“Simple and boring is the new exciting,” BMO Capital Markets analyst Rich Anderson wrote in a June report on the middle-market REIT that online investment blog REIT Wrecks pegs as this year’s high achiever among its peers.
Memphis-based Mid-America’s Sunbelt markets and mostly suburban garden-style assets are not especially exciting, nor is the company’s low debt level, but today, when a lot of companies are looking at red ink, “boring is definitely the new black,” the blog writer declared.
With the country’s financial deficit spiraling out of control and its real estate markets reeling from the economic collapse, a story that is easy to understand is a welcome relief, and Mid-America’s is such a tale.
“There are two things we do really well as a company. We know how to underwrite investment opportunities in a disciplined manner and identify value that may not be realized in a given property. Secondly, we know how to operate and execute property management very well onsite,” Mid-America CEO Eric Bolton said last month.
The REIT has grown at a measured clip, never straying far from the original company culture of its predecessor, The Cates Company, a property management firm founded by George Cates in 1977.
Cates’ strategy was to locate under performing apartment properties, seek out investment partners and acquire the assets, and add value to the communities that The Cates Company would manage. In 1994, he convinced his co-investors to pool their properties, roll ownership into a newly formed company called Mid-America Apartments and take that company public. He also folded his property management operation into that new entity.
“Mid-America went public with 24 communities, just under 6,000 apartments, and it was a combination of the ownership of those properties and the property management company that really was the beginning of Mid-America,” said Bolton, who came aboard as director of new development soon after the initial public offering, was promoted to president, COO and a director of the company in 1997, became CEO in 2001 and became chairman of the board a year later in 2002.
What has changed since Mid-America’s IPO is its footprint in the Sunbelt region, the size of its portfolio and its market allocation.
“Our original 6,000 apartments were located primarily in Jackson, Miss., and Jackson, Memphis and Chattanooga, Tenn., and now we are in 13 states across the Sunbelt,” said Bolton of the portfolio that currently consists of 42,685 units in 145 properties with an average age of 15 years.
Until about eight years ago, 80 percent of the REIT’s portfolio was located in secondary markets. In 2001, the company began diversifying into large tier markets with populations of one million or more, like Houston, Dallas, Phoenix, Tampa and Orlando. Even so, Mid-America maintained a significant presence in a number of the high growth markets many of its REIT peers have exited in recent years, scrambling to re-position their own portfolios on both coasts.
Bolton says it is Mid-America’s continued presence in the secondary markets, largely deserted by others, that differentiates it from most of the 11 other apartment companies listed on the New York Stock Exchange. In Q1 2009, his REIT derived 52 percent of its same store net operating income from its secondary markets, with the balance coming from its large tier markets.
“We think that’s probably about the right mix, although at different points in the real estate cycle we might see our large tier market segment move to 60 or 65 percent and our secondary market segment move down, but broadly speaking we are where we want to be,” he said.
Collectively, Mid-America’s markets are outperforming national employment trends. According to economy.com, job growth in the Sunbelt is expected to exceed the national average for the next four years — 1.5 percent versus 1.1 percent.
But Bolton believes the secondary markets will provide his REIT’s portfolio with more reliable income during the weak part of this economic cycle, which probably will continue through 2010.
“When the economy is going well and job growth is robust, the larger tier markets do pretty well. But when the economy slows down and goes into a bit of a recession like it is now, the larger markets tend to suffer a bit more and the secondary markets tend to be much more stable. You don’t get nearly the new construction and supply pressures in the secondary markets that you would in a market like Dallas, for example. And, likewise, if you diversify well across the secondary market category, you can avoid too much volatility in terms of market specific employment trends and capture a generally more stable level of demand,” he said.
During Mid-America’s Q1 earnings call, Executive VP/CFO Simon Wadsworth told analysts that, based on early March statistics, the REIT’s secondary markets added 30,000 jobs between February and March.
“That’s not going to fix anything overnight, but frankly, just being able to say the words ‘adding jobs’ was pretty fun,” he quipped.
Mid-America prides itself on the ability to avoid undue risk and that’s why the company stayed out of the condo business when many others took the plunge and drowned. “We talked about it, but there are two reasons why we elected not to get into that business,” said Bolton.
“First, we didn’t see the investments in that area as being opportunities that would create revenue and cash flow streams that were repetitive in nature and driven by fundamentals that would enable us to capture steady growth over the years. To us, the condo business is likely to be kind of a one-shot opportunity and you have to time it right to get in and out.
“And secondly, we didn’t have the expertise. We would have to go out and hire or buy that expertise and we felt that the risk and the disruption associated with that was just not worth it and the returns not attractive enough,” he said.
Mid-America did find opportunities to sell into the frenzy. “We sold some of our properties to condo converters that were paying incredible prices, overpaying frankly, for some of the assets we were selling and that also spooked us a little bit that the business was populated by that kind of behavior,” said Bolton.
And, except for a brief foray into development in 1997, with the acquisition of Flournoy Development Company of Columbus, Ga., for $423 million, the company has stuck close to its owner/operator roots.
