There's no question that apartments remain a hot commodity thanks to improving fundamentals and available financing. But rising prices and a limited supply of for-sale properties are starting to dampen investor interest.

In 2010, apartments dominated the acquisitions of Dallas-based Invesco Real Estate, representing more than half of its total property buys. The institutional investor estimates it spent $825 million on apartment properties last year. Its portfolio now boasts such pricey assets as the $125 million Metropolitan in Arlington, Va. and the $73.6 million Concord Park at Russett in Laurel, Md.

But Invesco plans to alter its strategy this year and take a more cautious approach toward apartments as bidding for top properties turns “painful,” says Greg Kraus, senior director of acquisitions at Invesco. The company will strengthen its investment in property types other than apartments.

“We think the capital markets have taken some of the steam out of the return expectations,” in the multifamily segment, notes Kraus. “We think that we are beginning to see better relative values heading into 2011 in some of the other commercial property sectors.”

Although the availability of low-cost capital is taking the sting out of current pricing, the intense competition has driven up values and affected yields. “We are starting to see property trade above replacement cost now,” says Kraus. “We think that is a signal to be cautious in how far we are willing to price an asset.”

Invesco bought the Metropolitan in Arlington, Va. in the third quarter of 2010 for $125 million at a 5% capitalization rate, the initial return based on the purchase price and annual net operating income of the asset. Invesco felt the price was justified because the property is a well-located trophy asset.

“We bought at 15% to 20% below replacement cost and we don't see any near-term competition,” says Kraus. Because the property was 100% occupied and the neighboring market was 98% full, rents have room to grow amid healthy demand, he adds.

Recovery ignites investment

The hot investment sales market isn't limited to trophy properties in top markets. Demand runs the gamut across Class-A, B and even well-located C properties in primary, secondary and tertiary markets. Buyers also are showing a strong appetite for specific niches ranging from urban high-rise units to seniors housing and student housing projects.

“People believe that over the next 36 months the overall fundamentals are going to be very good in terms of occupancy and percentage rent increases,” says Sean Deasy, co-head of the national multihousing investment sales group in the Irvine, Calif. office of financial intermediary Holliday Fenoglio Fowler.

Nationally, the net absorption for apartments in the first three quarters of 2010 reached 167,000 units compared with negative absorption of 2,781 units in 2009. Meanwhile, the vacancy rate fell to 7.1% in the third quarter. That's down from 7.9% a year earlier, reports New York-based Reis.

The average effective rent also shows positive growth over the past year, rising 1.6% from $964 per unit in 2009 to $980 in the third quarter of 2010, according to Reis. Some property owners are experiencing an even bigger jump in net effective rents. Owners in suburban Chicago, for example, reported 7% to 10% net effective rent growth during the first three quarters of 2010.

Also, new supply is extremely limited due to the lack of new construction in almost every major market. The number of apartment units completed during the first three quarters of 2010 totaled 79,653, down about 42% from the 137,068 units built in 2009, according to Reis.

Capital is available

Compared with other property types, the apartment sector is flush with cash. Buyers from large institutions to small private investors are finding ample sources of both debt and equity. “Up until mid-summer, apartments represented about 90% of the liquidity in the market,” says Thomas Dennard, CEO of Grandbridge Real Estate Capital in Charlotte, N.C.

Continued lending from government-sponsored enterprises Fannie Mae, Freddie Mac as well as the Federal Housing Authority helped to prop up the apartment sector through the downturn. In fact, the three entities were virtually the only active real estate lenders in the first half of 2010.

Life insurance companies returned to the table around mid-year, and even CMBS lenders have shown interest in multifamily lending, although it is difficult to compete with the rates Fannie and Freddie are offering, says Dennard.

As capital markets thaw, financing is trickling to more property sectors. Still, multifamily continues to dominate the industry in terms of available financing. Grandbridge estimates that it arranged roughly $3.3 billion in new loans in 2010, with multifamily accounting for more than 60% of that volume.

Equity also is flowing toward experienced apartment investors and operators. Apartment REITs top the list of successful buyers thanks to a strong showing on Wall Street. Total returns for 2010 through Dec. 16 were 40%, according to the National Association of Real Estate Investment Trusts.

Palo Alto, Calif.-based Essex Property Trust purchased 13 properties in 2010 valued at $650 million, more than double the $300 million the REIT had expected to invest for the year. Despite the competition in the market, Essex has been able to find great opportunities that range from bulk condominium deals to apartment developments that were not fully complete.

In late September, Essex purchased the Muse, a 152-unit community under development located in the North Hollywood Arts District of Los Angeles for $39.1 million. The Muse was roughly 97% complete at the time of purchase. Essex has since completed construction and has just started lease-up.

“We are finding opportunities with what I would call motivated sellers as opposed to distressed sellers,” says Craig Zimmerman, executive vice president of acquisitions at Essex Property Trust.

Battling stiff competition

The surge in demand for apartments has provided a welcome boost to investment transactions in the past year. During the first three quarters of 2010, apartment sales totaled nearly $19 billion — more than double the $9.4 billion in apartments that sold during the same period in 2009. However, most of that increase was due to rising prices.

The gain related to the number of properties that changed hands was a more modest 26% with 931 properties sold in 2010 compared with the 691 transactions that occurred during the first three quarters of 2009, according to data from New York-based Real Capital Analytics. The firm tracks property sales valued greater than $5 million.

