Art of the Deal

Joint venture possibilities proliferate as investor appetite for multifamily grows.

By Gary E. Mozer, George Smith Partners

Real estate investors—from institutions to individuals—are back, and they’re buying. The universe of investments on which these investors focus is expanding, and with such expansion, the relative value of this type of real estate is climbing. This combination of factors has resulted in a flood of investors attracted to the new risk-adjusted value of multifamily real estate over other investments.

The major changes in the current investment market have centered around the investors themselves, the assets that can now be financed, and the structure of the financing available. In both the debt and equity real estate capital markets, asset allocation models are now considering multifamily real estate to be a preferred asset class.

As a result, demand for investment opportunities is on the rise, paving the way for a broadened definition of the types of assets and markets that can now attract capital. The downturn of the U.S. housing market as a result of the Great Recession resulted in a surge for the multifamily market, and this market has been hot for new and experienced investors alike.

Despite the clear and robust increase in competition, we see no signs of this trend slowing in 2013, as the appetite for multifamily continues to grow.

It’s a more competitive game

In the past few years, commercial real estate professionals may have had 20 to 30 active institutional equity providers to joint venture a transaction, but today, we have over 100 with varying investment philosophies. As a result of real estate having such attractive cash-on-cash yields in today’s market, and real estate being a hard asset that has proven to be an inflation hedge, foreign capital, family offices and high-net worth investors are now finding themselves competing with opportunity/hedge funds, pension fund advisors and big institutions.

With so much competition for these profitable deals, new and old players alike must differentiate themselves in order to secure new investments. Investors are accomplishing this by specializing in particular aspects of a deal such as deal size, timing to close, cost of capital, structure, markets to which they are willing to go, or products in which they are willing to invest.

As the number of equity players entering the market continues to grow, the breadth of deals that investors are willing to secure will continue to expand.

Compromising on investment criteria

Only a year ago, investors had their sights set only on new apartments in core markets. This was due to the liquidity made available by Fannie Mae and Freddie Mac. However, over the past six months, George Smith Partners has placed over $100,000,000 of equity for uses such as apartment development, land to be re-entitled for apartment development, and the acquisition and repositioning of existing apartment product.

Outside of just compromising on the type of asset class, investors are now willing to compromise on virtually all aspects of a potential investment, provided the overall risk-adjusted return is appropriate. Investors are now stretching the acceptable asset quality and market size threshold for their investments, as well as investing in smaller deals.

This is the result of lowered yields that have been driven down by increased competition in core markets, forcing investors to expand their investment criteria in order to achieve the double-digit returns they desire. Joint venture investors are even willing to partner with sponsors who have less than perfect credit or other issues as a result of the downturn.  

Finance structure is changing

Along with all the changes in the equity market, compression of the Internal Rate of Return (IRR) has also occurred. Many investors that may have only accepted an investment with an IRR in excess of 20 percent are now accepting a return in only the mid- to high-teens. Yield is a fundamental function of risk, and as such, the type of investment commanding a 20 percent-plus return often carries more risk than most investors can stomach. Today’s deals projecting a 20 percent potential return are now yielding either 30 percent or mere single-digit returns, and the high standard deviation proves too risky for most investors.

Investors are now also trading upside for downside protection. Many times, a sponsor and an investor have different views on inflation and exit values. As a result of these two factors, we have found that if we allocate more of the return earlier in the waterfall, the investor will allow for a super promote in the last hurdle. Investors are recognizing the value created by a sponsor holding an asset with super promotes. The increased number of market players, combined with these innovative finance structures, has resulted in a broader scope of offerings from equity investors.

Key elements for sponsors to consider     

Despite uncertainty about the robustness of demand because of macro fundamentals, the addition of new investors and an increasing scope of product eligible for investment confirms that the market shows no signs of slowing. Investors have nuanced characteristics that need to be understood to get the best execution. A sponsor needs to be able to navigate industry terminology, the life cycles of funds, and the investor’s investment universe in order to be successful. Metrics such as the Internal Rate of Return (IRR), profit multiples, and the spread between the stable return on cost and the exit capitalization rate are benchmark indicators. Also, deals are structured in terms of senior and subordinate co-investment and look-back versus catch-up IRR’s, and a sponsor needs to understand the implications of these structures on returns.

Additionally, the timing of an investment relative to the investment period of a fund can influence the characteristics of an investor. For example, a fund at the end of its investment period that is in the process of raising its next fund will tend to be more conservative in evaluating potential opportunities. This is because these deals will be viewed as representative of the fund’s investment philosophy. Also, the term of a potential investment comes into play because it may allow the fund to invest the allocated capital more than once during the fund’s life cycle.

Finally, the opportunity cost of investing in a particular deal now factors into an investor’s decision-making process. Family offices are presented with opportunities daily, and staffing constraints often lead them to focus on particular niches in order to be efficient. Hedge funds have larger staffs, but the relative yield of a real estate investment versus other asset classes, such as distressed European debt or commodities, changes on any given day.

Navigating these new waters can be tricky with so many options available in today’s market. Being equipped with both the market knowledge needed and a solid financial intermediary partner can make a world of difference. With flexible terms and an investor out there for every type of deal, now is the time for property owners, developers and investors to make the leap into the market and secure equity for their multifamily deals.

Gary E. Mozer is principal and managing director of George Smith Partners. 

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