In the first of a new series of quarterly roundtable discussions, Massey Knakal partner James Nelson talks with Margaret Streicker Porres, president, Newcastle Realty Services; Martin Nussbaum, managing principal, Silverstone Property Group; Jordan Vogel, co-founder Benchmark Real Estate Group and; Joe Taylor, associate, Equity Residential, about investment strategies, who they cozy up to when it comes to equity and why it’s bad to fall in love with bricks.
Nelson: What projects are you currently working on and what is your typical business plan?
Nussbaum: In Brooklyn we’re focused on ground-up development. We are building 65 apartments on North 7th and 8th Streets, right off of Roebling, and have another 220 apartments planned for Myrtle Avenue, right behind Pratt University. In Manhattan, we have a high-end condo development site on Broadway, off Great Jones. We are rehabbing a 30-unit building in the West Village and another on 84th Street that we’re converting into more of a shared product type. In Bushwick, we bought a 60,000 s/f warehouse that we’re converting it into apartments as well.
Taylor: We have two ground-up projects underway; one at 400 Park Avenue South, a 270-unit apartment project that’s a joint venture with Toll Brothers; we’re building the bottom half and Toll Brothers is building the top half. 170 Amsterdam Avenue is a 237-unit ground-up luxury apartment development. Then we have two or three other deals in various stages of negotiations. Later this month we hope to close officially on the Archstone acquisition. In New York, EQR will own around 10 properties. This adds about 2,600 units to our portfolio Archstone owns roughly 144 assets in 40 different states nationally. EQR will acquire 78 properties mostly in NY, Boston, Washington DC and southern California. EQR will own about 60 percent of the portfolio and Avalon Bay will own 40 percent..
Streicker Porres: We are doing projects in three of the five boroughs right now. 101 West 78th street, opposite the Museum of Natural History, is a 44-unit building with three retail tenants on the ground floor. We just closed out the condo project at 84 Bedford Street, and 58 Barrow is under contract.
Vogel: We are working on four value-add multi-family opportunities in Downtown Manhattan. A 101-unit building we’re renovating in Murray Hill, and a 94-unit building we’re renovating in Gramercy. We have a shell of a building on Bedford Street that we’re turning into high-end rentals. And on St. Marks we’re renovating 24 apartments. So, we’re heavy in construction, we’re doing 220 renovations in 2013.
Nelson: Jordan, can you just mention your most recent portfolio sale, what that consisted of?
Vogel: Last summer, we sold an 8-building package in the Village to Kushner Companies for $58 million. I think it’s a long-term hold for Kushner and I think they’ll do well.
Nelson: Most of you are value-add operators. It used to be the families that would buy most of the product and hold onto it for generations. Today, it seems its tough for them to compete with you all, especially if you can boost returns by selling in the near term. Would you ever consider a long-term hold?
Nussbaum:In our portfolio we have about 40 different properties. With about a quarter of them, we think it warrants
holding them indefinitely, for various reasons — the area has a lot of growth, we think we can still unlock upside in the building. Other buildings, we think we’ve done as much as we can. I think that now is a great time to sell. People are paying big dollars per foot, cap rates are aggressive, all based on where interest rates are today. So, when we think we’ve done as much as we can and we’re going to benefit, we sell and hope to roll that into the next deal.
Taylor: EQR is a long-term holder in the multi-family sector. We are currently exiting secondary markets and redistributing that capital to our core markets, Boston, Washington D.C., New York and West Coast hubs. We may look at deals on a 10-year basis from performance standpoint, but we have an outlook far greater than that.
Streicker Porres: The first property I ever bought I still own, so in that regard, I do hold things for long-term. In my experience the expectation for hold length has a lot to do with partnership structures. If someone buys something on their own or within their organization, you can make long-term plays; if you’re partnering up with institutional investors, you have to play to their expectations as well, which typically runs on a five to seven-year hold.
Vogel: Debt’s cheap for everyone right now, and so when you’re asking if it’s hard to compete with long-term holders, I think it’s just a question of who has the cheapest equity. If you have cheaper equity, you can compete against those old-time families. If you’re partnering with institutional equity, you can’t. We are opportunistic and I would sell anything for the right price. I think the smartest quote I ever heard was from Sam Zell; ‘If someone is willing to pay you more than you think the property is worth, then it’s time to sell.’ Which is why we sold a bunch of properties last year.
