Going for the Gold

What do institutional investors want when they buy apartments?

Institutions that pool large amounts of capital to invest in multifamily and have a fiduciary responsibility to their investors are major players in the multifamily investment sale market. Accordingly, it helps to understand what they seek when they are buying apartments.

Although this is late in the apartment investment cycle, and prices are sky-high in the gateway cities, institutions—such as pension funds, insurance companies, investment advisors and even huge private equity funds—are still seeking product; and, in many top markets, there remains a dearth of sellers. “I would generally say most institutional investors think the multifamily market has entered a ‘mature’ part of the investment cycle,” agrees Brian Ward, president of Capital Markets, Americas, at Colliers International.

However, Ward says that institutional capital is still interested in acquiring apartment assets, albeit with a different thought pattern at this stage. “This does not mean that they won’t invest in multifamily as robustly as in the past three years, but they may be altering their strategy towards a longer-term hold, reduced debt leverage, etc.”

Institutions remain one of the leading investors in multifamily housing today. Data-reporting members of the National Council of Real Estate Fiduciaries, primarily pensions and insurance companies, owned about $350 billion in commercial real estate (about 25 percent in multifamily) in 2013. This number has increased since 2009, and compares to $284 billion in 2011. Data from CoStar Groups’s Property and Portfolio Research shows, though, that investment managers were net sellers of multifamily ($9.89 billion) in 2013, for the first time since 2009, while developers/owners and REITs remained net buyers of multifamily properties.

Benefits of selling to institutions

Nevertheless, for sellers who are exploring their options, there are various advantages of selling to institutions. Certainty of closing is one of the top-cited benefits. Some say another advantage of selling to these organizations is their strong net worth and ability to pay top dollar-—or to bid higher prices to separate themselves from other buyers. Non-institutional, smaller, players have “sharper pencils,” and may be strict with underwriting, says Marv Pearlstein, partner, Real Estate & Land Use, at the law firm of Manatt, Phelps & Phillips, LLP. On the other hand, institutions are not any less exacting in underwriting—“they are very thorough and ask good questions,” says Pearlstein. “If there are issues big or small, they are going to find them.” However, because of their lower cost of capital, the insurance-company or pension-fund buyers can be “a bit more flexible” in paying a higher price if need be: “What’s rounding for an institutional buyer may not be to the non-institutional buyer,” says Pearlstein.

“Institutional capital constitute well-capitalized buyers. They do not have to depend on raising capital or finding capital partners or arranging financing. The typical institutional buyer has the capital to fund the acquisition using its own balance sheet. There is therefore less uncertainty regarding whether they can arrange that capital, and they can close pretty quickly,” says Pearlstein. Moreover, “because they tend to favor the larger-size transactions, which require [a large amount of] equity, it is much easier for institutions than smaller buyers to purchase those properties,” says Marc deBaptiste, founder and principal of ARA Real Estate Investment Services.

From the institutions’ point of view, apartments represent a highly desired investment on a risk-adjusted basis. Multifamily has become a much more widely accepted institutional investment class, Ward points out. “Everyone is reading the same data,” and the research shows that apartment supply-and-demand balance in the apartment market is strongly positive in the long-term. The multifamily asset class has now become “a key component of long-term investment strategy” for institutions, Ward says. In today’s market, they are targeting IRRs, on an unleveraged basis, of 6 to 7 percent for “best of class” product, says deBaptiste. This  translates to cap rates as low as the mid-4 percent to 5 percent.

Still going for the top

For the most part, institutional players remain fairly conservative in their underwriting, and quite risk-adverse, says deBaptiste. As such, institutions continue to target top-of-the-line quality multifamily assets: Class A properties in the top markets, especially the gateway cities and or coastal markets. “From the risk standpoint, risk is mitigated by targeting the newest and the best properties,” explains deBaptiste. Class A apartments tend to be the most popular with tenants and achieve the highest rents. Also, newer properties involve less risk from a capital improvement standpoint.

The majority of ARA’s institutional clients are seeking “best-in-class, Class A, core properties,” says deBaptiste. Because of the sheer volume of capital these buyers have to put out, they seek properties of at least 300 units, but they are willing to lower their size requirements as necessary in order to access opportunities in the urban marketplace, notes deBaptiste. Institutions target properties that have little need for capital improvements, and generally may avoid properties with functional obsolescences that cannot be easily corrected, deBaptiste observes. An example is ceiling heights lower than 9 feet.

