real estate discussion question ( 150 words minimim)

C o v e r R e p o r t : C o m m e r c i a l / M u i t i f a m i l y

Strategic Investing in

ist^essed ets

BY XAVIER GUTIERREZ

Strong

apartment

demand makes

opportunistic

investments

in distressed

multifamily

assets a smart

move in today's

market.

or investors with the required expertise and readily

available capital, distressed multifamily properties represent

one of the best real estate investment opportunities to

emerge from the credit crisis of 2007-2008. Whether directly

acquiring assets or buying the debt on properties—such as

mortgages or construction l o a n s ^ t h e critical factors for success

are the abihty to close transactions in a timely manner and asset-

management capabilities for the rehabihtation or repositioning of

the acquired properties. •!• Phoenix Realty Group (PRG) is a

national real estate firm that provides capital and development

expertise for urban and infill real estate ventures. PRG is one of

many real estate companies that are leveraging expertise in multi-

family development and operations to take advantage of shifting

property markets. •!• PRG and its principals have long-term expe-

rience in multifamily rental investment and development, with

more than 130,000 multifamily units to their credit nationwide.

With a focus on work-force housing, the firm sees multifamily as

a sweet spot in its strategy with both existing and new invest-

ments, and as a good countercyclical investment alternative to new

construction. •J* With more than S400 million of available

equity raised from leading pension funds, insurance companies and

MORTGAGE B A N K I N G / JULY 2 0 0 8 67

G

other institutional investors, PRG is seeing new opportunities in multifamily properties that require restructured financing, physical renova- tion and rehabilitation, and repositioning in the marketplace. Undercapitalized and underman- aged projects that may now be a lead weight for the current owner or lender could easily be trans- formed into a well-operated property.

Troubled assets worth the effort The basic strategy, which is being pursued by a number of private equity funds and real estate operators across the country, is to create value through the acquisition of troubled assets directly from owners or by buying the debt altached to those properties.

In some cases over the past several years, investors and developers took advantage of cheap credit and a booming market, often leading to instances of overleveraging. Now, annid residential real estate and credit market slowdowns, they are not able to meet their debt service and are forced to sell.

In other cases, banks and other financial institu- tions have properties they are trying to sell in order to trim their portfolio exposure, limit potential losses, generate cash flow for other needs and improve their balance sheets. This could include distressed mortgages on multifamily urban residential and mixed-use properties that are already in default or that banks are preparing to reclassify as real estate-owned (REO).

Real estate firms with access to capital and significant expe- rience, expertise and development capacity are well positioned to take advantage of the opportunities that these distressed assets and debt present, They are able to buy properties with a variety of financial structures, including both senior debt and mezzanine financing, and create vahie through reposition- ing the assets. PRG, for example, has moved forward on plans to purchase either real estate assets or debt and subsequently reposition these properties using its in-house development and management expertise.

In a recent transaction, PRG acquired one property with more than 350 rental units in Naples, Florida. These imits were operating well, but the previous owner had committed to con- verting the property to condos—a plan that became impossi- ble to sustain in tbe recent market slowdown. Tbe lender soon found itself in possession of the underlying rental asset, which it sought to sell to a new operator. PRG had tbe expert- ise in multifamily rental to recognize the value of the proper- ty and create an action plan for gradual improvements that would maximize the property's value over time. The lender provided seller financing as part of the acquisition terms because it recognized PRG's asset-management skills.

This transaction contrasts with many in which debt-focused buyers seek to profit solely through the arbitrage of the mort- gages attached to multifamily properties. Many hedge funds, for example, might have little concern for the underlying value of the asset, instead seeking to buy the debt at the highest possible discount from tbe lender.

Lenders wanting to sell institutional-sized assets with 150

I one are

the days of

profitable

arbitrage

from a fast

flip of

residential

properties.

or more units are an especially appealing target for real estate equity providers. There is also a range of price points to suit any investor, from large indi- vidual properties to portfolios requiring $100 mil- lion or so of equity. Investors with discretionary capital in hand have the ability to react quickly, offering a fast and easy closing in exchange for a somewhat discounted sales price.

Strong apartment demand and decreasing supply support repositioning While the financial crisis is making discounted asset prices available on the front end of these transactions, there would be little interest in these opportunities without the demand that makes these properties viable on the back end. Gone are the days of profitable arbitrage from a fast flip of residential properties. Because of the sizes and types of properties involved, and the nature of the redevelopment and repositioning process, invest- ment in this sector reqviires deep experience in rehabilitation, repositioning and operation of multifamily properties—not to mention a hold strategy that allows investors to wait for and sell

into a healthy, stabilized residential market.

The dynamic driving the current process is the expected surge in demand for rental units in urban markets and dense, suburban infill locations in the nation's 50 largest metropoli- tan areas. The slowdown in home sales, tightening of credit standards and rising foreclosures will provide additional demand for apartments.

For the United States as a whole, the Washington, D,C.-based National Multi Housing Council's (N MHG's) March 2008 National Apartment Conditions Report showed that in 2007, the number of renters in professionally managed apart ments rose by the greatest number since 2000—an increase as large as any for the previous five years combined. Accord- ing to Harvard University's ]oint Center for Housing Studies, Cambridge, Massachusetts, it is estimated that the number of renter households in the United States grew by l million in 2007, in large part due to stricter mortgage underwriting guidelines.