I own one property that I’ll never sell just because it’s on the corner of 5th Avenue and 8th Street, and I don’t think I’ll ever buy anything else on lower 5th Avenue. I fell in love with the bricks, unfortunately. I think it’s good in real estate to not fall in love with the bricks. We sell when we believe that there’s no more value to be added and someone’s willing to pay more than I believe it’s worth.
Nelson: What is your typical source of equity and what type of returns and timelines are they looking for?
Nussbaum: About 75 percent of our investor base is comprised of high net worth or family office equity and 25 percent of our equity is institutional equity. Institutional equity is generally looking for a 2X multiple on their money on a 5-year hold or a 20% IRR [Internal Rate of Return]. The high net worth and family office investors are more flexible with their investments so timeline which can be more attractive. The returns requirements are also in the high teens to low 20% IRR.
Nelson: Jordan, you had quite a fundraising machine, can you talk about your audience of high net worth individuals and how that works?
Vogel: It’s a true old-fashioned syndication business. We’ve experienced the coconut tree effect, meaning at the beginning, it was all close friends and family. When we performed well, they told their friends, who then told their friends and its continued to expand. We currently have 160 high net worth individuals and family offices that invest with us. The average investment is $150,000 per investor and every investor has invested with us in more than one deal. It’s a tremendous amount of work to raise the equity while we’re under a contract. And a tremendous amount of risk and stress, because Aaron [Aaron Feldman, co-founder of Benchmark] and I put up our own money for our hard contract deposit, and we’re betting on ourselves that we can raise the equity. Today we can raise about $40 million of equity for any given deal.
Nelson: Joe, is Equity Residential solely focused on yield, and is your competitive advantage your cost of capital?
Taylor: Our competitive advantage most definitely is our extremely low cost of capital and by far the most efficient operating platform. Just like any analysis, we focus on yield and IRR. We’re beholden to our shareholders, so our job is to maximize their value, and so when we look at yield and IRR on these terms, we do so to compare one investment to another be it buying a stabilized asset versus new development, so we look at yields and compare the two yields to determine which is the best use of our capital.
Nelson: Margaret, last year was a busy sales year in Manhattan, long-term owners selling before capital gains went up. Is it difficult now that inventory has been depleted to find a product?
Streicker Porres: New York was in a frenzy by the end of 2012, I think a lot of people have appreciated the brief pause. I am sure that things will return to a normal and balanced pace for the duration of 2013. Right now, we’re all taking a breath and getting to spend our weekends at home, which is long overdue.
Vogel: I believe that the next three to six months are going to be quiet because anyone that wanted to sell sold at the end of last year. The deals that are lingering are those that were overpriced. Last summer, I was getting 20-25 setups a week. Now it’s 4-5 a week, and I’ve already seen four of them.
Nelson: Do you all prefer to buy a building that is fully rent-regulated, partially rent-regulated with some fair market units, or entirely fair market?
Nussbaum: I prefer buying buildings that are 50/50, I really like the opportunity to take the existing free market units and reposition that tenancy as a base case then look for the larger pop on the embedded upside of the rent-stabilized tenancy to take it to the next level. I think it’s very hard for someone like me to compete on a fully rent-regulated building. The amount of turnover that we need to underwrite to generate the returns we’re looking for are not comfortable for me. I don’t make aggressive assumptions on the rent-stabilized buy outs. For me, having something that’s close to 50/50 is more attractive.
Nelson: Joe, would you consider a property with rent-regulated tenants?
Taylor: We do acquire buildings that have rent-stabilization, be it some kind of 421a program or an 80/20 product. Some of our Trump portfolio on the West Side was 80/20, so some of those deals are just coming out of the program. From a development standpoint, we are only looking at doing deals that have some rent-stabilization component because of the tax nature of the city. We’ve purchase around 800 421a certificates in the last year and a half so that we can minimize the taxes we pay to the city while adding market rate units to the portfolio. Now we’re seeing that the 421a market is drying up and the certificates that are mostly held by guys like Peter Fine are no longer on the market so we’re starting to look at deals more on a 80/20 basis to get the tax breaks.
Nelson: What are the risks are on rent-regulation. Are there concerns that the restrictions will continue to become more challenging to operate a property?
Streicker Porres: The ability to operate and understand the playing field is a shifting playground. That said, the rent regulation laws have to be renewed every seven years, so we’ve got the next five to more or less know what we’ve got to work with.
