It took an earthquake to get Starpoint Properties into the acquisition/rehab business. And 11 years later, it looks like it was a fortunate break. On Jan. 17, 1994, two weeks after the Los Angeles-based investment company bought the Prairie Court apartment complex in Northridge, Calif., a temblor measuring 6.7 on the Richter Scale rolled through the area, damaging the property of more than 73 units.

The success at Prairie Court led to other earthquake-related projects, including Colfax Village Apartments, a half-vacant, 108-unit property in North Hollywood that Starpoint acquired in 1996. It spent $2 million to repair quake damage and make other improvements. In less than a year, occupancy jumped to 98% and monthly rents climbed 25% to $805. Annual net operating income ballooned 145% to more than $1 million.

Starpoint executives soon saw how the same formula could be applied profitably to all kinds of underperforming apartment assets — not just those that had suffered earthquake damage. Since then, Starpoint has acquired, improved and disposed of some $1 billion of multifamily assets, though it still owns Colfax Village and Prairie Court, now known as Prairie Villas.

“Ninety-five percent of the projects we buy have some type of rehab component,” says Paul Daneshrad, CEO of Starpoint. “We're taking Class C or D projects and turning them into Class B properties.”

Starpoint is one of a growing number of investors who seek enhanced returns by rehabbing rundown properties to command higher rents. The improvements can range from paint and landscaping to a total makeover. The players include private funds, institutions, wealthy individuals and real estate investment trusts.

The value-added strategy is hardly new. But the convergence of low interest rates, eager investment capital, an aging apartment base, and a modest slowdown in new apartment construction has intensified the activity. And, with prices soaring despite anemic rent growth in most markets, industrious investors are looking for bargains among the fixer-uppers.

But those are proving tougher to find: Prices of Class B and C properties climbed to more than $80,000 a unit last year, a 14% increase over 2002 and a 35% increase over 2001, according to Encino, Calif.-based Marcus & Millichap. “We have more players getting involved in acquisition/rehabs because it's so difficult to find decent yields on stabilized assets,” explains John Brownlee, senior managing director in the Dallas office of commercial mortgage intermediary Holliday Fenoglio Fowler. “Investors are trying to identify deals that have more upside potential.”

Rehabs have comprised 60% to 65% of all multifamily sales over the last five years, says Linwood Thompson, national director for Marcus & Millichap's Multi Housing Group in Atlanta. So, what's different now? Institutions are pouring more money into rehabs, whereas five years ago they focused on Class A product.

Marcus & Millichap was expected to broker $6.9 billion of multifamily product in 2004, up from $2.8 billion in 1999, says Thompson. “The best way to describe the market is that it's oversubscribed,” he says. “There are just more buyers than sellers, and it's been that way for three years.”

Rehabbers follow a proven formula: They identify and acquire underperforming middle-market properties, bring in new management, chase out problem tenants, and pour additional capital into the assets to spruce them up. The goals are to keep total investment 15% to 20% below replacement cost and achieve rent increases between 10% and 20%, while still offering tenants a cheap alternative to brand-new housing. These investors generally refinance or sell the assets within two to three years and, on average, can generate total returns of 14% to 16%.

Plenty of capital exists for buyers seeking value-added opportunities. Key Bank, for instance, typically makes two bridge loans on a project: one for about 75% of the acquisition cost and another for up to 85% of the renovation expense. The overall package is then underwritten at no more than 80% of a future value determined by a market study of rents and an appraisal, says Greg Rickard, senior vice president for Key Bank Real Estate Capital in Los Angeles.

“We'll look at these reposition financing opportunities all the time,” he says. “But we just make sure we don't go in and loan 95% of the cost of acquisition and get way ahead of ourselves before the investors even turn a single spade on the landscaping, or paint a single unit.”

Lucrative Lure

The potential financial gains from apartment rehabs are too good to ignore — and consequently the multifamily sector is attracting new players. About 18 months ago, Real Estate Partners, a real estate investment and management company that develops and rehabs industrial and office properties, jumped into the multifamily business. Today, the Irvine, Calif.-based company has amassed a 4,500-unit apartment portfolio valued at $250 million, chiefly by acquiring properties from apartment REITs that are shedding non-core assets.

In September, Real Estate Partners paid United Dominion Realty Trust $45 million for the 856-unit Terracina community in Phoenix, and is spending $7 million to rehab and reposition Terracina. Among the improvements: replacing the mid-'80s popcorn ceilings.

