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Apartment Finance Today: How To Beat The REITs

Sedgefield
The publicly traded REITs may be intimidating, behemoth competitors, but smaller private owners still stand a chance in the ring, if they use their nimbleness, focusing on acquisitions and operational programs, and stay off the REITs’ radar.

For most privately held apartment owners, the sudden presence of a public REIT next door is very bad news.

But not for David Hillman. Over the past 20 years, the founder and CEO of Southern Management has watched the big REITs muscle into his Mid-Atlantic markets, gobbling up the most desirable assets with their ravenous, insatiable appetites, and driving up prices beyond his reach.

Yet what makes the REITs intimidating— their size and structure— can also make them vulnerable, he says. “If a REIT owns a building next door to me, I’m the happiest guy on the planet,” says Hillman, who founded his Vienna, Va.–based company, which currently owns 25,000 units, in 1965. “They’re very good at getting investors to buy their stock. But the last thing they care about is the customer—they just nickel-and-dime them to death.”

By virtue of their public status, REITs enjoy a cost of capital that’s impossible for private owners to compete with. If you’re bidding against a REIT for a large trophy asset in a major market, just forget about it. Let the baby have its bottle.

That cheap Wall Street money comes with a price, however. There are a host of other deals— more creative acquisitions with a greater upside— that REITs can’t consider because of constant short-term pressure to produce quarterly earnings growth. And that pressure extends to the operational side, where REITs look to wring every last dollar out of their investment—and their residents.

At first glance, it may appear like a lopsided fight, pitting the giant REITs against the small, family-owned, regional operator. But more nimble entrepreneurial organizations can use their size to their advantage by offering more personalized customer service, responding more quickly to opportunities, and leveraging a deep local knowledge and network to uncover myriad opportunities.

Like David facing Goliath, bigger doesn’t necessarily mean better. “A freighter can carry a lot more cargo,” says Matthew Lester, founder and CEO of Orchard Lake, Mich.–based Princeton Enterprises. “But a speedboat can turn on a dime.”

Here are six strategies that private players can employ in the ring when faced with a challenger in the form of a public REIT.


1. Target Edgier, More Complex Deals

Many public REITs froze in the early days of the recession. As their stock prices fell, they were forced to hunker down and lick the wounds on their balance sheets. Meanwhile, privately owned Princeton Enterprises was extremely busy.

In 2008, the company acquired 20 apartment communities, and, over the past six years, its portfolio has tripled to 15,000 units. Last year alone, Princeton purchased 660 units and in the first four months of 2011 scored another 640 units—all of which were distressed. Part of that success comes from the company’s adaptability. During the downturn, it shied away from stabilized assets and saw greater opportunity and higher returns in distressed acquisitions.

“Funds from operation are what drive REITs day in and day out, but we can shift on the fly,” Lester says. “I can cease to emphasize cashon-cash distributions and shift toward renovation, which was crucial during the last downturn.”

Or take LumaCorp, which owns 4,600 units throughout several Texas markets. The company has watched REITs drive up the price of Class A assets in the Dallas/Fort Worth metro to the point where a 4.5 percent cap rate is no longer surprising.

So the company is targeting value-add deals and is currently bidding on a 300-unit, Class B-minus property that will need $2 million in rehab to bring it to a B-plus over an 18-month cycle. “That’s an area REITs can’t really play in, pumping the money in on a value-add play,” says Ian Mattingly, director of acquisitions and asset management at Dallas-based LumaCorp. “They’re in it for the cash flow.”

Indeed, REITs shy away from edgier deals— distressed assets, significant value-add plays, large redevelopments—anything “near-term dilutive but long-term accretive,” in Wall Street jargon. And since REITs are all about economies of scale, they often avoid secondary markets and deals for assets with fewer than 125 units.

“There are plenty of holes in the market where they’re not focused,” says Aaron Hancock, director of acquisitions for Laguna Niguel, Calif.– based Raintree Partners. “There’s still plenty of room to operate in a market where REITs are aggressive and still find niches where you can be very competitive.”

