E-news January 12, 2005

Diversification strategy brings risks, rewards

Should apartment owners invest in other types of property?

By Bennett Voyles

High vacancies and low cap rates might prompt apartment owners to consider taking some of their holdings out of the apartment sector to invest in other types of income-producing property.

But the question of whether to diversify a portfolio is a strategic one that requires careful analysis of the external market opportunities and threats, and the internal strengths and weakness of the apartment company.

The median price for apartments rose 45% from 2001 to 2004 while prices for retail and office buildings grew 25% and 21%, respectively, according to Marcus & Millichap figures. At the same time, net income for apartments declined 18.5%, compared with a 15% decrease for offices and a 6.7% gain for retail.

"Many apartment sellers are diversifying equity by entering into new markets and taking advantage of the cap rate spread that apartments have with retail, office and industrial properties," said Marcus & Millichap's "Special Research Report, Forecast 2005."

The strategy offers some tantalizing possibilities: diversified risk; locked-in, longer leases; stabilized cash flows; and tenants who generally require less customer care than apartment building residents demand.
"There's not too much passive investment in apartments because you have annual leases you have to roll over, you're constantly marketing every square foot of your project, and you're taking care of people," said Keith Misner, senior managing director of apartment brokerages service at Cushman & Wakefield in Washington, D.C.

But diversification also poses challenges, including the need to master another type of property. For example, retail leases can be much more complex than apartment leases, and outfitting space for a new office tenant can be very involved.

"[W]hen you're doing office, you might find yourself moving walls around and that can get expensive," said George Pandaleon, senior managing director of the institutional investment group at Grubb & Ellis in Los Angeles. Office properties can also be quite capital intensive to buy, according to Pandaleon.

Don't lose focus

"If you take the eye off the ball on a well-running apartment complex just for a short time, it can take a long time to rebuild the good will and the community and the perception," Misner said.

One company that has diversified is NAI Cohen-Esrey of Kansas City, Mo. The company, which has 700 employees, manages 15,000 apartment units and 8 million square feet of commercial property, and owns about a quarter of that portfolio. President and Chief Operating Officer R. Lee Harris said sector expertise is crucial.

"There's no way at all that we could have diversified … if we didn't have a large organization with people specializing in those areas," he said.

Owners who lack that depth of knowledge will make too many mistakes and won't understand the nuances of the different types of property, he added.

Some apartment companies develop new expertise within the context of a specific deal, said Larry G. Schedler, president of Larry G. Schedler & Associates, Inc., a New Orleans-area apartment broker. For instance, some builders in the densely populated New Orleans area add retail to their apartment projects as a way to gain community support or add to the attractiveness of the development. The mixed-use projects offer the opportunity to gain additional expertise.

A longtime apartment owner's insight into his hometown also can drive the decision to diversify. Someone who is deeply embedded in the local community may see an unmet need that others haven't noticed, Schedler said.

Apartment owners also can consider whether to bring in a partner or invest in real estate investment trusts as a diversification strategy.

How healthy are other sectors?

"Don't run into the forest fire," said Kim Betancort, senior vice president, analytical services for Realpoint, an investment advisory service owned by GMAC Commercial Mortgage of Horsham, Pa.

The vacancy rate for downtown office space is 14.4% nationwide, according to the latest Grubb & Ellis report. And office landlords could face a 500 million-square-foot shortfall in demand over the next 10 years because many office jobs will be outsourced overseas, according to a March report published by the Urban Land Institute and Columbia University Business School.

Retail also looks precarious on the national level.

"We're going to close 40% of the malls in America before we're done, and we're going to close thousands of strip centers," predicted Howard Davidowitz, a national retail consultant and investment banker in New York.

Local market conditions are relevant as well. For instance, many grocery chains are near bankruptcy, but high-end grocery stores in New York City are thriving.

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Condo craze continues for now

Some experts foresee slacking off of construction and conversion toward end of year.

By Brad Berton

With mortgage rates still favorable for entry-level and move-down homeowners, plentiful debt, equity and mezzanine capital will continue targeting condominium construction and conversion ventures at least through the early quarters of 2005. But except in the strongest condo markets such as Florida and California, rising mortgage rates or a high-profile disaster or two would tend to tighten the financing spigot, experts suggest.