Two years after purchasing Flournoy, Mid-America sold the development company back to the very same people they bought it from for $18 million, about what the REIT paid for the company, minus the 30 apartment properties that were included in the 1997 deal.
“After we got into it and began to understand more about the challenges and risks associated with development projects, we felt it was not a good fit for what we want to be as a company and how we want to perform for shareholders. There is a level of risk associated with development in this region of the country that may not necessarily exist in some other regions and we didn’t think the rewards would outweigh that risk,” said Bolton, referring to the Sunbelt region’s low barriers to entry that enable developers to entitle, build and deliver apartments in a very short time, often leading to sudden oversupply.
“There are enough merchant builders and developers out there that build in our region of the country and enough of them get into trouble that opportunities are created for us to make very attractive acquisitions, capture new product for the portfolio and do so with less risk,” said Bolton.
One such deal presented in June, when Mid-America was approached with the chance to acquire a yet-to-be-stabilized asset in the Gilbert sub-market of Phoenix, before the property was put on the market.
Completed in 2007, the 232-unit Sky View Ranch was only 76 percent occupied and the builder was under pressure from the lender. Mid- America paid $17.5 million, or $75,431 per unit, a price well below the recently tax-assessed appraisal, or assessed value, of $105,000 per unit, for the one-, two- and three-bedroom garden-style community that became the third asset its Phoenix portfolio.
“Fannie Mae and Freddie Mac are still very active in underwriting and financing multifamily real estate. However, from what we understand, they generally are not interested in financing non-stabilized properties. This results in fewer buyers being able to take on the investment and financing of properties that are still in their initial lease-up. With a strong balance sheet and in-place financing programs, Mid-America has an advantage in being able to move on acquisitions such as Sky View Ranch with more certainty and speed, creating attractive investment opportunities for our shareholders,” said Bolton.
With a balance sheet unburdened by a development pipeline, Mid-America is in a terrific position to capitalize on similar off-market transactions and increasing distress in the market, including the growing number of busted condo deals that Bolton approaches with extreme caution.
“We’re interested in looking at fractured condos, but it becomes a question of how many of the units are sold and how many are not and whether we can we get enough control of the overall community and the owners’ board to run the property as a single community,” he said.
Mid-America successfully pulled off such a feat when it purchased Village Oaks, a 240-unit condo conversion in Tampa, Fla., where 19 of the units had been sold for an average of $240,000 per unit. Of those 19 condos that were sold, 17 were in the process of foreclosure. Built by Opus South and Florida Southeast Development, the garden-style community was unoccupied when the condo converter bought it in December 2005 for $153,846 per unit. The unsold units were placed in receivership in April 2008 and Mid-America bought them from the lender last September for $21.2 million, or $98,800 per unit, $11.2 million less than what the converter owed the lender.
“We then made the lenders aware of the fact that we would love to buy the remaining sold units if they foreclosed and took them back. So far, we have purchased eight of those at an average price of $79,400 per unit,” said Bolton.
Although Mid-America is actively looking, Anderson expects only a few one-offs like the Phoenix and Tampa deals will satisfy the REIT’s careful acquisition criteria this year. He points out that to operate successfully in Mid-America’s commodity markets one must focus on cost controls, and he believes the REIT demonstrates that talent through conservative spending habits and an extensive due diligence process, including credit checks and criminal record reviews of all residents of a community considered for purchase.
Last year, Mid-America looked at 225 potential acquisitions, went into contract on 40 of them and closed on seven. And, more recently, Anderson notes, all offers the REIT has made on unsolicited off-market deals have been rejected as too low, but he thinks some of those could come back around at prices that make more sense.
Mid-America has $75 million earmarked to buy young communities (seven years or less) for its own account this year and another $75 million for a new $250 million value-add fund targeting older assets with an affiliate of Thackary Partners. This is the second such fund for the REIT and it will operate much like the first, with the REIT owning a one-third interest and earning fees for fund management and asset management and having the potential to earn promotion fees. Besides targeting markets where Mid-America already has a footprint, Charlotte and San Antonio also are on the radar screen, although the former continues to suffer from its exposure to the banking industry, said Bolton.
The REIT plans to sell only three assets this year, averaging around 30 years of age. Two have closed and the third is scheduled to close in August. Bolton admits it is a challenging market to sell anything in right now. “You really have to work with the buyer and do all you can to assist them in getting their financing and you have to recognize that wherever they do get their financing, the lender will be much more disciplined and structured in terms of the information they want,” he said.
Mid-America’s efforts at the beginning of the year to maximize revenues and boost occupancy prior to the busy leasing season paid off. Although same store NOI was down slightly in Q1, the REIT reported overall better-than-expected first quarter results with lower property operating and interest expenses, and FFO of $1.01 per share, representing a five percent year-over-year FFO increase and an all- time record high for the company.
Heading into the spring, the company saw a 6.6 percent year-over-year increase in walk-in traffic and a 4.3 percent increase in closing ratio, resulting in 7.4 percent more move-ins in the first quarter, compared to last year. The traffic increase was driven in part by traditional methods of off-property marketing and an enhanced online system to automate the leasing process from initial inquiry to finalization of the rental agreement. “Residents can now just show up to get the key and move in,” said Bolton.