2. Leverage Local Knowledge—and Relationships

One of the biggest advantages that a smaller investor can leverage is local knowledge.

For one, being knee-deep in operations breeds a depth of local information that’s irreplaceable. For all the REITs’ supposed “access to information” and research that measures a submarket’s fundamentals and trends, the data may not actually be worth much. “The on-theground information a smaller private holder has is far more valuable, current, and relevant,” Lester says. “The information furnished to REITs lags what I already know in a particular marketplace.”

For instance, Intel recently transferred hundreds of workers from California to its Austin, Texas, facilities but didn’t announce the move publicly. While that information might not show up in official research data and metrics, owners and lenders who are active in Austin knew about the move and planned accordingly.

Even in a primary market, there are plenty of pockets in and around town that REITs won’t consider. A REIT’s market research sometimes misses the finer points, but a wellspring of local knowledge allows you to make smarter investment decisions.

“They might not see the population growth in an overall market,” Mattingly says. “But since we can get in there with local knowledge and understand that this location is different than two streets over, we can really go after these sub-submarkets.”

What’s more, by being aware of what’s happening locally, smaller operators can use that information to make deals happen off the REITs’ radar. Raintree Partners, for example, has tried to outmaneuver the REITs by finding off-market deals for both assets and land. There are so many off-market possibilities in any given market that REITs can’t be on top of every one, especially if they’re based in other parts of the country.

“We’ve spent a ton of time making unsolicited offers directly to owners, and identifying brokers who want to work on off-market deals, so that we’re the first phone call when they find one,” Hancock says. “We know the markets and people very well, and there’s a potential to get an advantage in certain transactions because of that.”

In March, Raintree purchased an off-market deal in Burbank, Calif., paying $43 million for the 270-unit 1200 Riverside Apartments. In fact, of the more than 1,800 units the company has acquired since April 2009, about 30 percent, or 540 units, were off-market transactions.

3. Shine by Comparison

Even if a REIT buys an asset next to yours, it can actually be an advantage. In fact, one of the first things you might consider is to stop advertising.

“The REIT will spend more on advertising than they will on maintenance, so they’ll generate plenty of traffic,” Hillman says. “The small guy just has to make sure that his property has really terrific curb appeal.”

And if a REIT builds a new development right next to your existing asset, that can also play to your strength. It won’t take long for renters to run afoul of the REIT’s M.O. “Anything you build today is going to need a significant premium over our in-place rents, so we’d welcome it because it would give us something to sell against,” says LumaCorp’s Mattingly. “And once their renters get that 8 percent or 10 percent rent increase at the end of the year, they’re coming across the street to us.”

Being a long-term holder can also be a marketable advantage. Many REITs have relatively short investment horizons. And while REITs keep their properties in tip-top shape, they’re disinclined to invest in infrastructure if it doesn’t provide a return. “REITs focus on things that are going to bring more revenue. We’re able to sell the fact that we maintain things that don’t necessarily increase revenue, like HVAC systems and roofs,” says Cindy Clare, president of the management arm of McLean, Va.–based Kettler, which owns 7,875 units along the East Coast. “We do much more of that because we’re looking at a long-term hold, not quarter-to-quarter results.”

This philosophy of “shining by comparison” works on the back end, as well, particularly when it comes to lender relationships. Where REITs have the benefit of offering all-cash transactions, some companies are fighting back by providing just as quick a close. Princeton Enterprises, for example, has cultivated a cadre of lenders—from the GSEs to life companies and banks—to ensure certainty of close. “You have to go to your lender and say, ‘I’m not interested in fighting over 10 bps [basis points] on an interest rate,’” Lester says. “But I’m going to insist that you give me deal certainty.”

The same goes for the company’s equity investors, some of which can take down a whole deal, debt and equity, if necessary. In the secondary markets where Princeton Enterprises plays, this assurance is typically a strong advantage.

