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While some of the shift towards larger deals can be explained by the general increase in price per unit, a further analysis of the transactions reveals that the Class A deals in “coastal” markets are absorbing a large percentage of the capital.
Going forward, there are significant challenges to continuing this strategy:
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There are only so many Class A assets that can or will trade in these core/coastal markets since the REITs and institutional investors who currently own them have no need or desire to sell them.
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Majority of the easy condo to apartment deals conversion transactions have already been sold.
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There are only a handful of development projects that will come on line over the next few years in these markets.
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The most logical place to look for potential new acquisitions would be from Opportunity Funds or Value Add funds that need to turn assets. However, most of these assets acquired between 2004 and 2007 in these markets were not Class A assets.
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So where can the flood of dedicated apartment capital go?
Institutional investors effectively have limited options:
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New Construction on Existing Land:
Even though rents have risen substantially in most of these markets, they are generally not high enough to justify significant new construction given the current state of debt and equity markets. Much of the construction will get done by groups which already own the land and can take an adjustment on the land basis. Overall, investing in new development deals is not an option for many institutional investors.
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Drop Down In Asset Class:
Investors can go down the quality scale and buy Class B and/or older product but stay within the 5 or 6 coastal markets. Avalon Bay’s fund did this in acquiring two deals in the DC area in the last quarter.
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Enter Commodity Markets:
Investors can stay in the Class A product, but may have to go to the perceived “commodity" markets. This is going to be a non-starter for much of the REIT capital as it will confuse their “story to Wall Street” and potentially hurt their multiple.
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How this may play out in 2011?
We travel extensively for our clients and in doing so we get a good sense to where the available capital is actively looking. More importantly, we get to see who has real money to deploy and the pressure they are under to deploy it. Many groups claim to have the capital and are in active acquisition mode, but in reality, the number of players who can and will pull the trigger is much smaller.
As we roll into 2011, here are our thoughts:
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Class A “Coastal Properties”:
We believe the pricing will continue to stay tight, and the buyers in these markets are not as impacted by the recent 50 to 70 basis points run up in the US Treasuries. To these buyers, it’s more of a multiple story for REITs which trumps all or a protection of capital (and related jobs) for pension fund managers. For these managers, there is little reward to leave this strategy and go higher on the risk spectrum. Furthermore, the boards are not pushing for high yields, so it’s easier to stay in the more “bullet proof” assets/ markets.
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Class A “Commodity Markets”:
We see this part of the market slowing unless sellers adjust their expectations. The demand for these deals appears strong but the depth of the real buyers’ pool does not seem to match the supply that is currently on the market or that needs to flow through in next 18 months due to loan maturities. There have been a handful of smaller REITs which have been very active either on their own account or through joint ventures. Unlike the REITs in core markets, these buyers are looking for higher leveraged cash on cash (“COC”) returns, most likely for the joint ventures they represent. The jump in Treasury rates has significantly hurt COC returns.
Additionally, there have been several well heeled syndicators who historically have been B+ buyers but used the lower rates to buy higher quality newer deals and still deliver their investors solid COC returns. However, with the jump in Treasury rates, debt proceeds have dropped significantly, requiring the syndicator to raise more capital per each acquisition from the pool of investors. This will diminish their ability to aggressively buy similar quantity of deals as they did in 2009.
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Class B “Coastal Markets”:
In the coastal markets we believe the pricing will stay strong as the buyer pool will expand. The lower available LTV will make this market attractive to larger fund investors as a much higher level of equity is needed for each transaction. Despite issues such as finding the right operator to execute and to properly compensate them, the overall growth should be strong and pricing should be much better than the high demand Class A properties within the same markets. On a risk adjusted basis, we see this as the sweet spot for institutional capital. We are currently working with several clients in their reorganization/restructuring in these markets.
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Class B “Commodity” Markets:
Investors are currently a little bit hesitant in investing in this market. Although most investors will see a moderate growth, they are trying to figure out a play here versus Class A assets in the same markets. The lack of CMBS or aggressive agency financing will limit the number of transactions to be done in this market. The groups which have historically played in this market will move up the quality curve. Additionally, there is a loan balloon risk in this category.
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Class C:
This is a local player market right now. The days of the regional Class C accumulator are gone and possibly not coming back for a long time. The lack of any real financing and the large amount of foreclosures either current or in the future is limiting the buyer pool.
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Conclusion
We are very encouraged at the underlying rent rolls in most markets. We see 2011 as being an interesting year as investors adjust to the new realities of higher US Treasury rates. On commodity deals, buyers have been lulled into the benefits of significantly growing rent roll and a 2.5% 10-year treasury, and these two factors allowed deals to be made easily. Those days are gone. A big maturity balloon looms ahead of us, and the majority of the 2005-2007 transactions financed with 5-7 year paper cannot be refinanced out. In most situations, the rental growth rate going forward cannot be mathematically high enough to allow a full refinance. Next year should be fun as smart, creative capital will be rewarded.
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About the Author
Mike Kelly is the president and co-founder of Caldera Asset Management, a turnaround consulting and restructuring services firm specializing in multifamily assets. Caldera’s team has experience working with lenders, equity investors, lawyers and other consultants to solve complex problems associated with distressed multifamily assets including turnaround, refinancing, stabilization, restructuring, dispositions and property management. For more about Caldera, please visit www.calderaassetmanagement.com.
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