A new altitude

For more than 35 years, United Dominion Trust has been known as a middle-market apartment REIT. That was then. This is now.

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“I think that characterization’s a little bit dated,” he told the analyst, pointing out that monthly rents for the company’s apartments averaged nearly $900 by mid-year, up from about $700 just four years ago, and predicted that amount would top the $900 mark by the end of the year. And, although business information websites like Hoovers still describe the REIT in terms of its “prime demographic target, the middle-market apartment dweller” and Yahoo! Finance defines it as a company that “targets young professionals, blue-collar families, single-parent households, older singles, immigrants, and non-related parties,” United Dominion eliminated the words “middle-market” from its description in the company’s 2005 annual report, reflecting Toomey’s determination to take the company to a new level.

Instead of focusing on the demographic that was the company’s bread and butter for three decades, today Toomey is targeting those caught in the widening affordability gap between the cost of a home mortgage and rent in markets that provide the biggest variations between the two and promise good job growth and household formation going forward.

He has been focused on transforming the fourth largest apartment REIT in the country since he took over the top spot at United Dominion six years ago, when John McCann retired after 30 years with the company. McCann founded the company in Richmond, Va., with a group of Virginia businessmen in 1970 as Realty Industries Inc. and became CEO in 1984 when the company was renamed United Dominion Realty Trust. During his tenure with the company, it grew from $3 million in assets and three employees in 1972 to more than $4 billion of apartments in 277 communities and 2,500 employees by the time he left to found his own business, McCann Realty Partners LLC.

McCann’s goal for United Dominion was to make it into a national low- cost provider of quality apartment homes, which he achieved through development of B+ and A- assets, acquisitions and dispositions and mergers with smaller REITs like South West Property Trust Inc. at the end of 1996 and the acquisition of American Apartment Communities at the end of 1998.

For the first couple of years after taking over United Dominion’s reins in February of 2001, just as the tech wreck was gathering steam and the apartment sector was about to take a nose-dive following 9/11, Toomey focused on improving operations in the areas of both personnel and technology. He also began pruning the 77,000-unit portfolio that was spread over 60 markets from coast to coast when he replaced McCann.

At the dawn of the apartment market recovery in 2004, the company’s acquisition of the 16-property, 4,646-unit Essex Property Trust West Coast portfolio for $756 million, along with nearly 900 units in Northern and Southern California from Pacific Property Company for around $100 million, marked the beginning of the change in people’s perception of United Dominion. When the Essex deal was announced, Toomey said, “These transactions represent a fundamental change in the quality of our assets and the future growth of our company.”

While some questioned the wisdom of buying the Essex portfolio, which included 3,900 units in 13 assets in the southern half of the Golden State, one apartment community in the Bay Area and two in Oregon, at a 5.5 percent cap rate, by the beginning of December, the portfolio was doing a little over 6.4 percent and a 5.5 percent cap rate for coastal California properties is almost unheard of today. Current market caps for well-located Southern California and Bay Area assets average around four percent. The purchases doubled the company’s holdings in two of the most expensive housing markets in the country, a feat Toomey figures could have taken five years buying one-offs.

Over the past few years, United Dominion has balanced acquisitions with dispositions, trading up in asset quality while trading out of markets like Detroit and most of the rest of the Midwest to concentrate on 20 core markets and 10 trading markets. With its portfolio reconfiguration nearly complete, the company’s markets are two-thirds bi-coastal, with the rest mostly in Western and Sunbelt states.

Toomey compares his portfolio concentration strategy to managing a stock portfolio. “You’ve got certain ones you say, ‘I’m going to hang onto that forever,’ and others that you say, ‘As soon as it hits this price, I’m outta here,'” he said. His trading markets include low- barrier metros like Houston, Dallas, Austin, Atlanta, Phoenix and Denver. High-barrier core markets like California, Florida and Metro Washington, D.C., now produce around 55 percent of the REIT’s NOI. Under Toomey’s leadership United Dominion has exited around 30 markets, while watching rents rise from $703 in 2001 to an average of $899 last December. He predicts the company will cross the $1,000 average rent threshold this year.

During the past five years, United Dominion has sold $1.5 billion of apartments or 40 percent of the company’s portfolio, replacing those assets with $2.5 billion of younger, higher-quality properties in markets where good job and population growth are expected and single- family home costs are high. Another 20 percent has been developed or redeveloped, so 60 percent of the company that was there in 2001 no longer exists.

Analysts may be slow to pick up on the change, but institutional investors have taken notice of the transformation of the company that has expanded its appeal to attract a wider range of renters than its former middle-market target tenants. “Our shareholder base has changed dramatically since six years ago when it was 75 percent retail and 25 percent institutional. Today, that’s reversed and it’s 25 percent retail and 75 percent institutions, and institutions generally driven by growth rates and long-term valuation,” Toomey said.

Another important value-creation technique is the company’s asset renovation program. “It’s nothing new,” said Toomey, “but what is new is to have a company that’s able to do it in 20 to 30 markets. Most people are very good at one or two markets or one or two products. We think we’re good for anything from garden to high-rise renovation.”

