 percent, according to Real Capital.

In Washington, cap rates averaged 4.8 percent in the quarter, the research firm said.

“Rather than buying in D.C., where you get 50 bids on the asset that was just put out there, you’ll probably look at traditional top 20 markets and go into the ones that are a little less heady -- an Atlanta or a Charlotte,” Baker of Savills said. “We’re starting to see that happen. They don’t have a lot of choice if they have certain yield requirements.”

Atlanta apartment properties carried cap rates of 7.7 percent in the fourth quarter, and Charlotte had yields of 5.2 percent, according to Real Capital.

Eyelashes, Makeup

At Invesco, the interest in higher yields is shifting the firm’s attention this year to the greater Portland, Oregon, market, as well as Denver and the New Jersey suburbs of Philadelphia -- all places that didn’t even rank this time last year, Kraus said.

Invesco will spend about $4,800 a unit at Orchard Pointe to improve the kitchens, electrical fixtures and other “eyelashes and makeup,” according to Kraus. The complex was bought for a cap rate of 6.8 percent. With the upgrades, Invesco is estimating a 5-year unlevered return of 12 percent, he said. With leverage, the yield may be 19 percent.

“There are a lot of good properties that the capital hasn’t aggressively been chasing,” Kraus said. “People are looking and believing that they can underwrite a recovery.”

To contact the reporter on this story: Oshrat Carmiel in New York at ocarmiel1@bloomberg.net.

To contact the editor responsible for this story: Kara Wetzel at kwetzel@bloomberg.net

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