Multifamily REITs are developing billions of dollars of projects in the face of dual threats that jeopardize several quarters of rent increases in most markets nationwide. Owners and builders of vacant single-family homes and condominiums are trying to rent their properties amid a housing glut that has created new competitive pressures on apartments. What's more, slowing job growth threatens to depress multifamily rental demand.

REIT executives and multifamily experts estimate that some 1 million new and existing excess units — 750,000 single-family homes and 250,000 condos — have been dumped into a for-rent housing pool that generally numbers around 13 million units.

The so-called “shadow market” is potentially most troublesome to REITs operating in Phoenix, Southern California, South Florida and other areas where single-family housing and condo construction ran amok for much of this decade.

Meanwhile, employment growth has hit a speed bump. U.S. non-farm payrolls increased by an average of 84,250 monthly in 2007, a 52% decline over the prior year's growth, according to the Bureau of Labor Statistics. The bureau estimates payrolls contracted by 17,000 in January 2008 — the first loss since mid-2003.

Convincing the skeptics

The wobbly economic climate hardly inspires praise for new construction. “At the present moment, development is not playing well with investors,” says Timothy Pire, a managing director of public real estate securities for Chicago-based Heitman. The real estate investment firm manages some $5.1 billion in real estate stocks, and as of mid-February its portfolio was underweight in multifamily REITs. “Investors think companies won't be able to lease up the properties and yields will come in lower.”

Multifamily REITs posted a 28% negative total return, which includes stock price performance plus dividend yield over the 12-month period ending Jan. 31. That was five percentage points worse than the total returns generated by all equity REITs during the same time period, according to the FTSE NAREIT US Real Estate Index.

Yet fundamentals remain strong. Apartment vacancy nationally fell 20 basis points to 5.6% at the end of 2007, according to New York-based Reis, a commercial real estate research firm. Meanwhile, effective rents grew 4.6% during the same period, the biggest increase since 2000.

REITs typically shoot for initial yields on development between 7% and 8%, which are higher than the approximate 5% yields on acquisitions. But some apartment REIT executives anticipate initial yields for new development shrinking as much as 100 basis points depending on the market and asset.

“In the big picture, there's more emphasis on the skill set of the developer,” says Alexander Goldfarb, a REIT analyst with UBS. Those skills include containing costs and leasing up projects in a timely manner. “We've seen a few developments go over budget, and those are concerning,” adds Goldfarb.

Navigating the glut

Major REITs developing today include Equity Residential, Camden Property Trust, and AvalonBay Communities, as well as BRE Properties. All told, those companies have recently completed or are constructing some 20,400 units.

That figure doesn't include billions of dollars of projects the REITs plan to start this year, although some companies are slowing development in anticipation of moderating rents. REITs are also pursuing dispositions to fund construction (see sidebar, p. 52).

Houston-based Camden, which owns 63,000 apartment units in 18 U.S. markets, completed five projects last year valued at about $280 million, including joint venture developments. The REIT still has nine under construction this year totaling some $653 million. Moving forward, Camden has $1.5 billion in projects in various planning stages.

But the REIT has delayed construction on two Florida properties, and Camden executives suspect that the shadow market is the reason for a 15% to 20% drop in customer traffic in Las Vegas, Phoenix and Orlando.

“This is pretty unprecedented,” says Richard Campo, chairman and CEO of Camden, referring to the housing glut. “How long does it take to absorb the excess housing supply and how deep does it really go? I don't think anybody really has the answer to that yet.”

Imperfect timing

Ultimately, the shadow market or the slowing economy, or both, could force REIT executives to accept lower rents than planned at new projects. But as REITs gravitate to major markets with high barriers to entry, they lack the luxury of picking the perfect time to build.

Case in point: Alexandria, Va.-based AvalonBay, which operates in 16 markets including New York, Washington, D.C. and San Francisco, can spend five or more years in the entitlement process on some locations. That puts the REIT at the mercy of whatever economic conditions exist when it finally completes a project.

Yet AvalonBay, one of the most ambitious developers with 7,914 units recently completed or under construction, operates in markets that largely escaped single-family home and condo building excesses. Still, company executives expect job growth to slow in most of its markets. Consequently, AvalonBay has pared its planned development starts this year by $300 million to $1 billion.

“It still makes sense to develop when you can get initial yields that approach 7%,” says Timothy Naughton, president of AvalonBay. “But to the extent that housing and capital markets change, we may alter our plans.”

The bright side

Despite the mammoth shadow market and recession worries, REIT executives and institutional investors are far from panicky. In fact, some see reasons to feel bullish about the future.

Home ownership rates hovered around 64% for decades before peaking at more than 69% in 2004, thanks to government-driven programs and friendly mortgage products. But the rate dipped to 67.8% in the fourth quarter last year, according to the U.S. Census Bureau, and every decline of 100 basis points translates into 1 million new renters.

