FEATURE: No place like home

The multifamily sector is leading the recovery for US real estate with rising rents and occupancy levels. However, as increasing amounts of equity start to target the sector, is multifamily in danger of becoming yet another bubble? PERE magazine February 2011 issuE

It seems a bit premature to be talking of real estate bubbles a little more than two years after the Great Recession. Yet, for the US multifamily market, there are mounting concerns that such a bubble is starting to form. With numerous apartment deals in core cities having already sunk below the 5 percent cap rate mark as capital increasing targets the sector, some private equity real estate investors are privately questioning whether multifamily – traditionally considered real estate’s “safest bet” – has in fact become a risky gamble.

It’s undeniable that the US rental apartment sector experienced a good year in 2010. By the end of the year, national vacancy rates had fallen to 6.6 percent from 7.1 percent – one of the sharpest drops on record – with net effective rents rising an average of 0.5 percent each quarter in 2010, following five quarters of declines, according to data provider Reis. And, despite a normally sluggish fourth quarter, occupancy levels also have risen enough to ensure net absorption of 227,011 units from the system during the past year. In 2009, 1,650 apartments were added to stockpiles, with tenants vacating their rental homes as the recession took its toll. Altogether, Reis says, the data confirms that the multifamily sector bottomed out in the fourth quarter of 2009, with a strong recovery now underway.


The question is, of course, whether the multifamily sector is about to witness a perfect storm, where fundamentals couple with demographics to create a once-in-a-generation investment opportunity, or whether investors are speculating once again on unsubstantiated hope?

For Ed Oprindick, a senior portfolio manager for Trecap Partners’ Commercial Realty Partners III fund, multifamily’s recovery is being driven by “some of the best fundamentals” seen in decades. “The multifamily space has always been a competitive sector, especially over the past five or six years and in the prime coastal markets,” he says, accepting that it is “on everyone’s radar today”.

Yet, despite conceding that multifamily has become real estate’s hottest sector, Oprindick insists it isn’t in the grip of a bubble. “Most of the over-exuberance being seen in multifamily is for trophy assets in the core markets. That’s something we question as value-added players, but that doesn’t mean the sector as a whole should be ignored.”

Indeed, Mike McNamara, who heads Trecap’s acquisitions team, says the Philadelphia-based firm is putting its money where its mouth is, with plans to make up to $400 million of acquisitions in 2011 – twice as much as in 2010, when Trecap deployed $200 million for 2,000 apartment units through seven different deals. “Apartments are the gold standard for real estate,” he adds.

Building on generation Y

The reason for such optimism in the multifamily sector is down to several key factors, which are driving tenant demand. First and foremost is the long-term demand expected to come from the generation of “echo boomers”, who are just starting to come of age. Born between 1982 and 1995, the roughly 80 million “boomlets” are the largest generation of young people born since the 1960s and the age group with the greatest propensity to rent. “This alone will add significant demand side fundamentals to the multifamily space,” Oprindick says.

The multifamily space has always been a competitive sector, especially over the past five or six years and in the prime coastal markets. [It's] on everyone’s radar today.

Ed Oprindick, a senior portfolio manager for Trecap Partners’ Commercial Realty Partners III fund

But it’s not just population factors that are helping to lower vacancies and increasing rents. With foreclosures of single-family housing expected to rise further in 2011, busted homeowners are also back in the market in a big way. In 2006, the proportion of owner-occupiers peaked at 67.3 percent. That rate, though, has steadily declined in tandem with household finances and could sink as low as 64 or 65 percent, according to most multifamily investors PERE spoke to. Alongside historically low construction starts over the past three years, “people are starting to get the story of multifamily fundamentals,” says John Christie, senior director at listed multifamily REIT and private equity real estate fund manager, AvalonBay.

What makes these fundamentals so attractive for investors, Christie notes, is that they are independent of job growth. “For a long time, people have attributed changes in revenue in the multifamily sector to job growth, but the apartment market depends on more things than just the jobs market,” he says. “2010 saw little to no job growth, but this sector had a pretty good year.”

Investment momentum

Investors, though, are taking notice of multifamily’s turn of fortunes and plan to invest accordingly in the coming year. A Jones Lang LaSalle survey of 100 large-scale multifamily owners, investors and developers in November revealed that 93 percent of respondents were planning to increase their equity investment in the sector in 2011 – 40 percent of those by 75 percent or more over 2010 levels. And of the various strategies in play, 27 percent were eyeing value-added plays, followed by 20 percent targeting opportunistic investments and 19 percent focused on core. In the 2009 survey, 90 percent of investors said they would pursue opportunistic investments.

People are starting to get the story of multifamily fundamentals.

