Q&A with Sares Regis Group’s Kenneth Gladstein

Kenneth Gladstein, senior vice president of investments at Sares Regis Group, shares insights about the impact of renter psychology.

A multifamily investor, developer and manager with regional offices in Irvine, San Mateo and Ventura, California and Seattle and Denver, Sares Regis Group owns and operates a portfolio of about 14,000 apartments throughout the Western United States. Sares Regis has traditionally invested in joint ventures with major institutional partners and investors such as CIGNA, J.P. Morgan Investment Management, Blackrock, and a host of others. Currently the company is aggressively pursuing a number of acquisitions in the multifamily space, with the focus on value-add transactions.

Sares Regis is also in the market raising money from various institutional investors, pension funds, endowments and high net worth investor platforms for the Sares Regis Group Western States Multifamily Fund, which is targeted to the type of business conducted by the company for the past 20 years—investing in core-plus to value-add multifamily properties in the key Western states and predominantly California. Sares Regis is focused in the coastal markets in both Northern and Southern California and the Pacific Northwest because of the continued imbalance between supply and demand for apartments and the significant barriers to entry in those markets. From a broader perspective, due to favorable demographic changes that will positively affect the sector, the firm believes it’s a great time to be acquiring multifamily properties.

At the end of October, Sares Regis Group, along with its partner, CIGNA Realty Investors (CREI), closed the sale of Bella Villagio Apartments, a 231-unit luxury apartment community located in San Jose, Calif. The property was sold for $54 million to Essex Property Trust, for a significant profit only 15 months after it was acquired. MHN Editor-in-Chief Diana Mosher recently interviewed Kenneth Gladstein, senior vice president of investments, who oversees all of Sares Regis’ acquisitions of multifamily product for Northern California and the Pacific Northwest.

MHN: Tell our readers about the disposition of Bella Villagio Apartments. How did you achieve this quick turnaround, and what insights about the market does this reveal?

Gladstein: We did not intend as part of the original business plan to sell the asset as quickly as we did. We were one of the few investors able and willing to step in and close on investment property during the first half of 2009. There were very few transactions occurring in the latter half of 2008 and early 2009 for a number of reasons including that the market was in a tailspin because of the collapse of Lehman Brothers and the credit markets seizing up. So there were very few data points for investors to comp. Sares Regis was one of the few companies willing to underwrite, commit and get a transaction closed at that time.

I think we made a very good buy [with Bella Villagio Apartments], and we were rewarded for it in that we acquired the property at a very attractive basis relative to where it was valued two years earlier and versus its replacement cost. Our goal was to hold the property until rents and market cap rates improved; and there were eight years remaining on an existing FNMA loan, which provided us adequate time to realize a higher valuation. We also felt the current rents being obtained by the seller were below where they should be relative the property’s competitive set, so our goal was to move them to a market level and complete some minor deferred maintenance on the property to improve its image. We believed that there would come a time over the next several years when we would be able to exit our investment at a much higher value. The property was intrinsically worth substantially more than we paid, and we were confident we’d be able to realize that.

This ended up happening sooner than we thought. Number one, we were able to immediately achieve the higher rents we thought we could achieve versus the competitive set; and, number two, beginning in early 2010, we began seeing overall rents in the San Jose submarket increase. The movement itself was not a surprise as rents were probably down 20 percent to 30 percent from their peak in the fall of 2008 and we felt rents were going to do better. There are a lot of intrinsic reasons why rents should improve over the next few years, including demographics and immigration and a lack of supply. What we didn’t see at the time was the job growth that tends to fuel really strong rent growth, but clearly renter psychology had changed. People were more comfortable with the economy and where it might be going. And I think that helped create more demand for apartments on the part of young adults moving out from [their parents’] home and decoupling from roommate situations. That helped push the rents in advance of the job growth and we believe it should lead to further rent growth in the markets where we operate.

Ultimately it was a combination of the higher rents and revenue we were able to achieve at the property along with the strong investor demand that pushed capitalization rates lower throughout the early part of 2010 that led to an increase in the property’s value. The decrease in cap rates was fueled by several factors including borrowing costs that had moved significantly lower due to the availability of cheaper debt from Fannie and Freddie, private and institutional investors coming back in the market, and a dearth of properties that were being marketed and sold. As any owner/asset manager does, we evaluated where we were in terms of our original business plan and what might happen going forward—and a decision was made to take advantage of the favorable market conditions and to list the property for sale.

MHN: What else have you been working on, and what are some of the company’s long-term strategic goals?

