January 4, 2016
Interviewed by: Zoe Hughes
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Berkshire Eyes Core Multifamily Growth

Berkshire Group is focusing its strategy increasingly on core multifamily deals says CEO Chuck Leitner, amid warnings about the valueadd cycle.

Berkshire Group is focusing its strategy increasingly on core multifamily deals says CEO Chuck Leitner, amid warnings about the valueadd cycle.

Berkshire Eyes Core Multifamily Growth
With Chuck Leitner of Berkshire Group

Zoe Hughes, Privcap: I’m joined here today by Chuck Leitner, CEO of Berkshire Group. Chuck, thank you so much for joining me today.

Chuck Leitner, Berkshire Group: It’s a pleasure.

Hughes: When we talk about cycles in commercial real estate, I think there’s one sector that is frequently cited as being ahead of the pack, and it has to be multifamily. Berkshire is a significant player in the sector—Berkshire owns, manages and has in development more than 28,000 units. So, tell me, are we at the top of the cycle?

Leitner: It depends upon how and where you’re investing. I tend to not generalize, and we try to stay away from generalizing, that multi is at a particular stage. Certain parts of multi are pretty “peaky” and well into the later cycle. Value-added multifamily, as an example, has gotten pretty competitive in terms of getting appropriate risk-adjusted returns for buying older, for repositioning, redeveloping and raising rents along with that strategy and then, ultimately, selling a property for more than you put in it. That part of the market is pretty long in the tooth right now, but there are other parts of the market that have quite a bit of running room.

Generally, the fundamentals are still very good. Supply and demand is in line, with few exceptions in the U.S. Rents are increasing, not quite as quickly as they were a couple years ago, but there’s still healthy improvement in operating income in most of our markets. Again, with a few exceptions, supply and demand are in pretty good balance.

Hughes: Talk to me about the value-add side of things. Obviously, that is a significant part of the Berkshire portfolio—almost 50%. Are you pulling back from that? How are you actually approaching that strategy today?

Leitner: It’s all where you are in the cycle, so, yeah, we’ve been generally doing more selling out of our value-added positions and have been very careful about buying. We’re doing a bit of it here and there, but generally, as I said, the risk-adjusted returns are getting thin.

Hughes: How much will you sell? How much will you pull back?

Leitner: Last year (2014), we sold about $1 billion worth of what I would call value-added multifamily real estate in the U.S. We have quite a few 10,000 units and we’ll sell more. Not quite that much, but we will sell more. So, I think we’re net selling,

Now, all of our value-added multifamily assets are not just in individual repositioning properties. Also, in our value-added strategy, we do a significant amount of debt investing. We have quite an active program where we’re buying the first-loss CME position from Freddie Mac-issued, multifamily-backed portfolio pools. [We are] actually buying mortgage positions and we think the risk-adjusted returns there are still pretty good.

Hughes: So, that’s somewhere you’ll actually be ramping up the strategy instead?

Leitner: Correct. “We’ve been doing it for a while and I think we’ll continue to do it” would be the way I would say it. The third leg of our value-added strategy is ground-up development. In select markets, select locations with select partners, we’re still pretty active on the ground-up development side and doing that in our value-added strategy as well.

Hughes: Is that development for sale or perhaps development for holding?

Leitner: I would say, for the most part, in the value strategy, it’s development to lease and sell with either a local or regional partner that has incentive to do the same. As those assets sit in our value-added funds, which tend to be closed-end vehicles, that formula works pretty well. We are starting to do some more development in what I would call very high-quality, major-market locations that are more build-to-hold and are fitting into more of our long-term core investment strategies.

Hughes: Talk to me a little bit in regard to core. Is that an area where you would see an increase?

Leitner: We expect to do more core. We’ve been doing a fair amount of rebounds.

Hughes: Even given pricing?

Leitner: Yeah, pricing. There’s a lot of talk about low cap rates and high prices per unit. Again, I think quality locations are really the key—not necessarily brand-new product, but really high-quality locations where there are barriers to entry in terms of new competition. Or at least they’re understandable, where there’s real strong demand drivers and job creation, and you look at the markets where there still is some healthy job activity. We’ve bought a couple of properties in Boston, for example, which is our home market. Interestingly enough, we haven’t been that active there. But, right now, we think the supply-demand fundamentals are quite attractive and [there’s] good job creation there. [There’s] a lot of renter-versus-owner activity in a market like Boston.

So, we’re not uncomfortable with a lower cap rate on a quality property that we’d own for the long term. That doesn’t mean it’s not going to cycle up and down, but from a long-term perspective, we still like what we see in certain markets.

Hughes: You see strong fundamentals. Do you see those rents continuing to grow? Do you see vacancies beginning to compress a little bit? How are you viewing the demand side of fundamentals?

Leitner: In certain markets, we definitely have seen the effects of competition. Rent increases are getting smaller. They’re not going away, but they’re not the high single-digit numbers you were seeing in the really amazing times of a couple of years ago. So, you have to be realistic about rent growth, but there is growth. That does justify a going deal that might seem low, but if you can keep pace with inflation and you’ve got a long-term view, that still works. If you’re trying to fit that particular acquisition into a closed-end fund with a very precise window for an exit and a very precise return threshold, that gets a lot harder to do.

Hughes: Obviously, we’re late in the cycle. Give me a sense as to how you see that cycle playing out over the next three to five years. Many people are saying there’s going to be a recession within five years, guaranteed. How do you see it playing out for Berkshire?

Leitner: You can certainly worry yourself about that because you can say it’s been a long while, although this has been a very slow, gradual recovery, too. If you look at history, you might suggest that, if there is a correction, it’s going to be a long and slow one on the other end.

We’re not trying to predict the recession. We’re not trying to predict the direction of interest rates or even cap rates, for that matter. We think the outlook from a fundamental point of view is still very solid for multifamily. The owner-renter relationship has changed pretty dramatically over the last 10 years.

Hughes: Is that a real structural change within multifamily?

Leitner: I think it is. It can be debated, certainly, but when you look at the numbers, it’s very compelling. When you look at the underlying demographics and economic factors that I think are driving it, you’ve got a combination of lifestyle decision-making that’s affecting that—where household formation with children and the suburban, single-family home and school is happening later in a lot of people’s lives than it did 20 or 30 years ago. That keeps the rental-transitional cohort active in the market for longer. On the other side of the demographic curve, you’re getting a lot of empty-nest and downsizing.

Generally, yeah, we think that’s going to be an important driver for a while. I’m not a big believer in secular changes. I mean, we’re in a cyclical business in many ways, but the evidence is there that that’s pretty structural for a while. And that is good for our business.

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