July 7, 2015
Interviewed by: Privcap
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Multifamily’s Perfect Secondary Market Storm

A perfect storm is brewing in U.S. multifamily thanks to demographic changes, which will continue to drive strong returns in secondary, tertiary – and even suburban – markets, according to a panel of experts including LEM Capital, Post Brothers and Yardi Matrix.

A perfect storm is brewing in U.S. multifamily thanks to demographic changes, which will continue to drive strong returns in secondary, tertiary – and even suburban – markets, according to a panel of experts including LEM Capital, Post Brothers and Yardi Matrix.

Multifamily’s Perfect Secondary Market Storm
The Art & Science of Multifamily Investing

Zoe Hughes, Privcap: I’m joined here today by Matt Pestronk, President of Post Brothers Apartments; Joshua Grossman, Vice President of LEM Capital; and Jeff Adler, Vice President of Yardi Matrix. Gentlemen, thank you so much for joining me today.

When we look at the U.S. multifamily sector, it’s undoubted to say that the pace of transactions has certainly been growing at a very strong level for the past few years. It’s led many industry professionals to say that this is one of the best environments for multifamily investing in a generation. But it also means it’s exceptionally competitive. Today, we’re here to look at the reality of what’s going on for multifamily, what’s really happening in terms of fundamentals and how that’s impacting strategies across the board.

When we look at fundamentals, we obviously look to the demographics. Jeff, let me open this up to you. Is this round of demographics much different from what we’ve seen before and is it really extending that multifamily cycle we’re perhaps seeing?

Jeff Adler, Yardi Matrix: I think it’s very much the case. [As for] the demographics, and not only the demographics of market conditions, this is probably the perfect storm we’ve seen in multifamily for the last 30 or 40 years. You have two very large cohorts where the millennials are about 78 million. They’re now hitting their prime rental ages, as well as the boomers, who are now entering their 60s—[that’s] another 78 million cohorts.

In addition to just pure size and the age, you also have [what] I call “demographic preferences,” where this group is delaying marriage and delaying child rearing longer. They have a preference for urban-type living, though not necessarily central city living, and they’re much more associated with a live-work-play kind of experience. [With] all of these things, in addition to, frankly, the financial environment where you’ve got student debt, you have a blowout from the last cycle on the housing side. They do not necessarily think of housing as a great investment anyway. All are driving this towards this amazing multifamily kind of cycle.

What inning are we in? I would say that we’re in the sixth inning of a game that’s going into extra innings.

Hughes: Is this going to be an extra innings in terms of the multifamily real estate cycle?

Matt Pestronk, Post Brothers: We see continued absolutely excellent fundamentals underlying the dynamics of the markets in which we own. That being said, I can’t speak to any markets besides Washington to New York—that quarter. But I think that, certainly, a dose of conservatism is called for when looking at new investments in terms of the underlying fundamentals of rent growth because, at some point, not every property can be class-A and rents can’t be pushed forever because, in a lot of places, rents are pushing up on the sort of affordability ratios you look for when you’re underwriting residents to live in your apartments.

Hughes: Josh, do you think this is going to be an extended real estate cycle?

Joshua Grossman, LEM Capital: We’re seeing…we think the fundamentals are very strong. The pool of potential renters is just enormous. As a firm, we’re very much focused on the fat segment of the bell curve, that class-B product. If the new products [are] being delivered at $2.25 or $2.50 square-foot rent, we’ll really focus on that $1.25 to $1.50 a square foot. And those are certain markets, especially on the West Coast, [where] vacancies are very low.

Wages have not been increasing as fast as rents have; single-family home prices are going up and people need places to live. So we think there’s a huge amount of demand, but…it’s just where you focus on the bell curve.

Adler: One of the things I’ve really begun taking a deep look at is a lot of investors have come to us and said, “We want to leave the top six markets, our primary markets. We want to search for yield. Where should we go and why should we go there?” So, we began thinking about what differentiates—what makes a primary market a primary market? Is there a set of secondary markets that are quite large American cities or metropolitan areas that actually have the attributes of a primary market or almost—

Pestronk: They’re called 18-hour cities now.

Adler: They’re 18, exactly. We went through this notion of saying there really were three main drivers. It was your intellectual capital set of nodes. It’s not just that there’s employment, but what’s the nature of the employment and is it such in the creative industries where wealth is being created?

Then, is the business climate one that’s conducive to creation of new jobs? Then, it passes through a screen of civic leadership, which is—if you look at income growth and income distribution for the last 30 years, it’s been highly concentrated toward the upper end where education exists.

Grossman: When looking at markets, I think it’s important to take a nuanced perspective because if you’re trying to have a project that calibrated to a low income, middle-market tenant base, it’s OK if that job base is nurses, teachers, administrative assistants or office workers. If you have a property that’s much more focused on higher-end demographic, then you need some of these research techs, docs and software programmers—people like that.