This trend toward increasing demand for rental housing is also supported by Encino, Galifornia-based Marcus & Mil lichap Real Estate Investment Services Inc. in its 2008 Nation- al Apartment Report. The report states: "More stringent lend- ing is resulting in higher apartment-renter retention rates, while adjustable-rate mortgage |ARM] resets and foreclosures will continue to push overextended homeowners back into the rental pool."

The report notes the five least-affordable housing markets in 2008—New York City; and San Jose, Los Angeles, San Fran- cisco and Oakland, California—are the markets expected to have the lowest apartment vacancy rates this year, with occu- pancies in the range of 96 percent to 97 percent.

The University of Southern California (USC) Lusk Center for Real Estate's Casden Real Estate Economics Forecast for 2008 supports this conclusion, reporting that occupancy rates in Southern California will remain tight at 96 percent to 97

68 MORTGAGE BANKING / JULY 2008

I percent this year, while rents will rise an average of 2.5 percent to 3 percent.

"Renting remains attractive when mortgages are harder to obtain for high-priced homes," Delores Conway, director of tbe Casden Forecast, stated in a press release summarizing the report's findings. "Although the nationai econo- my is skating close to a recession, the region's apartment market is supported by demand for trade, regional economic strength and higher- paying jobs in health-care and professional serv- ices," she said.

Longer term, the Marcus & Millichap report adds, "Over the next five years, echo-boomer demo- graphics, foreign immigration and limits on new supply point to a strong outlook tor apartments."

The report notes that if nothing is done to add more rental units to the market, supply and demand for apartments will increasingly fall out of balance. "In 2007, there were just 84,000 apart- ment units delivered. During the 1990s, it was closer to 170,000 a year—so we are building less than half the production of the last decade," the report states.

Broken condo conversions can be salvaged The Marcus ik Millicbap National Apartment Report also notes that current market dynamics "are creating a growing pool of vacant homes, condos and failed condo conversions"— and that is where investors see opportunity.

Primary property targets are fractured condominium con- versions that are partially constructed. While originally built as rental properties, developers started the condo-conversion process to chase the booming market, but either ran out of money or did not attract a sufficient number of buyers to move forward.

In fact, condo buyers who had put down deposits in health- ier days were walking away as the market turned, because they saw values for condominiums declining. This was especially true among a growing contingent of speculators who did not

WHY OWNERS ARE SELLING

f nothing is

done to add

more rental

units to the

market, supply

and demand

for apartments

¥riU increasing-

ly fall out of

balance.

veraged assets sh flow needed for other purposes faulted borrower

• Iciled condo conversion Undercapitalized owner

rtfolio exposure smatched asset owner (bank real estate-ownifd •O])

. ..lese dynamics dre acnve ift toaay 5 market, and prM

may b* affected by several factors at once. M

intend to live in the units they were buying. Fractured condos are found in major cities

nationwide, and are particularly attractive to equi- ty providers where rental demand is strong and consistent—usually within close commuting dis- tances to centers of employment.

According to a first-quarter apartment research report by Marcus & Millichap, the San Diego apart- ment market will continue to post relatively tight fundamentals in 2008, though some threats will linger. These include failed conversions and unsold condos competing for space demand. "With the condo-conversion trend having reached an end, many unsold condo units are returning as high-end rentals and competing with traditional apartment properties," the report states.

According to a January 2008 Commercial Prop- erty News interview with Matthew Texler, vice president at Bethesda, Maryland-based Meridian Capital Group, the credit crunch has been so dra matic in the Washington, D.C, region that demand has fallen for condos. "There were three main demand generators for these units — investors looking to turn quick profits, . . . first-

lliiic yuppie owners looking to buy a place in the new hot downtown . . . and baby boomers who were selling suburban homes and moving back into the city after years of raising families in the suburbs," said Texler. "This spigot of demand was turned off when tbese people couldn't sell their houses in a declining suburban residential market." This has created a situation wbere so many condo projects in D.C. now sit frac- tured with partially sold units, and owners of unsold units struggle to find financing.

In South Florida, the fractured condo market grew so large that by the end of 2007, Los Angeles-based CB Richard Ellis Group Inc. had created a practice devoted exclusively to bro- ken condo projects, and was listing 55 condo communities with more than 6,000 units for sale. The brokerage was reporting discount ranges of 30 percent to 40 percent of retail listed prices and 20 percent to 30 percent of closed sales on these properties.

But this does not mean fractured condo conversions don't have intrinsic value. Real estate firms are interested in acquir ing the debt on the construction loans, completing unfinished construction and returning the buildings to the market as rental apartments. The condo-conversion map is retained in rase market conditions change at some point in ihe future, but the immediate goal is to re-establish a value for the property and put it back into operation. With know-how, this can be done quickly and economically, and the property can start gen erating cash fiow much sooner than waiting for the condo-con- version market to revive.