Gladstein: As a vertically integrated firm, we have experienced investment, development, property management and construction divisions. Within our Investment Division we are always leveraging our firm’s core competencies to reposition existing assets and achieve higher revenue and value. Historically that’s mostly been through our acquiring B-quality properties and repositioning them—bringing in our professional management, as well as by physically improving the unit interiors, common areas and amenities, and addressing issues of deferred maintenance—all with an eye to achieving an attractive return on cost for our investment and adding value to the asset.

We’re also pursuing distressed opportunities in our markets, and distressed means both owner distress as well as asset distress. Owner distress might come in the form of liquidity needs unrelated to the asset itself and an owners need to raise cash through a sale. Other forms of owner distress could arise from a loan maturity issue whereby the owner is unable to contribute new equity to rebalance the loan that may be overleveraged based on today’s underwriting. In both those instances, the asset may be a perfectly fine and strong performing asset. That’s a function of what’s happened to the market over the last few years with values falling and credit becoming a little more restrictive. And then of course there’s typical asset distress such as underperforming properties, but also failed condo developments that are going to be sold, leased up and acquired as multifamily properties.

We’re actively pursuing those, both in terms of the real estate directly as well as notes and loans. So there are a host of different and attractive opportunities that we’re pursuing in the market today. Some of those opportunities are being marketed through investment brokers but a significant number of them are being sourced by us through relationships that we have directly with owners, from banks, insurance companies and special servicers of loans. There are many different sources and relationships that we have developed over the past 20 years and that provide us with a competitive advantage in sourcing unique investment opportunities. We gain from our experience in the market and strength of relationships that have been developed over many, many years—also from the fact that we have people on the ground in these places with deep market knowledge.

MHN: REITs have just celebrated their 50th anniversary; how do you see that landscape changing going forward?

Gladstein: The public REITs have had a significant run-up in their share prices. As a result, they have been able to use that currency to be very aggressive in buying in the market since the beginning of the year. The REITs tend to be focused on buying A quality, stabilized, and newer assets in the best locations. They have been competing aggressively and are probably the largest buyer of apartments that we’ve seen in our coastal market since the beginning of the year. At the same time, they’ve been selling some of their B product in secondary and tertiary locations, and we view those as opportunities for us as an investor.

MHN: What’s your view of the economy? Have we seen the worst? How concerned are you about the effect of the jobless recovery on the apartment sector?

Gladstein: It’s interesting. In our markets—and I’ll talk specifically to the Bay Area—I think psychology has improved clearly. While we’re closely watching the jobs numbers, we believe things will continue to improve in the economy and that jobs will continue to come back. A lot of people are concerned about the rate of job growth. Our crystal ball on that is no better than others. As you look at some of the Silicon Valley firms, you can see the jobs they’ve added. For example, I attended a presentation earlier this week that pointed out that in the last year, Facebook, headquartered in Palo Alto has added 700 jobs; Twitter has added 200 jobs; LinkedIn in Mountain View has added 450; Zenga has added 750; Google has added 3,600.

So I think we’re clearly seeing some job growth. As we start to see more significant job growth, the increases in demand for apartments will happen. It will also happen as a result of demographics through the Echo Boomers, the Gen Ys moving into apartments, the Baby Boomers downsizing into apartments, and immigration continuing—all of these factors, we think, will continue to create more demand for apartments. Also, the homeownership rate continues to fall in this country. We cruised along at 63 percent homeownership in this country for years until the easy credit threw that number up to 68 percent to 69 percent. Now we’re back to about 67, 66 percent. And most economists predict that number will fall back down to 63 percent. Every percentage point is about 1.3 million households. That’s a lot of future demand for apartments.

MHN: Are you seeing capital come off the sidelines? When will we see a complete thaw?

Gladstein: Equity has definitely come back into the market. The pension fund advisors are back, and private investors continue to be able to finance transactions with the help of attractive agency debt.  So there is plenty of equity in the market, but that equity tends to be a little bifurcated. The majority of the equity coming back into the market is seeking core, stable properties: A products in A locations. The balance of the equity in the market is seeking opportunistic investments. There’s not been a lot “in the middle” there for straight value-add, and when rents were falling, there really wasn’t a lot of value-add to underwrite. But as rents start to rise, we’ll start to see more of those opportunities.

And on the debt side of the equation, the agencies (Fannie and Freddie) have been providing the predominant amount of debt capital to the multifamily market over the past year—my guess is in excess of 90 percent. However, the life companies are back in the market and their rates are right on top of agency rates. So they are being very competitive to the agencies—for the right leverage, the right asset, the right location, and the right borrower.

MHN: What keeps you up at night? What silver linings have you observed lately?

Gladstein: What do I worry about the most here? I’d say the state and federal budget situations and their effects on the economy. These are the two biggest things. But, I don’t want to elaborate… I’m an optimist. The silver lining would be supply and demographics. I think the demographics are set up in favor of apartments and of renter demand increasing.

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