Taking stock

How do investors view multifamily and their REITs? Fundamentals are up. Capital is abundant. Competition between private and public firms is mounting.


Most analyses of the multifamily market present the view from developers, owners and managers on the state of the industry and their respective portfolios. The investor view of the market is equally important, if not more. The growing influence of capital markets, as funds pour into private equity apartment firms nearly unrestrained, is shifting the balance of power between REITs and private firms, and between public and private investors.

This paradigm shift is leading some REITs, such as AMLI Residential, to go private and has sparked heightened merger and acquisition activity. Notable examples being Camden Property Trust’s acquisition of Summit Properties, ING Clarion Partners and Lehman Brothers acquisition of Gables Residential Trust, and Morgan Stanley’s acquisition of AMLI Residential Properties Trust and the Town & Country Trust.

A new entrant to the National Multi Housing Council’s (NMHC) top 50 rankings, Morgan Stanley ranked 7 among owners after increasing its holdings 87 percent. Morgan Stanley logged the largest portfolio increase of any apartment owners, adding 46,473 units. The number of units it acquired in 2004 alone is greater than the holdings of all but the top 18 firms in the NMHC top 50.

Some industry pundits view deals such as Morgan Stanley’s, as evidence that apartment communities are being valued higher in the private market than the public. Some say that except for REITs like Equity Residential, Archstone-Smith, and AvalonBay, they’re all vulnerable to takeover. Green Street Advisor analyst Craig Leupold thinks even AvalonBay could be a takeout candidate by institutional investors eager to get their hands on a “high quality, well-located portfolio and solid development platform.”

“REITs will remain a major owner, acquirer and developer of apartments,” says Peter D. Linneman, the principal of Linneman Associates and the Albert Sussman Professor of Real Estate, Finance, and Public Policy at the Wharton School of Business of the University of Pennsylvania, and a leading strategic analyst in the real estate industry. “Largely what has happened is some of the less strategic REITs have finally called it quits. In markets without excessive condo development, there will continue to be strengthening net operating income (NOI) as the recovery continues. Those markets with excessive condo supply will weaken as these units switch to rentals.”

Linneman says that REIT pricing is basically in balance relative to risk for the first time in 15 years. “I expect REITs to appreciate by 3 percent in the next 12 months. The going private effort is primarily a leveraged bet on rates staying low and NOIs growing. If the bet is correct, they will play out. If not, the losses will be large for the equity players. At this point in the cycle these are reasonable, but risky, investment plays.”

According to Linneman, more capital, particularly institutional capital, will flow to both private and public real estate, as this money moves to sectors which have outperformed, rather than will. He puts total unleveraged return in the range of six to eight percent, in line with the risk in an environment where stocks will do 8.5 percent and Treasuries
4.75 percent.

“Never say never,” says George Skoufis, director of the real estate finance group at Standard & Poor’s. “With capital burning a hole in private equity pockets mixed with the current cost of compliance, whether Sarbanes Oxley (see ed. note at end of article) or the low capitalization (cap) rate environment, it wouldn’t be out of the realm of possibility to see more buyouts. A mitigating perspective is that many of the remaining rated apartment REITs are of more meaningful scale and have development capabilities through which to create value outside of acquisitions.”

Greg Mutz, chief executive officer of AMLI Residential Properties Trust, knows from experience how costs of the Sarbanes Oxley Act, compliance issues and other significant costs of operating a public company can drive smaller REITs to go private. “Our costs were two or three times our size,” says Mutz. “We paid as much as REITs five times larger. It’s not the only factor, but it is significant.”

Skoufis believes that real estate pricing is softening, including the condo market. This is important because if a leveraged buyer pays a high price with the intention of flipping a portion of the asset at a higher price, say to a condo converter, a softer market would make buyers think twice. “The remaining REITs,” says Skoufis, “that are of moderate size, have desirable portfolios and are moderately leveraged are BRE and Essex. We do expect to see more buyouts. Looking back over the last 10 years, this sector experienced the most consolidation, primarily in the form of mergers, with the ratings impact being benign to slightly positive, compared to LBOs (leveraged buy outs) we have seen that generally result in negative rating actions.”

Asked about the impact heightened consolidation
activity might have on the market, Skoufis said, “My first thought is that market pricing for assets are being driven lower and lower, making it difficult for REITs to compete for good assets. Conversely, these transactions, coupled with the condo craze, have resulted in a remarkable source of liquidity for the sub sector. Through the last cycle and continuing today, apartment REITs have been aggressively recycling capital through the sale of non-core and core assets, and reinvesting that capital into low cap rate/yielding assets (going-in) with better long-term growth prospects.”