Hughes: How exactly are you executing on those strategies? How does that impact in terms of what you’re delivering?

Pestronk: We have two properties we’re selling now that we bought in highly distressed situations in 2010, 2011. They were basically complete development or redevelopments. One is on the edge of downtown in Philadelphia, an extremely architecturally significant building, 163 units—a really interesting-looking property, very easy to manage and caters to the top end of the renter market in Philadelphia. We’ll sell it to any core buyer that would want to buy anything—they would buy this.

Another property we developed is more toward what I would call “the middle of the top,” where our average resident in the building—the first building I mentioned of 163 units—the average renter income is $125,000 there. The other property caters more to the middle of the market of college graduates, maybe $60,000 to $80,000.

We really see an opportunity to focus on, within our markets, what I call the “white-collar collegegraduate segment.” If we’re focused on buying something suburban, it’s got to be in a real infill location—inner-ring suburbs that have walkable downtowns and trains. We love those markets and we think they’re underserved.

Adler: I think that is defining this cycle compared to past cycles. It is this notion of either access to transit or access to walkability is where value is being created and will continue to be created. The data is pretty clear that, in 10 years, the millennials will move out to the suburbs, but the suburbs will either be your infill-type suburbs with transportation or the suburbs will look like that. It will have retail nodes and office nodes and walkability or transit nodes so it looks like it.

Pestronk: The suburbs are cheap right now, but they’re cheap for things that are obsolete generally across not just apartments, but office buildings. Suburban office is cheap, but suburban office needs to change.

Adler: But if you look to see where’s economic growth occurring, where’s valuation going to occur, for places that…aren’t blessed with intellectual historic capitals, like Boston, New York, something like Philly or DC, they are creating places that will attract capital and where rents will grow over an extended period of time because they’re making these infrastructure changes.

Grossman: We work with local guys in every market who understand, [who] know every block and the history of every trade and…if you look at the major six markets, you’re…more focused on buying the MSA. When you get down to these kinds of secondary and tertiary markets, you’re more focused on buying—is it good? Or you’re buying like a property that’s relevant to a specific two or three sets of employers or a specific school district.

Hughes: Are you getting much more into specific submarkets than when you’re actually looking at the secondary and, perhaps, even the tertiary market?

Grossman: Absolutely.

Adler: It’s interesting. I’ll take an example of Houston, which you think is all energy related. It’s actually not one city. It’s actually 10 cities. There are 10 nodes of where there’s a combination of the kind of people who have intellectual capital—the retail and the office. So, in fact, you are buying and, if you’re going to be successful, you have to go beyond the metro area into these where are those particular nodes placed.

Grossman: We spend a lot of time also focusing on retail development, with people like Wal-Mart, Costco and Whole Foods. They just do great demographic research and just portend positive demographic trends in an area that’s transforming.

Hughes: What are you seeing in terms of capital flows into the secondary markets, because people seem to be wanting to take on more risk?

Pestronk: We invest in market that’s basically anywhere two hours from downtown Philadelphia, north and south. And I would say, the entire state of New Jersey is a primary market in terms of multifamily. We have really no issues; this is just a tremendously liquid environment.

Generally, what we’re doing is buying something that’s potentially an area that looks bad, because of the asset we’re buying, and changing it. Sometimes people are afraid of that, but if you can find that today and you believe in the other things about the cycle holding up, there’s an incredible opportunity to be made there.

Adler: What’s interesting, again, about real estate (and I’m talking of multifamily, but you could say this to other asset classes) is there is a tremendous number of value-creation strategies. For a long time, people shied away from it because they said, “Oh, my gosh, it’s a development risk.” You’re going to basically…almost tear the thing down because you’ve got to put new building systems in. You’ve got to put in everything now. The difference is, if replacement cost is $200,000 a unit and you can get the thing for $40,000 or $50,000, even if you put $50,000 into it, you’ve just created a tremendous amount of value. It’s just that you’ve got to be very careful about how you find them.

Hughes: Josh, are you finding that the secondary markets are becoming even more liquid, that that capital is really flowing in? It presents a great exit strategy, but it’s also competition as well.

Grossman: I think 12 months or even 18 months ago, you definitely saw cap rate spreads. And, recently, they’ve compressed. So maybe you still get a bit more. You only get 25, maybe 50 basis points of cap rate in somewhere like Birmingham, Alabama, versus in Atlanta. I think that can decrease further and I think those markets are just harder to understand. You have to be with the right local guy who knows it block by block, like you guys do Philadelphia and Jersey.

Pestronk: Going into a market without an operating partner, which you guys don’t do, I think that going in and saying everyone in Birmingham’s an idiot. “I’m going to make a 30 IRR and this deal is a surefire way to not make a 30 IRR.” We get lots of deals sent to us all the time. I don’t really see any type of premium discount rather in these secondary markets…relative to even the major secondary markets. And I would say the secondary markets are just priced like the suburbs of the absolute first-tier cities, period.

