Will it be smooth sailing for the apartment sector or is it about to hit some rough seas?

Jeffrey I. Friedman, chairman, president and CEO of Associated Estates, a multifamily REIT based in Richmond Heights, Ohio, took time to chat with REIT Insider, sharing his thoughts on weak job growth, future apartment demand, cap rates, potential overbuilding and REIT valuations.

Friedman has a unique perspective since Associated Estates is the smallest apartment REIT in the U.S. and also boasts a significant presence in the Midwest, a region that doesn’t get much attention from other apartment REITs. The REIT is focused on both acquisition and development, and as a result, Friedman is tracking closely cap rate compression and new unit permitting.

Friedman has been involved in the real estate business since 1969, joined Associated Estates in 1974 and took over as chairman and CEO in 1993. Today, the REIT’s portfolio consists of 54 properties containing 13,835 units across 10 states.

An edited transcript follows.

REIT Insider: Everyone always talks about job creation as the demand driver for the apartment market, but you’ve been pretty vocal that household formation is more important. Can you explain your perspective?

Friedman: There’s a bit of misconception that what is going on in the job market drives demand for the apartment market. That’s not true—household formation drives apartment demand. What is going on in the job market impacts our ability to raise rents.

We’ve had five years of increased household formation and an increase in the number of people who are most likely to rent—the 21 to 35-year-old cohort group. And the number of renters is at an all-time high. At the same time, homeownership rates are declining. So basically, demand will continue to be strong.

REIT Insider: It sounds like apartment owners should be really happy right now. Are they going to be happy for much longer?

Friedman: Typically we’ve seen three-year cycles in the apartment sector. In our view, the downcycle ended in 2010, and 2011 was the first year of the upcycle. We actually think this upcycle will be longer, but of course we don’t know how long. We do expect the fundamentals will continue beyond 2014.

REIT Insider: Without question, the investment sales market has heated up, and cap rates have been driven down across the U.S. There’s now talk about a multifamily bubble since these cap rates are similar to those seen at the height of the market. What are you seeing?

Friedman: We recently sold a property in Atlanta, and we thought we got a really good price with a low cap rate. At the same time, the buyer thought they got a great buy. It all comes down to rent assumptions—you have to make sure to be realistic about growth assumptions.

And frankly, you won’t know for five to seven years if you made a good deal or a great deal. But it’s clear to me that even at low cap rates, these assets are still trading at or below what it could cost to build them new. We are selective buyers in a measured way, and there are still good opportunities to buy. We think what we are buying today represents good value and many are hard to replicate.

REIT Insider: Associated Estates tripled its market cap in 2010 by issuing equity and acquiring a number of assets at a time when many other REITs were struggling just to stay afloat. How did you achieve that?

Friedman: Our ability to grow over the past couple of years is driven by the capital allocation decisions we made in 2005 and 2006. It’s not like we had some crystal ball and could see the future, but we saw that prices were frothy, and we decided to sell. We ended up selling at peak prices, and we took those proceeds and got our balance sheet in order by paying down debt, and we also bought back stock. We improved our balance sheet to position ourselves to be able to grow, and we bought at very low prices.

REIT Insider: Multifamily is just about the only real estate sector where any development is occurring. What are your thoughts on the new supply—are we getting to a place where overbuilding is a concern?

Friedman: No, I don’t think so. The supply-demand environment as it relates to expected permitting in the U.S. continues to be in equilibrium. There are certain markets and submarkets where oversupply could be a problem if all the planned projects get built, but it’s my bet that they won’t.

The banks and the borrowers are much more efficient today, and most of the developers have a very focused approach to where they develop. I think you have to boil it down to the submarket. For example, we have plans to build a 250-unit project in the Uptown submarket of Dallas. That submarket is seeing very few permits so we feel good about it. But the Dallas-Fort Worth MSA looks like it has a lot of potential permits and development activity, so again, it’s about the specific submarket.

REIT Insider: Apartment REITs have been among the top performers in the REIT sector, and investors have paid attention to the point where some are trading above their NAV. What are your thoughts on that?

Friedman: We see a lot of runway left for apartments, and that’s why we believe the current valuations for apartment REITs are merited. With that said, I want to point out that Associated Estates is actually trading at a discount to our NAV.

We’re the smallest apartment REIT, and there’s a discount associated with less liquidity. And, we’re the only publically-traded REIT with a significant presence in the Midwest, and investors don’t place the same multiple on the Midwest that they do on some of the faster growing markets. But, our Midwest portfolio has been our strongest performing region because there hasn’t been any new supply for a long time in our submarkets. And for us, through the end of 2011 over a 5-year period, we had the number one total shareholder return of all 12 apartment REITs.