From the consolidation angle, asserts Skoufis, abundant capital and real estate’s status as a highly desirable assert class appears to be a real, long-term component of many firms’ investment strategies. “We’ve seen several go-private transactions outside the apartment sector recently,” adds Skoufis, “including Arden Realty (property management) and Carr America (office), Center Point (industrial) and Capital Automotive (triple-net).”

The impact of REITS

In analyzing the National Multi-housing Council’s rankings of top 50 owners and managers for 2005, 14 REITs were in the top 50 owners and 4 REITs were in the top 10: AIMCO (2), Equity Residential (3), United Dominion Realty Trust (8) and Archstone-Smith (9). Of the more than 200 publicly traded REITs followed by NAREIT (National Association of Real Estate Trusts, www.nareit.com), roughly 30 specialize in apartment owning and managing, between 10,000 and 250,000 units each.

Commenting on the 2005 rankings, Mark Obrinsky, chief economist at the NMHC, said, “This year’s rankings show the degree to which the apartment industry is maturing and stabilizing. In the late 1990s, the industry was on a dramatic growth trajectory as real estate investment trusts (REITs) emerged and began amassing relatively large portfolios. Growth in those years averaged nine to 11 percent. For the last several years, however, that growth has slowed to approximately three or four percent, and private firms have been the growth leaders.”

In the decade or so since REITs emerged as an influential force in the apartment industry, significant changes have come about in the multihousing sector. Structured as tax-advantaged companies and formed for the purpose of owning and operating real estate portfolios, REITs are not generally subject to corporate income tax. They are, however, required to distribute at least 90 percent of taxable income to shareholders. This produces a relatively stable and predictable dividend, and potential price appreciation. It’s also an easily identifiable asset. This structure has made REITs an attractive investment.

Beginning in the 1990s, REITs were able to leverage equity capitalization to develop large portfolios that brought with them economies of scale gleaned from efficient management and operations. The REITs were favored by Wall Street and combined with their size, exerted tremendous influence on the apartment market.

As public firms, REITs were more accountable than their private peers and had more stringent reporting requirements. These two factors created the need for better technology to manage and report on the portfolios, as well as the need for more professional staff to manage the properties and utilize the latest applications and technology available. This trend soon carried over to the private firms. The industry simply matured overall, as well.

Many happy returns

How good an investment are apartments? According to Obrinsky of the NMHC, demographic trends point to continued “moderate” growth in demand for apartment products. In comparison to other property types, apartments have shorter average development periods, making quicker and smoother transitions from supply to demand, thereby abating volatility of building cycles.

The latest data available (2003) show 16 million apartment residences with a combined value of $1.34 trillion at year-end, an increase over the value of the prior two year period and a slight decline from 2000. Apartment value increased at a compound annual growth rate of 4.7 percent from 1990-2003 despite the prevalence of two recessions within that period. Among the portfolios of pension funds and other large investors, apartments during the period 1984-2004 provided a higher total return with less variance than the average for all property types according to data from the National Council of Real Estate Investment Fiduciaries, www.ncreif.org. Over this same period, apartments averaged a 9.3 percent total annual return compared to 7.6 percent for all property types combined.

According to NAREIT, equity REITs had a compound annual growth of 34.7 percent in 2004, marking the fifth consecutive year it had outpaced other market benchmarks.

An article in The Boston Business Journal reported that a study by Pricewaterhouse-Coopers found that REITs raised more cash through initial public offering of stock than any other industry during the first six months of 2005, comprising 21 percent of all the IPO proceeds during that period.

Skoufis, for one, sees the multifamily sector showing a modest recovery on the national level, although he sees the pace as slow. “Vacancy declined to 5.8 percent for the third quarter of 2005 from a high of 7.1 percent in early 2004. Meanwhile, net absorption turned positive by a slim margin at year-end 2004 for the first time since 2000 and remained positive through the first three quarters of 2005. Both figures should continue to improve over the next several years.”

In his review, Skoufis sees vacancy dropping to 5.7 percent by 2009 and net absorption increasing to 117,988 units. Neither figure is expected to reach the very low vacancy or high net absorption levels reached in the last cyclical peak. Condo conversions aided quarterly performance by removing units from the rental pool together with strong absorption in areas like Houston, due to the relocation of residents displaced by Hurricane Katrina.

According to Leupold, cap rates are the key figures to watch as interests rates could lead to their increase. They are the primary drivers for the apartment sector.

Most analysts and industry observers see strong fundamentals in job growth, demographic trends, interest rates and the cooling of the home buying market as supporting positive near-term growth and market stability. The big questions are the impact any cooling of the condo market may have, repercussions of sector consolidation and continued presence of capital in the market should we enter a down cycle.