Lenders will likely remain quite comfortable funding promising condo projects and sponsorships - even select suburban garden-type complexes - as long as homebuying mortgage rates don't rise by more than 100, or even 150, basis points, predicted Michael Kavanau, senior managing director at Holliday Fenoglio Fowler (HFF).

A third or more of the apartment acquisition transactions for which HFF is arranging financing these days are conversion ventures, and that ratio seems certain to continue at least through 2005's early months, Kavanau added.

Accordingly, a group of high-powered nontraditional banking outfits are beginning to drive the conversion financing marketplace, even as traditional commercial banks continue to dominate from-scratch construction lending. The likes of Fremont Investment & Loan, Merrill Lynch Capital, LaSalle Bank and GE Real Estate have all established attractive condo-conversion lending programs, Kavanau noted.

As for ground-up condo construction loans: "The real competition is from bank to bank," according to Jay Wagley, managing director at L.J. Melody & Co. He and others also cautioned that noteworthy financial failures would tend to shift lender interest toward rentals at the expense of higher-risk condo conversion and construction projects.

"The capital markets will continue to support condo development and conversions until we experience some disappointments; then we'll pull back," agreed Peter Donovan, CEO of Deutsche Bank Berkshire Mortgage. "I won't say that's going to happen in 2005, but at some point it will get maxed out."

Others, however, suggest condos will retain their share of multi-housing activity permanently in the best markets - mortgage-rate considerations notwithstanding.

"We believe that condominium ownership is here to stay," stressed Tom Jaekel, chief investment officer at Cohen Capital. "We also believe it will be driven less by favorable interest rates and more by demand for the improved quality of life that comes from living in urban districts with lots of amenities within walking distance."

Market strength is key

Whether nor not the conversion craze runs its course in 2005, Jaekel and others agreed that lenders will limit their best rates and terms to top-notch sponsors in top-performing marketplaces. While new players will certainly aim to jump on the condo bandwagon, lenders probably won't offer the same support they're now giving proven sponsors, Kavanau cautioned.

"How a deal is structured depends on numerous variables," Wagley stressed, "but the real key to condo financing is sponsorship and depth of market." Successful Melody clients are even frequently securing nonrecourse loans in the $50 million-plus range with no pre-sale requirements.

But condo equity and mezzanine sources typically require that even the strongest developers hold off until they close some solid pre-sale activity, Kavanau related. They might get a go-ahead at 35% pre-sales with truly promising projects or markets, but 40% to 50% will likely be the norm next year, he said.

Construction lenders typically like to stick in the sub-80% loan-to-cost vicinity for condos, Kavanau noted. That suggests modest continued demand for mezzanine financing to round out the capital stack, he continued, adding that such sources remain plentiful and affordable.

January/February 2005

Making the Market

Southeast focus

What's in Apartment Finance Today, January/February 2005, the print version

We've completely redesigned Apartment Finance Today magazine. In addition to a bold, new look, 2005 will also see even more in-depth coverage of the financial decisions that make a multifamily development sucessful and ownership profitable.

COVER STORY

Coming events

January

10-11—American Seniors Housing Association, Fall Meeting; Carlsbad, Calif.; (202) 237-0900; www.seniorshousing.org

13—National Association of Home Builders (NAHB), International Builders Show; Orlando, Fla.; (800) 368-5242; www.nahb.org

19-21—National Multi Housing Council, Annual Meeting; La Quinta, Calif.; (202) 974-2300; www.nmhc.org

February

6-9—Mortgage Bankers Association, Commercial Real Estate Finance/Multifamily Conference; San Diego; (202) 557-2700; www.mbaa.org

28—Real Estate Conference Group, Real Estate 2005; Beverly Hills, Calif.; (310) 271-1276; www.realestateoutlook.com

March

8-11—MIPIM, Annual Conference; Cannes, France; (212) 284-5130; Patric Dolan; www.mipim.com

13—NAHB, National Green Building Awards; Atlanta; (800) 368-5242; www.nahb.org

15—Chicagoland Apartment Association, Annual Tradeshow; Oak Brook, Ill.; (847) 678-5717; www.caapts.org

April

3—NAHB, Multifamily Pillars of the Industry Conference; Miami; (800) 368-5242; www.nahb.org

16-20—Institute of Real Estate Management, Leadership and Legislative Summit; Washington, D.C.; (800) 837-0706; www.irem.org

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