John Christie, senior director  AvalonBay

“We have come through a period where there has been very little activity over the past couple of years and now, as capital comes back into real estate, there are certain sectors that are really getting a lot of attention and seeing a rebound in valuations,” explains James Martha, head of Henderson Global Investors’ North America property business. Multifamily is such a sector, but Martha warns that most of the attention to date has been focused on Class A trophy assets in the top 10 US markets.

“Can multifamily get overheated?” asks Henderson’s director of property portfolio management AJ Richard. “Possibly in some markets, particularly in the top locations. But a vast portion of the multifamily market hasn’t received the attention of investors to date.”

Most of the concern over an emerging bubble in multifamily stems from a spate of recent deals, where cap rates have sunk sub-5 percent. Among the most talked about in 2010 was JPMorgan Asset Management’s acquisition of the Park Lane Seaport high-rise apartment complex in Boston for $193.8 million in December. Purchased from a joint venture between Cornerstone Real Estate Advisers and the Fallon Company, the transaction for 465 units, which were 95 percent leased, 18,000-square-feet of retail space and 520 parking spaces represented a 4.9 percent cap rate. Another deal that month saw JPMorgan acquire an apartment property in Charlotte, North Carolina, for $40.5 million, or a cap rate of 5 percent, according to data provider Real Capital Analytics.

“For the top markets such as New York, Boston, Washington DC, San Francisco and Southern California, the potential exists for the market to break below the cap rates of 2006,” explains Jubeen Vaghefi, managing director at Jones Lang LaSalle and leader of the firm’s multifamily practice. The issue, he contends, is a matter of supply and demand.

“Over the past 10 to 15 years, there was a lot of multifamily construction in primary, secondary and tertiary markets, but those construction starts have dropped to unprecedented levels,” Vaghefi says. “That comes at a period of time when more people are looking to rent. It’s simple arithmetic and something that means I strongly disagree with the bubble critique.”

Henderson’s Martha agrees: “The concern over bubbles being created in real estate is a real one as we watch capital come back into the asset class. However, for multifamily, there is no question that it is fundamentals that are driving capital flows as opposed to speculation.”

Finding equilibrium

With such supply-demand dynamics, some multifamily investors are eyeing development as a good, if not short-term, opportunity. AvalonBay’s Christie says the REIT expects to start an estimated $700 million of development in 2011, on top of roughly the same amount in 2010.

Can multifamily get overheated? Possibly in some markets, particularly in the top locations. But a vast portion of the multifamily market hasn’t received the attention of investors to date.

Henderson Global Investors' director of property portfolio management AJ Richard

“We really ramped up our development activity in 2010 because we believe we are leaving the bottom of the business cycle and are entering an up cycle,” Christie says. “As such, we want to be out of the gate quicker than anyone else.” Although AvalonBay restricts its development activity to its REIT operations, he says the lower cap rates descend the more attractive the spread between development and acquisition becomes for the entire sector. The key, though, is being shovel-ready with a development today – not an easy proposition for an industry where private multifamily builders in particular were significantly hobbled by the financial crisis.

For much of the private equity real estate world, therefore, investment activity has come through recapitalisations, either of developers or the assets themselves. In the final three months of 2010, AREA Property Partners closed on more than $240 million worth of deals, comprising almost 3,000 apartment units across three states, according to RCA. In one deal, the New York-based firm converted the broken condo project Terrazas River Park in Miami into rental apartments after buying the asset out of foreclosure from lender iStar Financial for a reported $44.8 million. Richard Mack, chief executive officer of the firm’s North America business, says the deal also acted as the catalyst for another – with AREA providing a 65 percent loan-to-value first mortgage for a multifamily conversion of the neighbouring condo, River Oaks.

There’s no longer an oversupply, and there’s no slack in the market. You don’t see this type of equilibrium in the other property sectors at this point in time.

Russ Appel, president of The Praedium Group

“The fundamentals for multifamily are quite strong, and it’s not because we’re seeing a lot of job growth,” Mack says. “Positive demographics, people being hesitant about buying a home and the fact you can buy assets below replacement costs make this sector very attractive to us.” But he adds: “As rents come back, so does the competition and multifamily can be expensive. You have to understand what you are buying and be very careful.” That being said, he notes that off-market multifamily transactions with solid supply-demand dynamics are “compelling”.

Mack is joined by Russ Appel, president of The Praedium Group, which acquired more than $300 million of apartments comprising around 4,000 units in 2010. “Even with slow job growth, you will see consistent leasing demand for multifamily,” he says. “Compare that to the US office, retail or industrial sectors and you realise that multifamily has reached a leasing equilibrium point. There’s no longer an oversupply, and there’s no slack in the market.” He added: “You don’t see this type of equilibrium in the other property sectors at this point in time.”