Hughes: Are any of you getting concerned that there is too much excess development happening or is it really in very select pockets?

Pestronk: The city of Philadelphia and the state of New Jersey have a lot of development going on right now and, historically, more than ever has happened at once. We developed a building (the one I referenced) that we’re selling, and then we consciously chose not to develop anything else downtown because there were a dozen other projects in various stages of planning. That doesn’t sound like a lot, but it’s maybe 70,000 people in the greater downtown and the class-A plus renter demographics not enormous.

So we stopped developing there once we started developing this building because we thought there is a potential of the symptoms of oversupply coming on. In fact, the opposite happened and there are some projects I wish we would have done in those intervening years because we would have done really well. So I can tell you that simply the 80 million millennials—if you’re placed where they want to be, I honestly don’t think developers can permanently overbuild any markets. Maybe a few.

Hughes: Because that’s quite a contrarian view.

Adler: We’ve taken a look at job growth and graphed it against apartment completions as a percent of the stock, which I always think is the relevant measure. And there are only three markets right now that, I would say, are oversupplied or about to be oversupplied, which are Charlotte, Austin and, to a certain extent, Nashville. All of those are also high in job creation. It’s a question of timing.

Now, if you look at the other markets, there are submarkets at the high end—because all this stuff is coming in at the high end, in the central business district, they are going to be oversupplied for 18 months. So rents won’t go up quite as fast. They’ll go up four versus eight. Still, you’d like to take that to the bank all day long.

Pestronk: But that’s a developer’s problem. It’s not the common equity’s problem, right?

Adler: Yeah. If you think about it, that’s still really good. I would say the one thing that really talks to Josh’s strategy and, to a certain extent, yours, Matt, is the gap between the higher end and the midrange is very wide. It’s at least $500, $600, $700 a month. If you think about that, you’re really talking about entirely different renters.

Pestronk: So, [with] the value-add strategy that Jeff mentioned about pushing class-B rents, I think you have to be very careful about estimating inelastic demand vis-à-vis the income of people in the middle. Josh, what type of business plans do you see being as successful in terms of going from a C to a B? What works?

Grossman: We’re focused on that fat segment on the bell curve. What you’re doing is buying a late-’80s, early-’90s vintage deal. It’s generally been undermanaged. The guy’s been out of town. He’s maybe using a third party, but he’s not really paying attention. The deal is capital starred and you can come in and spend your dollars. You can create almost like-new amenities, heavily focused on the leasing tour. And interior finishes that are very well-calibrated to the tenant base.

We’re very focused on incremental return or return on incremental dollars spent. So, if we’re going to do granite counters versus (maybe this is being too esoteric)…laminate counters, you have to make sure you’re getting paid extra rent dollars for the extra $1,000 you’re spending.

So, we end up with a product that’s well-calibrated to a tenant where they can come in and they’re making that $40,000 to $50,000 a year.

Pestronk: I would love to be able to find a property like that, but you can’t. Brokers are selling properties that are 10 years old…like at JP Morgan, someone like that, that you really look at the going in numbers. You’re not buying it out of the low five caps. Try around a four and you just can’t make what I believe would be a reasonable rate of return. It’s probably going to pencil, doing what you describe, would be effective. You could raise rents. The people have the money to pay additional rent, but the return’s probably going to be around 11% or 12% to the deal.

Grossman: I would also say there are different components of value-add, because you have some dollars that you think you can charge, so just bring your product to where it should be within its rightful place in the competitive set. You have dollars that you can generate by executing a value-add program, improving finishes, giving tenants better amenities, etc. Then, you have whatever you get from the market.

We’re very focused on manufacturing yield. And we’re not buying these deals and just riding the market. These truly are value-add opportunities.

Hughes: Let me be a bit contrarian and ask: when you’re talking about the demographics, all these demand drivers that are really fueling multifamily, isn’t this just purely down to the size of the cohort that is coming through?

Adler: First, demographics are pretty powerful. Yes, they have the weight of numbers behind them. There’s no question about that. In addition to that, the generation before didn’t have a student debt. The requirements for purchasing the home are higher now, from both a credit score and a down payment, so it’s not as easy. Maybe singlefamily rentals will fill in some of that gap. I think it will, but there are bigger obstacles.

And the psychology of “I’m going to go buy a house because it’s going to create wealth and that’s what people do,” which was a norm 20 or 30 years ago—that norm doesn’t exist.

Pestronk: And people are getting married significantly later.

Adler: They are getting married later and they’re having that second child later. All of those things mean that, in my view, it’s not that age cohorts or demographics have been overturned. It’s lengthening what you would normally see anyway. Now…it’s longer and the effect is longer, which is why, again, anyone who says, “This time it’s different,” they usually say, “That’s garbage.” Because it’s not.

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