Making Sense of Two Divergent Investment Trends

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John Battle

The best way to describe the current state of the commercial real estate investment market is bifurcated. At one end of the spectrum are institutional buyers with literally billions of dollars to invest. These buyers are only acquiring Class A properties located in gateway cities such as New York, Washington D.C., San Francisco, Los Angeles and Seattle.

When these types of properties become available, they generate 20 to 40 offers or more, resulting in a bidding war among the top three or four bidders at capitalization rates in the low 5 to 6 percent range.

At the other end of the spectrum, Class B buildings continue to struggle. So too do Class A assets that are not located in gateway cities. Although some of the bidders that have been unsuccessful in their preferred markets are now considering smaller markets such as Philadelphia, St. Louis and southern Orange County, they expect to get a much better return on their investment, typically a cap rate in the neighborhood of 7 percent.

The general feeling around the country from acquisition managers who have been most active is that this trend will continue for at least the next two years while the credit markets struggle to reach some sort of equilibrium.

Insatiable appetite for apartments

The multifamily market is one segment of the investment arena that is truly on fire without much regard to asset class as long as it is located in a gateway city. Class A properties of 100 units or more built after 1990 command the most attention due to the tremendous amount of capital that has been earmarked for these types of properties by major institutional investors such as pension funds, hedge funds and sovereign wealth funds.

As is the case with comparable commercial properties in other sectors, when Class A apartment properties are marketed for sale many offers are submitted, and the price at which they trade can easily reach the low 4 percent cap rate range.

Judging by the real estate forecast conferences I’ve attended this year, there seems to be no disagreement as to why these multifamily projects are in such high demand by institutional investors.

An increase in the number of households being formed, decreasing home values, and a general disenchantment with the “American dream” of home purchasing has led to an increase in demand for rental apartments.

At the same time, a lack of new apartment construction during the long real estate recession has resulted in increased occupancies and the elimination of rental concessions such as free rent and moving allowances.

These factors are driving projections that rental rates will increase an average of 5 to 8 percent per year for the next five years, making multifamily investing far more lucrative.

As more individuals opt for renting versus ownership, they are favoring larger Class A properties because they provide amenities that make apartment living more home-like. These comforts can include outdoor seating areas, pools, common area meeting rooms, granite countertops and other architectural details and WiFi.

Seeds of development

With the improvement in capital markets, the surge in multifamily investment interest has also spread to developers. We are seeing a rise in demand for land in prime areas as well. Construction financing is now readily available at all-time low interest rates that allow developers to justify paying pre-recession prices for fully entitled sites in these preferred markets.

There is a tremendous rush to get into the ground in order to take advantage of this “perfect storm” of circumstances that makes apartments so attractive today to various equity sources.

At the other end of the spectrum, we are still finding numerous assets in various levels of distress due to investors buying at the peak of the market, high leverage used to acquire the properties, and the tepid economic recovery.

These troubled properties, typically purchased between 2005-2008 just prior to the Lehman Brothers collapse when the market was at its peak and underwriting requirements were extremely lax compared to today’s more conservative view of values and future appreciation, are fewer than many had predicted however.

While banks have been aggressively disposing of troubled assets, special servicers and financial institutions that hold the loans on many of these assets are reluctant to realize the tremendous losses that would result from dispositions.

Instead, they have shown a preference for loan modifications and other forms of workouts that avoid having to take title to the properties. This trend is expected to continue for the next several years.

I believe that 2012 will produce more opportunities for the shrewd investor who scrutinizes any potential acquisition in order to be certain that a sufficient return on equity is achievable.

I am also cautioning investors that they will need a longer time horizon to achieve their projected returns. The “quick flip” for a reasonable profit is much more difficult to achieve today primarily because of the continued malaise in the general economy.

For investors who keep these points in mind, there should be ample opportunity in 2012.

John Battle, SIOR, is a founding principal of Lee & Associates-LA North/Ventura Inc. He has specialized in investment sales for more than 30 years.

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