CBRE Investors is actively eyeing multifamily for its $2.1 billion value-added vehicle, CBRE Strategic Partners US Value 5. While some markets are overheating, the firm argues that many markets have a “long way to go”

Richard Ellis’ Steve Zaleski, talk of a bubble in the US multifamily sector has more to do with hyperbole than facts based on fundamentals. The managing director of the Los Angeles-based firm’s multifamily group stresses that while some markets are overheating – Washington DC and San Francisco among them – for most of the US “there is still a long way for fundamentals to go”.

The Icon,

“The market is driven by local supply constraints and, in many cases, rents are actually low,” Zaleski says. As such, some investors can underwrite lower cap rates “because they see the potential for a rebound and higher rental income as fundamentals kick in.”

During 2010, CBRE Investors acquired almost 3,000 apartment units for an estimated $500 million, according to data provider Real Capital Analytics. In November, the firm acquired two apartment blocks — the Icon and Park District — in Atlanta’s Atlantic Station development for an estimated $54 million. Zaleski declined to comment on financial details, but he says the deed-in-lieu of foreclosure transactions represented a 60 percent discount to replacement costs and a 5 percent cap rate – at 1998 rent levels.

“In this market, we’re not really comfortable underwriting rental growth until we start seeing job growth,” Zaleski says. “However, as in most markets, you need to understand what income you’re actually capping.”
The Atlanta apartment deal – which was followed by CBRE Investors’ acquisition of a 534,000-square-foot office building and retail centre from AIG for an estimated $230 million in the same complex – was the result of a borrower restructuring its debt load with the banks. “That could be a significant opportunity for investors in 2011, where you can buy at discounts to replacement costs but the banks get out whole or near to whole,” Zaleski says.

The US government has been the go-to source for multifamily financing for decades. However, as debate rages over the future of its two biggest agencies, Fannie Mae and Freddie Mac, is such cheap credit helping or hindering the sector?

If leverage is the life-blood of real estate, then the multifamily sector had just one entity to thank for a vital transfusion at the height of the Great Recession – the US government.

US Treasury

While all other real estate sectors were squeezed hard by the mass retreat of commercial property lenders from the market, multifamily investors could at least turn to the government sponsored entities (GSEs) of Freddie Mac, Fannie Mae and the US Department of Housing and Urban Development for support. Indeed, at their peak in 2008, the GSEs collectively financed more than 80 percent of all multifamily deals in the US.

Today, that figure is down to around 64 percent and falling further as traditional lenders re-enter the market. However, it is precisely because of the availability of such cheap credit that critics fear a bubble is emerging in multifamily. The sector may be benefitting from the best fundamentals in decades, they argue to PERE, but the ease of financing, particularly from the GSEs, has the potential for encouraging speculative investments by investors desperate for yield.

Of course, Fannie and Freddie – the two largest GSEs, which own or guarantee more than $5 trillion in residential debt, including single- and multifamily loans – are not newcomers to the commercial real estate market. The Federal National Mortgage Association (aka Fannie Mae) was created as part of the response to the Great Depression in 1938 and expanded in 1968 to boost the secondary mortgage market and affordable housing. The Federal Home Loan Mortgage Corporation, or Freddie Mac, followed in 1970, charged with the same goals. It is such mandates, though, that ensure Fannie and Freddie act as defacto CPR kits for the single- and multifamily sectors.

“Fannie and Freddie kept their doors open during the crisis and kept things steady for the multifamily sector,” says Frank Nitschke, a principal at Prudential Real Estate Investors Research. “Multifamily is a relatively stable property type because everyone needs a place to live at the end of the day. But the GSEs played into that by providing liquidity that you just didn’t find anywhere else. That pricing and liquidity was very helpful when the private sector was going through its problems.”

For Fannie and Freddie, however, the long-term future is uncertain. The two GSEs were taken over by the US government in 2008, and the taxpayer bill for the rescue could be anywhere between $221 billion and $363 billion, according to the federal regulator overseeing the entities. As political argument rages over the country’s deficit, Fannie and Freddie are prime targets for reform. Indeed, after US Treasury Secretary Tim Geithner led a debate on the future of housing finance last August, the Obama administration was set to unveil a plan to overhaul the system as PERE went to press.

“There is a question mark over the future of the agencies, and there are a lot of strong feelings behind it,” Nitschke adds. “Whatever form reform takes though, I believe the agencies will have an important role to play going forward.”

Part of that role will include providing financing for multifamily transactions in secondary and tertiary markets. Over the past few months, traditional lenders, particularly life companies, have become more aggressive in originating new multifamily loans. However, much of that activity remains focused on prime assets in prime markets, all sponsored by strong owners and still with fairly conservative underwriting. Although the GSEs concentrate on stabilised, cash-flowing assets, their role in boosting liquidity in vast swathes of the US multifamily market will be critical, Nitschke says.