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Investing opportunities in Class B apartments.

As institutional interest in apartment properties grows, savvy companies nationwide are developing comprehensive market analysis to aid institutions in their multifamily investing.

One company concentrating on the Chicago markets is Marquette Property Investment of Aurora, Illinois. The firm has just released an extensive study of apartment performance in the Chicago metropolitan area over a 20-year period (1970 to 1989).

The study concludes that rents have grown at an annual compounded rate averaging 6 percent during the past 20 years. However, changes in supply and demand and new construction have created cyclical fluctuations in this rate (Figure 1).

While the study supports the worthiness of apartment investment, perhaps its most significant conclusion is that "Class B properties offer the greatest upside opportunity during the near term for investment returns." The study predicts that returns of at least 18 percent on equity and 14 percent on all costs are possible for a apartment portfolios over the next three to five years.

Bruno N. Bottarelli, co-managing partner of Margquette Property Investments, explains this investment strategy in an exclusive interview with the Journal of Property Management.

Fundamentally there are two factors that place existing Class B properties in the best position to compete with new Class A space during the mid-1990s. The first is the current low prices for these properties. Foreclosures, deeds in lieu of foreclosure, and the inability to obtain refinancing of existing properties have lowered market value on virtually all product. This scenario is most common in the Southwest and the Northeast, but it will probably become more widespread nationwide if credit availability does not improve.

The second factor contributing to the current attractiveness of B property investment is the anticipated rental rate increases that should occur over the next five years. With no new supply and steadily increasing occupancies, effective rents already have begun to rise slightly in the Chicago area.

Rent rates for well-maintained B properties located in high-growth employment corridors should increase even more rapidly in 1992, '93, and '94. Construction of new Class A properties in these areas will push up rents in both A and B existing properties.

A B property, one that is approximately 10 years old and needs some cosmetic refurbishing but one that is structurally sound, offers investment advantages over new construction for several reasons. An older property normally has lower-rate debt and thus less pressure to keep rents at market. Such a property probably has a higher intrinsic value than would be reflected in its current NOI. In addition, the present lack of liquidity has forced the value of many apartment below replacement cost.

Figure 2 recaps the projections for a typical refurbished and remarketed B property in a Chicago suburb.

Buying a B property now, especially if it has been taken over by the RTC, often means that investors can purchase viable properties for less than 50 percent of replacement. This is less likely in the Midwest because there are fewer foreclosed properties, but it is very possible in the more embattled parts of the county

Then, by infusing only a relatively small amount, perhaps $4,000 per unit to replace appliances, put in new carpeting, and generally upgrade the appearance, the property is in a position to compete effectively with new Class A construction at a much lower cost per unit. The same strategy will work with a Class C property as well. Because of the additional structural renovation needed, the risk and the up-front costs usually are greater, ranging between $8,000 and $15,000 per unit. But coupled with the greater risk is the potential for greater return if the renovation is successful.

The difficulty of implementing this strategy currently is the lack of available construction money to undertake necessary upgrades. However, because there may be as much as 30-or 40-percent intrinsic equity in the property, banks are beginning to look favorably on these types of loans.

Other options for equity and/or construction money include credit companies, which are becoming very active; a new HUD mortgage program; and a rehabilitation tax credit program that has been available for some time, but is becoming more attractive as other sources of credit evaporated.

Another alternative is soliciting equity participation directly from a pension fund. This option effectively makes the project an all-cash deal.

An interesting sideline is that pension funds, which traditionally have been seen as long-range investors, are becoming more willing to make shorter two-and three-year investments to avoid the volatility of the down cycle. Institutions are beginning to realize that if they buy now, at the bottom, they realize a much higher IRR by selling at the top of the next construction cycle than they would holding the property through two or three future swings.

When pension funds put money out at the top of a cycle, the only way they can achieve an acceptable return is to hold the property long-term. But when properties can be bought cheaply, as many can today, returns ranging from 15 to 25 percent can be realized in two or three years. These high short-term returns held mitigate lower long-term returns on the other properties in the portfolio.

Of course, the difficulty with realizing this strategy is that owners are unlikely to sell at these prices if they are not forced to by circumstances. For this reason, markets such as Houston, Denver, and San Antonio are seeing the greatest proportion of activity now. But as more properties become REO, more product will be available.

One unanswered question is who will be the buyers at the top of the next cycle to take these investors out. While this is difficult to predict, it is likely that there will still be pension-fund and foreign money searching for investments. One key to making this investment possible is to couple yield expectations for properties with the fluctuations in the cycle of apartment returns.

Another key to making this strategy work is to continually drive rent levels in B properties to the high end of the market. This need to maximize rents has shifted the focus of management away from containing costs toward marketing. Incentive-based management fees on leasing and performance are one indication of this shift.

The renovation and remarketing of well-located multifamily apartments remains a strong investment option for institutions in the next few years, if the price is right, the on-going management is sound, and the yield expectations are tempered to the cyclical nature of apartment revenue growth.
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Title Annotation:Asset Management
Publication:Journal of Property Management
Article Type:Interview
Date:Nov 1, 1991
Words:1075
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