Improved Outlook for Multi-Family Investments

Q1-11 Situation Analysis

Fourth quarter data from MIT’s Transaction-Based Index suggests that commercial real estate (CRE) bottomed out one year ago and has begun a smart recovery since. When all of its types are lumped together (apartments, industrial, office, retail), CRE is priced well above the trend line established through 2004 (the beginning of the bubble). Apartments, considered separately, are recovering below their pre-bubble trend.

Therefore, among the various types of CRE, apartments appear to be a bargain in today’s market, and this is borne out in MIT’s Supply and Demand Indices. Demand relative to supply is greater for apartments than for CRE at large. Apartment investors feel that this is a good moment for them. With some very important caveats, LANDCO agrees.

Among the most important things to note about these statistics is that they are transaction-based. Transactions today are still inhibited by a great caution on the part

of real estate investors. Most of the capital being deployed is controlled by large funds and fund-managers seeking core and core-plus apartments — i.e., Class A properties — mostly in the hotter rental markets. Therefore, the recovery depicted in these charts is occurring among the newest and most highly valued projects. And even that recovery, propelled by institutions often willing to accept cap rates below 6%, has not yet returned to trend.

So the apartment market right now is bimodal between Class A, which is trading more or less as shown in MIT’s data, and Classes B-C, which do not yet reflect the same level of price-recovery or demand. B’s and C’s are older properties, usually in impaired physical condition to one extent or another, whose tenants are working people. In this subset, price-recovery has been lackluster or non-existent, so these properties are at greater risk of defaulting on loan repayment and being foreclosed. As a result, investors in Class B and C properties must not only contend with the physical condition and revenue production of their buildings, but they must also be conscious of the risk that any

number of neighboring properties may come to the market as foreclosures.¹ This second-tier of residential property has not yet achieved the same upward path as Class A.

Under the right circumstances, therefore, LANDCO believes that Class B and C apartment renovation projects can be acquired ahead of the market. 2011-12 will see a high level of foreclosures, keeping prices down, but setting the stage for substantial growth even in excess of what we have begun to see in Class A. And this is true not just because B is a bargain relative to A, but because apartments of every type have a favorable long-term outlook.

• They are a staple. People need housing in ways that they don’t need more office space or another retail location for their business.
• Apartment buildings of various qualities and locations will almost always find tenants at some price. The same is not so generally true of other
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  types of real estate. There are office buildings and commercial locations, for example, that given changed circumstances will scarcely rent at any price.

• Home ownership is not quite the panacea it once was. Renting a decent apartment in a convenient location at an affordable price is seen today as a sound alternative to buying a home in the suburbs or a condo downtown.
• Apartments are not being produced at a rate sufficient to meet long-term demand, and the cost of building new housing is far beyond the price at which existing residential property can be acquired.
• Desirable sites are not limitless. Sprawl is not the solution it once was to housing cost or availability. Infill locations and transit-orientation can help overcome certain kinds of physical obsolescence in older buildings.

This is not to say that there are not systemic risks among all apartment classes, for example:

• The risk of slow job-growth and economic stagnation
• The risk of increased cost or decreased availability of apartment mortgages
• The risk of a long-term increase in cost of funds (e.g., rising cap rates)

And there are particular risks in undertaking the renovation of older property, for example:

• Costly retrofits, as in the case of green HVAC systems or thermal windows
• Obsolescence that cannot feasibly be renovated, such as 8’ ceiling height
• Hidden conditions, such as extensive dry rot or foundation failure

Pricing and planning are keys to the success of an investment in this property type, which is off the radar screen of large institutional investors yet which plays to LANDCO’s strength in construction, engineering, retrofit,

and the basic operational details of multi-family housing. After four years on the sidelines, LANDCO looks forward to making bargain-priced acquisitions in 2011.

In a future Situation Analysis, we will discuss some of the implications of the non-residential recovery and what it may suggest about the real estate investment climate overall.

1. LANDCO’s Q1-10 Situation Analysis examined the issues of obsolescence and foreclosure.