Some of this repositioning might result in a mixed-use property being created. Especially in urban areas, the ground level of large residential buildings can often be converted to retail spaces that serve tenants and make the neighborhood more attractive. In a project with ground-floor retail and upper-floor condos already planned, the developer can keep the retail but convert to apartments above.

70 MORTGAGE BANKING / JULY 2008

Networking critical to finding the best deals Drawing upon its direct discussions witli lenders, I'RG estimates that approximately half of the trou bled properties on the market are not being pub licly advertised. Many of these are sourced througli relationships with national networks of develop ers, brokers, lenders, sellers and buyers. Because so many of the opportunities are off-market, interest- ed buyers are seeking out owners and lenders mostly by word of-mouth.

PRG, for example, approaches banks and lenders directly to discuss troubled debt or port folios of REO properties. In many cases, we've found that banks are seeking a better price by negotiating directly with large, well-capitali/cd investors rather than taking the risk ot a public auction or bidding process. At the same time, an investor with cash on-hand can close quickly, allowing a swift resolution for the seller. But banks are not the only ones competing for these liquid dollars—hedge funds and private capital funds also wish to sell porttolios that were picked up in the rising market and which now need to be cut loose.

S should target

firms that have

the real estate

expertise to

redevelop and

reposition the

property for

the best

chance of

success.

Where are the buyers? In turbulent markets, it may seem that new potential buyers crop up on a weekly basis. But how can banks and other finan- cial institutions find qualified buyers for distressed assets? Beyond the obvious qualification of having the capital to complete the transaction, sellers should target firms that have the real estate expertise to redevelop and reposition the prop erty for the best chance of success. These will be the buyers that are most interested in examining the true value of a dis- tressed asset, as well as the buyers a lender will likely prefer to partner with if the seller maintains any interest in the proper- ty after the sale, such as seller financing

The best way to target aiid qualify a serious potential buyer is to focus on track records—in terms of both real estate assets and capital resources:

• Seek out experience Target real estate development and finance firms with a

strong track record in the type of asset being sold. These firms should have demonstrated strong real estate investment and operations experience rather than simple "money-manage- ment" experience or a sole focus on the allocation of invest- ment capital into diverse sectors that may have nothing to do with real estate. If a potential buyer can point to a firm with an existing portfolio of healthy operating rental properties, for example, it is likely worth including on the short list of poten- tial buyers. Likewise, if the potential buyer can demonstrate several successful "turnaround" projects of roughly the same size assets as the one being sold, sellers would be wise to tar- get such firms as potential buyers.

In some cases, banks are simply trying to remove under performing mortgages and properties from their books. This is particularly true if they are under pressure from bank reg- ulators to clean up their balance sheets quickly. But in other cases, lenders may be in a position to work with the buyer to

[('capture some of the value in the property at some time in the future. In that case, a joint ven ture is created where the new investor will buy

ellers t he debt and take it off the lender's books, but the lender can potentially realize some value on the hack end through holding a contingent interest in tbe property.

If the property can be repositioned, managed (H marketed better, or if unfinished construction (.111 be completed, value is created that can be shared with a lending partner. This is where real estate development expertise is critical, and sell- eis should ensure that their potential partners are lip to the task.

• Seek out itistitutionally backed investment Target real estate investment lirms that have

ihe backing of institutional investors. The firms I hilt have proven themselves to high-caliber insti- iiitional investors (including pension funds and insurance companies) are the ones that most 11| ten have the capital and expertise to successfully I lose deals. Firms like these continue to receive ( apital commitments from this top echelon, even .imidst a turbulent real estate market. These

go to extensive lengths to evaluate and select firms based upon their key investment strategies and capabilities.

Institvitional investors recognize the growing opportunity in multifamily rental investments, which firms like PRG are then tasked with executing. PRG's investors include insurance companies such as The Northwestern Mutual Life Insurance Co., Milwaukee, and John Hancock Realty Advisors, Boston, as well as some of the country's largest public pension funds, including the California Public Employees' Retirement System fCalPERS), Sacramento, California; the Los Angeles City Employees' Retirement System (LACERS); the Los Angeles County Employee Retirement Association (LACERA); the New York State Common Retirement Fund, Albany, New York; and the New York City Pension Systems.

Investors like these recognize that the best returns at this time in the credit cycle are found where one can take advan- tage of the stresses in the capital markets. In PRG's case, we have raised S725 million in equity to invest and continue to talk to both existing investors and new investors about rais- ing additional capital focused on the multifamily asset class and other opportunities brought about by changing real estate markets.

Given the challenges in todays credit markets, the acquisi- tion of distressed multifamily rental assets or the debt on those properties presents an attractive, large scale investment opportunity. However, to truly take advantage of these oppor- tunities, real estate investors need more than readily available capital to purchase assets at a discount. The true creation of value will come from real estate firms that have capital along with the real estate expertise, experience and capacity to repo- sition or redevelop those assets to meet the great ongoing demand for rental housing, h©

Xavier Gutierrez l i senior vice president, capital markets, with Phoenix Realty

Group LLC (PRG) in Los Angeles. He can be rparhed at xiRutierrpifOphopnixre. rom

MORTGAGE B A N K I N G / JULY 2008 71