The jewel in the crown of the company’s redevelopment activity is the kitchen and bath program Toomey launched about four years ago in Washington, D.C., and expanded into his growing California markets in 2004. Back then, kitchen rehab costs ran around $4,000/unit with an expected lift of $71/month in rent and could be completed in a weekend. Today, the program is focused more on quality than velocity, adding more granite and higher-end finishes, costing around $10,000/ unit and still cooking up average returns of eight percent to10 percent and taking about a week.

“We’re more focused on quality because, if you walk into any apartment in America, I guarantee the first thing you’re going to see is the kitchen. It’s the piece that markets. It closes the sale and, frankly, it’s a room that a lot of people spend a lot of time in, at least while they’re awake,” he said, exhibiting his famously wry sense of humor.

“If I spend $10,000 on the kitchen and raise the rent $100 a month, then I’m creating about $20,000 to $24,000 of value for the real estate,” said Toomey. “So, I am creating a value substantially above the cost investment and we’re doing from 500 to 800 a month.” Because 55 percent of the apartments in the country were built in the 1970s and 1980s and the kitchens are dated, Toomey believes his kitchen and bath program provides a long-term opportunity for the REIT to create value and reduce resident turnover.

Recent rental increases range from $82/month for units with new kitchens in Baltimore to $143 a month in Portland and $138 and $136 in Southern and Northern California, respectively. By early December last year, United Dominion had completed 14,000 kitchen and bath upgrades since the program kicked off and has another 20,000 in the pipeline.

“And, if we look at something and say that it’s in the right location and we want to do more than just the kitchen, we have the capabilities to go in and do everything from the ground up,” he said.
Compared to new development, which can take a minimum of two years just to buy and entitle the land and another couple of years for the actual construction, Toomey believes redevelopment produces a similar product in about one-third the time, with lower risk and higher returns. He’s seeing returns of 8.5 percent to nine percent on full rehabs, while the expected pay-back on new development averages around 6.5 percent nationwide.

Toomey believes renovation is an art and each property is a new puzzle. “Puzzles aren’t solved all the same way and, if you take your time and if you have the skills, you can probably create the most value out of solving that puzzle,” he said, using as an example the company’s plans for the redevelopment of the former Parker’s Landing in Tampa into the rejuvenated, expanded community renamed Island Walk.

Toomey has called Parker’s Landing/Island Walk “the ultimate puzzle” of a redevelopment project. The 15-year-old community that United Dominion acquired from James Klingbeil in 1998 for $38.9 million, or $44,420/unit, consists of almost 900 units.

“The problem with a community that size is how do you keep it full? You need over 160 pieces of traffic a month, right around four or five pieces of traffic a day. That is hard to sustain in any community. So it’s never always full. What do you do with something of this size? Our answer was to make it four different investments,” he said early in December, adding that the solution is expected to create $36 million in value for United Dominion’s shareholders.

The 1998 acquisition of American Apartment Communities included 9.08 vacant acres across the street from Parker’s Landing in an area where a median-priced home sells for around $733,000 today. The United Dominion team decided to build 54 townhomes on the empty piece. That portion of the project broke ground in November. First closings on the $400,000 townhomes are expected this year, with a value creation for the company of around $6 million.

Another piece of the Island Walk solution is condo conversion, a business United Dominion launched a couple of years ago. The first phase of The Gallery at Bayport, the designation for the condo portion of Island Walk on the east side of the roughly triangular property, was transformed to 176 condos last year and sold out at an average price of $156,400. First closings at the 320-unit second phase are expected this year. Since it costs $25,000/door to make them condo-ready, the value created by the conversion effort is around $20 million, Toomey estimates.

The final piece of the Island Walk project is the full-scope redevelopment of the 400 remaining apartments that is expected to increase cash flow from the community by 40 percent to nearly $5 million and create value of around $10 million. The redevelopment part of the community’s makeover is similar in scope to the makeover at the 34-year-old, 576-unit Legacy at Mayland in Richmond, Va., which the REIT acquired in December of 1991. The full-scope redevelopment there is reaching completion and fulfilling expectations. Prior to the rehab, the community was generating around $2.3 million annual NOI. The cash flow dropped to just $500,000 during the 33-month renovation, but, when it comes back online this year, Toomey expects a 100 percent growth in cash flow to around $4.6 million. He believes the 11 percent cash-on-cash return more than justifies the one-cent-per-share dilution in FFO created by taking the community offline during its overhaul.

As of the end of Q3 2005, the company had a redevelopment pipeline of 4,635 units in 14 communities in Florida, Virginia, Texas, Tennessee and North Carolina, with completion dates ranging from that quarter through Q4 2008.

Toomey also applies the puzzle principle to development, which is a growing value-creation element of United Dominion’s business. Over the past year or so, the company has added a number of experienced people to its ground-up development team, while continuing to pursue joint-venture and pre-sale development opportunities in markets where the REIT has no one on the ground to oversee the construction.

As of December, the REIT had $905 million of development underway in both wholly owned and joint venture deals and another $1.3 billion in various stages of investigation. “That’s a prudent number. Our annual goal is $300 million to $500 million of deliveries, about five percent of the enterprise value, and we think that’s a prudent level at which we can produce a very high quality of development and be selective about it.”