Institutional investors are “generally focused on newer product and coastal markets,” agrees Ward. But they have also expanded their investments beyond the gateway markets in their search for products and yields, he suggests. In addition to New York, Washington, D.C., San Francisco/the Bay Area, Boston and Chicago, preferred markets today include Seattle, Southern California, Denver, Dallas, Houston, Atlanta and South Florida, notes Ward.

More aggressive, value-add, plays

While Class A apartments are traditionally the focus of the well-capitalized institutional investors, many of these investors, says deBaptiste, are now also allocating investment dollars for multifamily value-add opportunities. The core portfolio provides steady returns, whereas value-add investments feature higher risk, but also higher returns. Indeed, affirms Pearlstein, the interest in higher-yielding plays is currently very high. “All of our clients who develop and invest are very interested in development opportunities,” says Pearlstein. “The value proposition is more easily found in rehab and repositioning play involving value creation.”

In these value-add buys, institutions, often via developer partners, will target apartments of not older than 1990s vintage that offer opportunities for value increases, says deBaptiste. The most popular segment of the value-add market with institutions tend to be the one requiring capital expenditures of not more than $3,000 to $7,000 per unit. Typically, these investments can involve modifications in the unit kitchens and bathrooms, and plumbing and electrical modifications, as well as clubhouse and fitness center facelifts. If the location is “ideal and irreplaceable,” the investor would look to even older properties that require a more extensive rehabilitation budget, adds deBaptiste.

Institutional due diligence

“The best way to prepare for sale to an institution is to analyze the transaction as [the institution] would,” advised Ward. “This means understanding every detail of the asset that will drive their investment process.” Rent roll, asset features, market conditions, exit strategies and investment returns are all key elements of what institutions will examine.

As far as investment returns analysis, Ward advises that institutions are now focusing not only on IRR: “They are also interested in what their return on investment is, from both a total dollar profit and profit multiple perspective.” Generally, these buyers would analyze what are both their leveraged and the non-leveraged returns, “using both low- and high-debt leverage scenarios.” Ward points out that today, institutions may prefer their returns to be derived primarily from rental income. “They are also keenly interested in breaking down their total return into returns from cash flow and returns from sale. The more they can derive total return from cash flows, the better because it mitigates exit risk.”

Institutional investors usually run three scenarios for each investment: “optimistic, base case or most probably, and pessimistic.” According to Ward, “It is critical that each optimistic sales assumption be tested with a pessimistic one to understand how an institutional investor will evaluate the risk in the deal.” Ward adds, “Sensitize changes in assumptions: Every investor will want to understand how changes in the key assumptions will impact their investment.”

Ward says the exit strategy is usually the first question that an institution will consider. They will ask: how will they exit; will conditions be conducive to exit; and are there multiple exit strategies? As far as rent rolls, the institutional property buyer will seek to understand: the tenant composition, rollover, current and historical vacancy and occupancy trends, collection loss, employment mix and opportunities for wage growth, says Ward.

And he suggests sellers can be sure that institutional investor due diligence will also include the close examination of asset features such as: property visibility, deferred maintenance, historical trends for maintenance and reserves and immediate capital needs. Institutional investors will also be mindful of market features including existing and new supply, barriers to entry, access to employment and transportation, and sales comparables.

Pre-existing issues 

Pearlstein maintains that the larger institutional investors will also be seeking investments that are free of unresolved litigation, disputes, or issues with local authorities. These overhanging issues will cause the buyer to apply a discount to the value of the property, he says. “Institutional capital wants to come in and not inherit problems that pre-existed… Sellers who want to attract as much competition as possible should make their properties clean in that regard.” Ultimately, it is worth more for the owner to spend the time and money to clear the issues than to pass them on. “It behooves the owner to rectify unresolved issues because they will realize more from the sale of the asset,” he says.

Pearlstein cites as example a fully tenanted, “lovely” asset that was located in a market with strong indicators. However, the property had an ongoing dispute with the city about whether it was required to provide affordable units. “These issues should be cleared up before the property goes to market,” he says. In another example, the owner of a busted condominium property decided to try to buy back —even at premium-—the few condo units that were sold in order to be able to be able to offer a 100-percent-apartment rental property.

It’s thanks to the institutional player and their standards and requirements that the apartment industry has become more transparent and sophisticated. “The institutional buyer,” says deBaptiste, “has continued to elevate the industry.”