Thomas Thompson, president of Real Estate Partners, has hired veterans from multifamily REITs to find potential acquisitions in secondary markets, where “we aren't competing head-on with REITs and because we can acquire properties at a reasonable cost,” he says.

The company, which plans to hold properties for three to five years, expects rents to increase between 8.5% and 12% after rehabs. The firm also wants to see annual returns on its investment grow from about 9% immediately after acquisition to about 16% or 17%.

Class A Alternatives

Among the REITs pursuing the acquisition/rehab strategy is Home Properties, which has focused on rehabs for 10 years and owns or manages some 50,000 units in the Northeast and Mid-Atlantic. Faced with new competition from private investors using cheap debt, the Rochester, N.Y.-based REIT this year changed its financial formula. Its board approved a plan to increase the company's leverage, which historically has been about 40%. At the end of third-quarter 2004, Home Properties' debt had climbed to 44% of its market capitalization of $3.6 billion.

More REITs are likely to pursue the value-added strategy, believes Stephen Swett, an analyst with Wachovia Securities, because they have so few options for growth when cap rates for Class A properties hover around 5.5%. “In this environment, REITs can choose not to grow,” he says, “or they can find alternative ways to grow.”

United Dominion, a Denver-based REIT, has embarked on a two-pronged strategy to rehab its existing stock and pursue value-added opportunities in markets such as Florida, Washington, D.C. and California. Since 2002, the REIT has spent some $27.2 million on major kitchen and bath rehabs in its existing Class B portfolio, which has yielded total returns on investment ranging from 12% to 18%.

Meanwhile, a $1.6 million renovation of the 218-unit Taylor Place in Arlington, Va., which the company acquired in 2002 for $21 million, has helped boost monthly rent at the community by almost 22%, to $1,059, according to the company. Additionally, Taylor Place's net operating income increased 19.2%, to $1.4 million, about a year after United Dominion bought the property and began the rehab.

Some Markets Pose a Challenge

The supply of assets that are ripe for renovation is abundant. Across the country, the apartment stock is 35 years old on average, according to a 2000 report by the National Multi Housing Council. The report predicted that investors would pour $5 billion annually into apartment renovations between 2000 and 2010.

Still, there are few opportunities in markets such as Southern California. Even Class C properties in the region sell at cap rates of 5%, down from 8% five years ago, according to local investors. That's because the sector never experienced much of a regional slump, and value-added buyers plucked the low-hanging fruit between the mid-1990s and 2002. Starpoint's Daneshrad says his firm will review more than 500 to 1,000 potential deals today — compared with 30 deals five years ago — in order to find one that's worth pursuing.

Another obstacle: Many would-be apartment sellers over the last couple of years have refinanced with 10-year agency or conduit debt, which requires buyers to assume the loans or pay hefty yield-maintenance penalties for retiring the debt early, says Raymond Polverini, senior vice president of CT Realty Corp. in Newport Beach, Calif. Plus, the agency loans often are only 40% or 50% of the purchase price, which makes financing those projects more difficult because they require a larger stack of expensive capital, such as mezzanine debt or equity.

Indeed, the market conditions in Southern California have prompted CT Realty to lower its multifamily return expectations a couple of percentage points from what Polverini would only describe as the “high teens.” And, for the first time in more than a decade, the firm is looking to buy outside California.

San Diego-based Crown Pacific Properties formed a joint venture with a fund managed by AEW Capital Management about a year ago. The joint-venture partners are focusing on markets that are showing signs of a rebound, including Phoenix, Denver, Austin, Dallas, Seattle and the San Francisco Bay Area. Crown Pacific has acquired four Phoenix properties totaling some 1,500 units. In March, it paid $15 million for the 254-unit Camelback Towers, now known as Landmark Towers, and is undertaking a major renovation of the 40-year-old building.

John Ed Easley, president of Crown Pacific, says he expects rents to increase 10% to 20% across the portfolio as the company completes renovations. At Landmark Towers, however, rents have already jumped 25%. “In these markets, new apartment development has slowed way down,” Easley says. “And even with low cap rates, you can still buy a lot of properties under replacement cost, even after the renovations. So, it's still a pretty good investment story.”

Joe Gose is a Kansas City-based writer.

Proven Formula for Rehabs

Apartment owners often use a four-point plan for rehabs as this project in Phoenix shows:

Buy: →→→$42 million, 800-unit apartment property

Invest: →→→ $10 million rehabbing exterior and interior

Increase Rents: →→→ 10%

Flip Property: →→→ the same 800-unit property sold for $62 million within 36 months.