Toomey gained a wealth of development experience while serving at Lincoln Property Company, where he was senior VP and treasurer from 1990 to 1995, prior to joining AIMCO in 1996 as executive VP of finance and administration and working up to COO, the position he left to take over the President/CEO slot at United Dominion. “At Lincoln, it was amazing. We were able to build so much more because we were very standardized in our development discipline.” Today, he approaches each new piece of dirt as new real estate riddle, an opportunity to find the most innovative and creative solutions to the development challenge.

“I spent six years with Lincoln and my right hand and partner Mark Wallis was CFO. Lincoln was a $17 billion real estate empire during the time I was there and we built 105,000 apartment homes in 45 markets and annual apartment deliveries were $1.5 billion. Combine all the apartment REITs today and their development pipelines and they still do not match that,” Toomey told a group of analysts early last summer.

That kind of development activity can be both good and bad, he said, explaining that a mega-developer can make a lot of money up-front, but it costs around $3 million in annual overhead to operate each regional development office. “That’s what it costs to have a land guy, entitlement, construction management and lease-up,” he said.

At United Dominion, he approaches the development challenge in three ways. He employs a small in-house development team of around 90 people with about half dedicated to rehabs and kitchen and bath makeovers and the other half focused on ground-up development activity, mostly in Sunbelt states, with a major focus on Texas. “We have guys there on the ground we’ve known for 20-plus years and we know how to develop in Texas. We’re very good at garden stuff in Texas,” he said.

“When we step outside of that market, we want to tap local partners because, in this business, you win or lose in the entitlement process and in the subcontracting business,” Toomey continued. “If you don’t have good subs and don’t get through entitlement quickly, you’re not going to make anywhere near your proformas. You’ll deliver late, over cost and have people walk off the job. So, I want a local team.”

He works with those local development experts like Trammell Crow Residential, Legacy Partners, Lincoln Property Company, JPI and Fairfield Residential through either pre-sale agreements or joint ventures.

For the pre-sale deals, he contacts the local players in markets where he’s looking to develop and tells them, “We’ll pay you market rate in your construction and development fee, we will take the market rent risk and you take the construction risk.” The developer devises a budget to which United Dominion agrees, with appropriate contingencies. And the partners agree that when the property stabilizes, it will be appraised by an independent appraiser and the difference between the agreed-upon construction cost and the appraised value will be split with the developer.

“This is how it’s supposed to work. A property built for $100 million, appraises for $120 million three years down the road when it’s stabilized. I basically can buy the community at $110 million. They get $10 million in profit and I basically have bought one at $110 million and ideally the retail is $120 million,” he said.

What happens on the balance sheet? The REIT has a pipeline of acquisitions that Toomey can time against sales. He doesn’t have to take that lease-up risk and ends up paying between wholesale and retail for the brand new property.

“It’s a great way to tap a local talent team and I can keep my overhead down,” Toomey said.

United Dominion recently wrapped up development of two wholly owned
communities — the 414-unit, $67 million Verano at Rancho Cucamonga Town Square in California’s Inland Empire and the 367-unit, $32 million Mandalay on the Lake in Las Colinas, Texas. The REIT has another four communities currently underway in Texas, including 522 units in three communities in Plano that are scheduled for completion in Q2 and Q3 of this year and a 320-unit community in Houston that should be finished by mid-2008.

Toomey also has pre-sale development agreements with Lincoln Property Company on the 371-unit, $52.5 million The Place at Millennia Apartments in Orlando and with the Zaremba Group for the 200-unit, $24 million Waterford Apartments in Phoenix that are scheduled for completion in Q3 2007 and Q1 2008, respectively. And United Dominion is the equity partner for the construction of JPI’s 298-unit, $138 million Jefferson at Marina del Rey and Su Development’s 400-unit, $135 million Bellevue Plaza in Bellevue, Wash., which also includes 65,000 s.f. of ground-floor retail. Completion of the coastal Southern California asset is scheduled for early next year. The Bellevue high-rise should be finished in 2010.

On the operations side, the company has been focused on technology, particularly on the front end, where interaction with the customer takes place, optimizing search engine capability and regularly sprucing up its web site. “You’ve got to make it easy for the customer to find you, interact with you, and, almost, be entertained by you,” Toomey said. The effort is paying off, with 36 percent of United Dominion’s leases being generated by the Internet, a number that is increasing by about 20 percent a year.

Toomey’s long-range goal is to obtain and process 90 percent of the company’s leases via the Internet, which he believes will be facilitated even more when United Dominion rolls out a lease pricing optimizer program next year. The company currently is testing the two most popular price optimization tools — LRO and YieldStar – but it’s too early to speculate on which will be chosen to round out the REIT’s web-based programs that already include the OpsBuyer Enterprise application, the procurement program the company installed in August 2002, and RealPage’s OneSite property management system that was rolled out across the company’s portfolio last year.

He believes that by creating value in a number of different ways, by constantly improving operations, focusing on creative development and redevelopment and careful management of portfolio concentration, United Dominion will have enduring ability to excel.