4. Implement Creative Programs

Smaller owners can also use their flexibility to implement programs most REITs would never dream of. For instance, Southern Management pays the utility costs on 80 percent of its 25,000 units.

Since the company is buying electricity in bulk on the wholesale market, it realizes a 40 percent discount compared with retail costs. And by locking in a price for the long term, it’s able to predict where prices are going to be. The utility cost is baked into the rent, but it adds a level of convenience—and cost savings—for the resident and has become one of the company’s marketing tools.

One way that Princeton Enterprises has gained a competitive advantage is by taking certain functions, like bad debt collections, in-house. The company would typically recover between 3 percent and 5 percent of bad debt using a third-party service. But under its own initiative, the company is now recovering about 15 percent. That means that for its annual bad debt bill of about $1.5 million, the company is now getting back roughly $225,000, as opposed to the $60,000 it recovered using third parties.

Bringing certain services in-house helped Village Green Cos. lower its operating expenses as well. Each year since 2008, the Farmington Hills, Mich.–based company has brought a variety of previously subcontracted services in-house—renovation, landscape architect, interior decorator, advertising, green building experts. The company also now trains its maintenance staff in electrical, HVAC, and plumbing work, raising their compensation in the process, so that very little is now farmed out.

“We’ve reinvented ourselves in how we hire, train, and compensate people,” says Jonathan Holtzman, chairman and CEO of Village Green. “This recession taught us how to dramatically reduce our operating expenses—we’re not relying on rent increases; we’re relying on NOI growth in part from lower expenses.”

5. Focus on Staff

When it comes to compensating employees, you would think that REITs would have a natural advantage. But that often isn’t the case: REITs don’t have an entrepreneurial attitude with their team members.

The Laramar Group, which owns about 7,500 units and thirdparty– manages another 34,500, offers bonuses to any of its employees who help find a new property management client or an acquisition target that the company buys. “When you get into a big REIT structure, it gets difficult to do one-off stuff like that,” says Dave Woodward, managing partner and CEO of Denver-based Laramar. “But those little things—a property manager getting a couple-thousand-dollar check for helping out —are extremely motivational.”

Indeed, many private owners hire staff away from REITs because they don’t feel valued. Southern Management, for one, features profit sharing for all its full-time employees, including maintenance staff. And the company has a flat organization—25 years ago, it got rid of the regional-manager level and empowered the field staff to police their own budgets. The company has 1,300 full-time employees and last year saw turnover of only 9 percent (the industry median is closer to 30 percent, according to the National Multi Housing Council).

6. Trust Your Gut

Competing with REITs on the acquisition side is pretty tough. But there are plenty of opportunities that REITs won’t entertain, and it’s up to the smaller, more nimble entrepreneurs to uncover them.

“Find your advantage, whether it’s local knowledge or a focus on smaller properties or secondary and tertiary markets,” Woodward says. “Value-add is going to be coming back. And the ability to buy some foreclosed real estate from lenders or special servicers is going to present some opportunity.”

Woodward would know. Before the recession, Laramar was a strictly value-add developer, but it quickly shifted into property management in 2008, targeting special servicer and receivership work. Since then, its portfolio has ballooned by about 34,000 units.

Laramar’s ability to stay nimble and shift gears quickly also came in handy when the company opened its New York office last fall. “All it took was getting asked if we could do some management work in New York, and we immediately set up an office. My sense is it would take a REIT a longer period of time to get their arms around that opportunity,” Woodward says.

And Laramar will be going back to its value-add roots—the firm is currently raising its next fund, and it plans to leverage its recent property management work to find some choice distress acquisitions. “Doing all of this work for the special servicers, we get interesting looks at potential investment opportunities,” Woodward says.

The good news for Woodward and others is, once those opportunities are made, it’s even easier to beat the REITs on the operational side. “Their cost of capital is so much better than virtually any of us in this space,” Lester says. “You have to offset that advantage by outperforming them operationally, and good private multifamily owners can certainly do that.”

BY JERRY ASCIERTO
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