BOTTOM LINE: ASSET MANAGEMENT

APARTMENT FINANCE TODAY • SEPTEMBER 2007

Time Is Not on Your Side

By Bendix Anderson

Prices for apartment properties are as good as they are likely to get for the next year or more, making this a great time to sell. Despite chaos in the capital markets, buyers still abound for strong properties in high barrierto- entry markets and for Class B and C properties that can be renovated to raise their rents.

“If you’re thinking about a sale in the next one to three years, I’d think about it now,” said Mark Forrester, a partner in the Phoenix office of Hendricks & Partners, a real estate brokerage.

That’s because as the year closes, prices are likely to creep down. Capitalization rates, which move in the opposite direction from sales prices, could rise by as much as 50 basis points as prices drop, according to experts like Keith Misner, senior managing director for property broker Cushman & Wakefield. A property’s cap rate represents the net operating income of a property as a percentage of the sales price. “The peak of the market is behind us,” he said.

In the first half of the year, the national weighted average cap rate for garden apartments was 5.8 percent, 30 to 40 basis points higher than the record lows recorded at the peak of the condominium boom in 2005.

The average garden apartment property sold for $86,000 per unit in the first half of 2007, the same price as the year before and down 10 percent from the record prices of 2005, according to data from Real Capital Analytics, a New York City-based research firm.

One reason for the slide in prices is diminishing demand. First, condominium converters were driven from the market by stalled condo sales and falling prices. Now, property buyers that relied on high-leverage conduit loans have been hurt by tumult in capital markets. As of mid-August, it was almost impossible to close on a conduit loan for an apartment property, said Stephen Blank, a senior resident fellow for the Urban Land Institute, a nonprofit think tank. When conduit lenders return to making loans, they will almost certainly demand tougher terms, restricting the bidding power of buyers that depend on leverage.

“The pool of buyers for properties is probably going to be smaller,” said Richard Kelly, vice president for LumaCorp, Inc., a Dallas-based owner and manager of apartments.

To decide what to sell, owners should look at the preferences of the buyers that remain, including institutional buyers that deploy equity from their own balance sheets, like real estate investment trusts (REITs) and pension funds. Developers that purchase properties to renovate are also active, using short-term, floating- rate construction financing from the balance sheets of commercial banks and other institutions.

Institutions pay high prices

for strong fundamentals Properties located in strong markets with high barriers to development are still drawing strong bids from institutional investors, Misner said. These properties are prized by REITs and pensions funds because the steady stream of rental income they produce is protected from overbuilding.

In the second quarter of 2007, for example, Equity Residential bought 2,310 apartments in major cities, including three properties on the Upper West Side of Manhattan, at an average price of $239,000 per unit. That’s roughly three times the price per unit Equity received from the sale of 6,307 apartments in lessprotected secondary markets over the same period.

With real estate fundamentals like rent growth and vacancy rates highly valued by these institutional buyers, it’s also a good time to sell properties in markets that are strong now but which may soon be threatened by a glut of new construction.

For example, this summer Starpoint Properties sold the 300 apartments at its Emerald Terrace property in Southern California a full two years earlier than it had originally planned. That’s because Starpoint saw a tidal wave of new rental construction about to hit Emerald’s submarket just outside of downtown Los Angeles. So the developer accelerated its renovation at Emerald Terrace to finish while rents and occupancies were still high in the market, and sold at a cap rate of less than 5 percent.

Value-added deals attract attention

It’s also a great time to sell Class B and C properties that buyers can renovate to increase rents.

These “value-added” buyers, like Starpoint, often use construction financing from the balance sheets of commercial banks—financing that has been relatively unaffected by the crisis in the capital markets. Valueadded opportunities are also beginning to draw the attention of institutional investors including REITs, according to Forrester of Hendricks & Partners.

Buyers are so eager to purchase these properties that the difference in cap rates between Class A properties and renovation-ready Class C properties in the strongest markets has shrunk from about 200 basis points a few years ago to just 50 basis points today, according to Paul Daneshrad, CEO of Starpoint.

To evaluate whether a property has the potential to upgrade from a Class C to a Class B, or even from a Class B to a Class A-, first assess the location. “If the ground were vacant, would someone build a new apartment building there?” asked Jeff Hawks, principal in the Denver office of Apartment Realty Advisors (ARA). Then assess the floor plans. Are the units large enough to earn high rents in your markets without tearing out walls?

To prove that a property has the potential to sharply increase its rents, renovate a few test apartments, said Matt Rotan, principal in the Houston office of ARA. For example, spend $2,200 to give a promising vacant apartment two-tone paint, vinyl plank flooring, closet dividers, and upgraded faucets, and raise the rent by $85. If you succeed in finding tenants willing to pay the new rent, it will help prove the property’s potential to prospective buyers.

Here’s one more reason to sell Class C properties now: Although the buildings are often older and more expensive to maintain than Class A properties, those extra costs are rarely recognized by today’s buyers in their calculations of the project’s sale price. “Capital expenditures are often below the NOI line,” Daneshrad said.

In other words, the supply-anddemand equation still favors most sellers. But that may not last too much longer.