Guest Blog with Lili Dunn: Lights, Camera… Where’s the action?

After essentially shutting down since the fall of 2008, the real estate transaction market is starting to show some signs of life. According to Real Capital Analytics (RCA), a leading real estate data provider, July marked the first consecutive gain in transaction volume in seven quarters. Yet sales volume is barely 10 percent of the market peak in the first half of 2007. Why so slow?

Considering the events of the past year and the front page media headlines, one would think there would be many distressed apartment asset sales–but surprisingly, that’s not the case. Banks have been recapitalized and appear motivated to restructure debt/ownership positions rather than foreclose, realize a loss, inherit operational burdens and, potentially, affect capital/regulatory requirements. As a result, they tend to be in a “pretend and extend” phase. Many distressed assets also have complicated layers of equity and financing, requiring consents from several investors with conflicting investment objectives. Underscoring this, per RCA, less than 10 percent of the distressed situations that have emerged have actually been resolved.

In most cases, deals are being brought to market by partnerships, institutions or insurance companies that are looking to bolster liquidity or lower exposure to real estate. The majority of the buyers are smaller private investors/regional companies. Many of the investors are i) entrepreneurs who were active outside of real estate; ii) foreign buyers looking for a relatively stable investment; or iii) seasoned owners/funds that were previously active in other real estate sectors. Buyers seem to be most focused on high quality locations and assets with low operating risk as well as an attractive discount to replacement cost and cash-on-cash yield. On top of this, smaller assets ($10 – $50 million) that can potentially limit exposure and risk seem to be attracting the most attention; according to RCA, the average apartment deal sold this year is roughly $20 million. Unlike other real estate sectors, ample financing from the GSEs and positive leverage have helped to support apartment pricing. Although cap rates have increased 150-200 bp (values down 25 percent-40 percent) since the market peak, the rate of change is decreasing but there is still a lot of pricing discovery and equity remains volatile.

In May, AVB completed the first REIT deal of the year, when we acquired Verona Apartments for $33.1M (or $150,000 per home) on behalf of our Fund. The property, built in 1994, comprises of 220 homes and is located in downtown Bellevue, Wash. The price reflects a discount of approximately 45 percent below estimated replacement cost and a 200 bp increase over a sale AVB completed in Seattle less than one year ago. Given that AVB manages over 1000 apartments in Bellevue, Verona will benefit from the company’s deep local knowledge, established management platform and economies of scale. In addition, there is potential to reposition the asset through additional physical upgrades as the market strengthens.

We’re still early in the revaluation process but the market appears to be firming again and confidence is re-emerging. Uncertainty can bring tremendous opportunity for buyers with strong reputations, extensive track records and discretionary equity. Assuming short-term operating weakness is underwritten, now may be an ideal time to secure high quality assets at relatively attractive risk adjusted returns that should be well positioned to take advantage of strong fundamentals once the market recovers.

(Lili Dunn is the senior vice president of investments for AvalonBay.)