By the end of Q1, Mid-America’s same store occupancy had reached 95.5 percent, 200 basis points higher than the previous quarter, and gained another 20 basis points by the end of April. That hike came at the expense of effective rents, which declined 0.2 percent from Q1 2008, but with a relatively full portfolio, Mid-America is less likely to concede on rents going into the heavy leasing season, when it matters most.
“We also recommitted to our long-standing practice of not compromising credit and leasing standards as we sought to close on more lease applicants,” said Bolton. Using its standardized credit scoring system, the REIT turned away 171 more applicants in Q1 than in the same quarter last year and was happy to report very low net collection loss of 0.14 percent of total contractural rents in the quarter.
This year, the company doesn’t expect to push rents on new leases, which declined year-over-year in Q1 by 7.1 percent. But renewal rents were up an average of 2.7 percent, due in part to new resident retention and renovation programs and other revenue-driving initiatives.
“We have automated our retention efforts to a large degree and now, through the home office, we’re able to generate a professional renewal notice that we send to our residents whose leases are coming up for renewal, where we discuss their options. We are also able to track the notices on a weekly basis, see how many went out and how many residents responded and how many have came into the office to say, ‘Yes, I’m going to stay,’ or ‘No, I’m not going to stay,'” said Bolton. The company also makes sure that marketing information about the risks, costs and hassles associated with moving are supplied to residents who indicate they don’t plan to renew their lease.
The company is scaling back the extent of its redevelopment activities by around 50 percent because it is seeing diminishing rent increases on rehabbed units. Until recently, the company spent around $5,000 per unit to spruce up kitchens and baths when residents moved out, generating 11 percent increases in monthly rent per renovated unit.
But after achieving rent hikes of only nine percent on 600 rehabbed units in the first quarter, Mid-America has moved to what it refers to as the Renovate Light Program, planning less extensive face lifts this year for between 1,800 and 2,000 units at around $2,000.
“We also ramped up a renewal renovation program and we are reaching out to our existing residents to generate excitement about staying with us and going through the renovation process,” said Bolton. “We provide them with the opportunity to make an upgrade to their unit, whether it’s bringing in new plumbing fixtures, new lights, or perhaps retiling the floor, with a slight rent increase, of course,” said Bolton, explaining that the benefits to the company are two-fold — a reduction in turn costs and higher rents on renewal.
Mid-America will continue to derive ancillary income from its trash removal and pest control programs and expects an additional $650,000 in incremental revenue from a new bulk cable program this year and closer to $1 million next year, when that program is up and running across the entire portfolio.
By negotiating with the cable providers, the REIT is able to buy cable services for an entire community on a bulk basis and resell it to the residents at a price with some profit built in. “Importantly, our residents are seeing their bills go way down. They were paying something in the $50 or $60 a month range and we’re selling it to them in a range of $30 to $45, so they are happy and we’re happy because we’re making a profit on the arrangement and the cable company is happy because they have a locked-in deal with one customer as opposed to, say, 240 customers in a given community,” said Bolton. The program is in place at 41 properties so far, with another 19 or 20 expected to come online in the third quarter.
Optimism meets caution
Over the years, Mid-America has worked to maintain a distinction between the company’s property management and asset management roles and responsibilities. Bolton looks at property management as the day- to-day tasks associated with leasing and turning apartments and meeting residents’ needs. He views asset management as the process of driving efficiencies to the business and portfolio-wide operations.
The REIT also has had to adjust the way it finances its business.
Where it once sought out individual loans to finance individual properties, today it has more elaborate, sophisticated credit facilities in place that finance pools of assets. “We have much more capability as to how we go about raising money and financing the growth of the company, and that’s been a huge change over the past fifteen years,” said Bolton.
Today Mid-America has $1.35 billion of recourse debt from Fannie Mae and Freddie Mac that will mature between 2011 and 2018. Anderson notes that although the value of the facilities’ underlying assets, assuming a 7.3 percent economic cap rate, is in the 60 to 65 percent range, the REIT’s all-in cost at today’s rates is less than one percent, making the company vulnerable to interest rate hikes when it comes time to refinance.
In fact, the inevitable rise in interest rates gives Bolton the greatest cause for pause. “We may see inflation begin to emerge and the cost of financing is going to increase. As it does, asset values and operating income have to appreciate, as well, for us to be able to make a positive investment spread on the cost of capital,” he said.
“So the cost of capital rising is one of the realities we have to deal with, but, having said that, I am very gratified to be in the apartment business as opposed to some of the other real estate sectors, because after a tough year this year and probably next, the fundamentals for the apartment business actually look very, very good in 2011 and probably for the next several years thereafter,” Bolton predicted.
“In other words,” he added, “real estate performance over time still cycles and it’s important to keep a long-term and disciplined approach to deploying capital and protecting value in existing assets. While at times it may not be the most exciting story, we think it serves our shareholders well.”