The increase in dollar volume comes as no surprise as competition and short supply push prices higher. Cap rates have compressed 75 to 125 basis points over the past 12 to 18 months. “Deals are being competitively bid at every point, and I expect the same thing for next year,” says Zimmerman.

On the West Coast, the highest-quality apartments are selling for cap rates ranging from 4.5% to 4.75%, while Class-B properties in optimal locations sell at cap rates of 5% to 5.5%, Zimmerman adds. According to CoStar, cap rates on all apartment transactions averaged 6.9% in the third quarter, a decline of 80 basis points from a year earlier.

Value-added opportunities

As cash-on-cash yields for trophy assets have dropped to 4% to 7%, some investors are targeting value-added opportunities to boost yields. These are assets that can be purchased at a discount that can either be renovated or repositioned.

“There are tremendous opportunities to acquire assets at very, very attractive prices that are going to create either tremendous long-term appreciation or produce tremendous yield today — and in many cases both,” says Matt Lester, founder and president of Princeton Enterprises LLC, a real estate investment and management company based in Orchard Lake, Mich.

Princeton is targeting Class-B and B- assets that do not have downside risk such as obsolescence, poor layout or poor location. The firm is looking to achieve cash-on-cash returns in double digits, and in some cases is forecasting as much as a 15% yield starting on day one.

Princeton also is finding opportunities to buy higher-quality B+ assets at attractive prices. Its recent purchase of Chimney's of Oak Creek Apartments in Kettering, Ohio is an example. The asset had gone back to the lender and was being marketed by special servicer ING.

Princeton assumed the $9.7 million loan on the property, and brought another $1.5 million to the table for capital expenditures. The property had an 83% occupancy rate that was trending higher. By December 2010, Chimney's reached 89% occupancy and is expected to cross the 90% threshold in 2011.

Princeton soon will be able to reduce the aggressive discounts set by the receiver. “It isn't going to be a screaming large yield right out of the box, but it will be close to 10%,” says Lester.

Low-cost capital fuels deals

The low financing rates are expected to drive more deals in the coming months. Before December, borrowers could finance a multifamily transaction with a 10-year loan at a 5.25% interest rate.

Borrowers seeking modest loan-to-value loans were able to find even more favorable pricing with rates below 5%. “I've been in the business since 1978, and I've never seen rates that low ever,” says Dennard. Rates on a comparable loan three years ago were close to 7%.

Although the 10-year Treasury yield jumped about 80 basis points to 3.3% in mid-December, rates remain at historic low levels. And borrowers can still find Fannie, Freddie and FHA loans at loan-to-value ratios ranging from 75% to 80%. Even some life companies lend up to 75% to strong borrowers.

Rising sale prices and speculation that interest rates will rise this year are expected to drive more sales. “We have seen velocity pick up dramatically during the second half of 2010. We also are seeing an influx right now of additional RFPs [request for proposals] and deal flow that will likely hit the street in first quarter,” says Deasy of Holliday Fenoglio Fowler.

Buyer demand for apartments is expected to remain high, says Lester of Princeton Enterprises. “I think a lot of buyers are going to look back on 2011 and be very, very happy with what they acquired as long as they avoid those difficult pitfalls of buying something that just doesn't work and doesn't have a future.”

Construction Plans Come Out of Hibernation

Apartment developers are setting their sights on new construction as the property sector begins to post gains in occupancies and rents. Denver-based UDR, one of the largest apartment REITs in the country, has four new projects in the pipeline, including the $43.1 million Lodge at Stoughton. The 240-unit development in Stoughton, Mass. is slated for completion in the fourth quarter of 2012.

Favorable market fundamentals, positive demographic trends, and a growing pool of renters are contributing to UDR's decision to pursue development plans. “All of those factors make us believe that new construction is warranted in the current market, given that you have a clear plan in place and have access to sufficient capital,” says UDR president and CEO Thomas Toomey.

Developers prudently put the brakes on new building as the industry worked to absorb the overhang of vacant space. The sector reported several quarters of negative absorption with vacancies climbing to 8% in 2009, reports Reis.

With rising vacancies, falling rents and a lending freeze, it's no wonder new construction stalled. In the first three quarters of 2010, just 79,653 apartment units were completed, down 42% from the 137,068 units built in 2009, notes Reis. Limited new supply is expected to foster improving fundamentals.

Will developers be able to secure financing? Specialists, such as developers of student and seniors housing, will likely find an easier time accessing capital than market-rate builders.

“The lending community doesn't really have tremendous appetite for putting construction loans on their books right now, whether the fundamentals support it or not,” says Greg Kraus, senior director of acquisitions at Dallas-based Invesco Real Estate. “That is going to mute near-term supply and continue to drive fundamentals.”

Banks with strong balance sheets are more likely to lend for new projects, particularly student and seniors housing. “Local colleges and universities virtually everywhere in the country are burgeoning, and they have no money to build more dorms,” says Thomas Dennard, CEO of Grandbridge Real Estate Capital in Charlotte, N.C. “So the private sector has been filling in and building units.”

Minnetonka, Minn.-based Opus Development Corp. plans to complete the 120-unit Stadium Village Flats near the University of Minnesota in 2012. “Going forward, market-rate apartment development will be more spotty,” says Dennard, “but I do think we will see more signs of that in the first quarter.”

Beth Mattson-Teig is based in Minneapolis