REIT experts concede that some renters will gravitate toward single-family homes or condos available for rent. But a growing number of stories about renters being kicked out of foreclosed homes could quickly dull that alternative's luster. The California Apartment Association, for example, estimates that renters occupy 25% of single-family homes and condos in foreclosure.

Renters will avoid single-family homes and condos as more of those stories surface, suggests Michael Torres, CEO and portfolio manager of Adelante Capital Management, a $3.3 billion Oakland-based fund that primarily invests in REITs. “That's a clear advantage that REITs have over the private single-family owner who rents out his property,” he adds.

While 30-year fixed-mortgage interest rates of approximately 5.7% are still considered relatively low, home buyers face a tougher time getting loans without a decent credit history and money down. Thus, the same traditional apartment renter who got financing to buy a house a few years ago — and in all likelihood shouldn't have — won't be able to get a loan today.

Echo boomers between the ages of 18 and 24, another traditional renter group that took advantage of lax residential mortgage underwriting, also are returning to apartments, experts say. Moreover, falling home values have chilled home-buying enthusiasm. According to the National Association of Realtors, the average single-family home price in December 2007 fell 5% year-over-year to $254,900.

“The sharp downturn in the for-sale housing market is positive for the apartment market,” says Mark Obrinsky, chief economist with the National Multi Housing Council, a multifamily trade group based in Washington, D.C. “Even people who can get a loan don't feel any urgency about buying right now.”

Against that backdrop, development should provide apartment REITs with an opportunity to add value to their bottom lines. But REIT executives and investors alike hope shadow market competition, or a depressed job market, won't stall lease-ups and delay returns.

“Development is a great value-add proposition,” says Heitman's Pire. “It all makes sense … as long as markets are going your way.”
— Joe Gose is a Kansas City-based writer.

Apartment REITs Intent on Disposal

Executives of multifamily REITs plan to sell off chunks of their portfolios this year and use the proceeds to fund development, repurchase shares and pay down debt. That might sound Pollyannish to some market observers given the collapse of commercial property sales following the debt market fallout in August last year.

But multifamily investors have capital sources that office, industrial and retail buyers lack: Fannie Mae and Freddie Mac, the government- sponsored entities (GSEs) that buy multifamily loans. In fact, last year Fannie financed a record $60 billion in apartment deals, picking up the slack when liquidity virtually evaporated after conduit lenders bailed out of the market.

“We're certainly seeing a lot of interest in Fannie Mae executions again this year,” says Phil Weber, senior vice president of Fannie Mae's multifamily division.

Indeed, early this year, Denver-based UDR Inc. agreed to sell 25,684 units for $1.7 billion to joint-venture partners DRA Advisors and Steven D. Bell & Co.

The buyers tapped a Fannie-backed loan of some $1.35 billion with a term of seven years and an interest rate below 5%, according to Ed Harrington, president of Steven D. Bell. The Greensboro, N.C.-based real estate investment and management firm owns 34,000 apartment units, among other commercial properties. It has partnered with DRA, a New York-based real estate investment adviser, on other acquisitions.

“Clearly Fannie and Freddie are providing liquidity, which sets multifamily apart,” says Alexander Goldfarb, a REIT analyst with UBS.

The UDR sale should boost the confidence of REITs like Alexandria, Va.-based AvalonBay Communities. The company, which owns roughly 52,000 units in 16 markets, plans to sell upwards of $1 billion worth of properties in 2008. That's one-third more than the REIT typically sells in any given year.

Timothy Naughton, president of AvalonBay, acknowledges that plenty of buyers with access to capital are showing interest in the REIT's properties. But parties still have to agree on a figure. “We're pricing assets for the first time in several months,” he says. “The big question is whether cap rates are going to hold in 2009.”

Yet the ability of Fannie and Freddie to grease the sales skids has helped stabilize apartment prices while uncertainty surrounds prices of other property types, says Dan Fasulo, managing director of research for Real Capital Analytics, a New York-based commercial real estate research firm.

When condominium converters exited the market in 2006, the average price per unit for mid- and high-rise apartments dropped 33% to $150,000 before rebounding, reports Real Capital Analytics. “We've already seen a major correction,” Fasulo adds, which could help sustain apartment pricing, too.

In addition to funding some $1 billion in development this year, AvalonBay executives intend to use disposal proceeds to repurchase stock. In fact most REITs, which are generally trading at big discounts to net asset value, are pursuing the strategy to boost share price as well as earnings per share.

The practice allows REITs to take advantage of the spread between high prices it can fetch for assets from private buyers — a price that represents a 5% cap rate for example — and a lower price at which the public market values its shares, typically an implied cap rate of 6% or 7% for most REITs today.

“REITs are likely to be big sellers this year because they have incentive to take advantage of that arbitrage,” Naughton says. “Buying back shares is a more attractive use of capital than other alternatives such as one-off acquisitions.”
— Joe Gose