Vogel:Deals that are too heavily weighed on rent stabilization or rent regulation are difficult to appropriately finance.
I’ve looked at deals where it’s 100 percent rent stabilized and, because banks are only underwriting to current cash flow, you can only borrow 20 to 30 percent loan to cost. I like deals that are fully fair market, but I often can’t compete against a condo converter because we only do luxury rentals. 50/50 is a good mix for us from a financial standpoint.
Nelson: Do you all buy on cap rate, price per square foot, gross rent multiple, price per unit and then where do you see that pricing today compared to say ’07?
Vogel: The price per foot is the most important for me today. I’ve come to realize that cap rates have gotten so sharp in the neighborhoods where I buy that I hear too many times from competitors that ‘Oh I would never buy that property at a 4 cap, but I love it at a 4½ cap.’
The reality is, when you’re doing a value add residential play, there is no cash flow until you finish the project, so to differentiate between 50 basis points on the cap rate doesn’t make a whole lot of sense. We look for buildings in exceptional locations that are a true value. We did realize when we sold to Kushner Companies that sometimes when you add a ton of value and you don’t increase the building footprint, the square footage is often capped just because there’s always going to be a ceiling to what you can sell a walk up in the Village for on a price per square foot basis.
A perfect example is 156 Sullivan, which Massey Knakal had on the market for a while. Prime Soho, beautiful building, and we couldn’t sell it for better than a 5 cap because that correlated to 900 psf. Because we bought the building at $380 psf, it was fine, but I believe that there’s going to be a lot of people buying today in the $700 or $800 psf range, they are all for the project at $1,000 psf and they are going to be very disappointed when they put the building on the market and realize that, regardless of the cap rate, they’re not going to sell their walk-up for 1,200 or 1,300 psf.
Streicker Porres: I look at price per square foot and it might be old-school, but I like rent roll multiples. I focus on operational expenses, energy efficiency and value add from the expense perspective as well as income perspective. So the cap rate, while relevant, is not as important to me.
Nussbaum: We’re definitely driven by price per square foot and the other item we look at a lot is yield on cost .
Nelson: And where do you see pricing today vs. five years ago?
Nussbuam: It’s just much, much more competitive now. Much higher.
Vogel: It’s higher than last year. I think that on a price per foot basis, price per unit basis, cap rate basis it’s actually pretty comparable to the highs of 2007. Market fundamentals are stronger, rents in the neighborhoods where I buy are 15 to 20 percent higher, so I think you can justify paying more. But it’s more of an anomaly to me of how much prices have increased over the last six months. The typical mid-block, walk-up East Village building I could buy at $400 psf in the summer of 2012 and January of 2013 it’s $700 psf. There’s no reason you should see a 75 percent increase in pricing over a six-month period where fundamentals haven’t changed and debt is 25 to 50 basis points cheaper.
Streicker Porres: Rents are moving faster in the less prime neighborhoods. Unemployment and the financial meltdown held them for a period of time in the middle markets. As we’re coming out of four years of flat rents, we are seeing rapid movement in outer borough locations.
Nelson: Joe, where’s the top of the market in some of these Class A rental buildings with rents over $100 psf. Is that sustainable?
Taylor: There’s only a couple buildings in the city that are approaching that right now. You have The Corner on 72nd and you have 2 Cooper Square. Most of the new deals we’re underwriting and building are priced in the $80-81 range and then with growth trended in a pro forma exiting construction, we’re seeing 10 percent growth on top of that. I think the reason why we’re in markets like New York is because you have transactional and physical vacancy somewhere around two percent, and you have an area where there are high income earners, we see growth no matter what.
Nelson: Martin, you’ve been building rental, how’s it possible to find land, especially when you’re competing against condo developers?
Nussbaum: It’s very difficult right now to underwrite to a rental, particularly with the tax issues. In Brooklyn, I do think it is still possible, the sites that we have so far have all been sites that have 421A abatements or we’ve bought certificates in conjunction with purchasing the property. Land prices plus hard and soft costs can still underwrite to attractive rental returns. Brooklyn’s rental growth has been tremendous. We developed a building in Williamsburg and are achieving rent per square foot numbers greater that $60. So if you’re getting $80 a foot today in Manhattan, and you’re at$60 a foot in Brooklyn, the math works for development in Brooklyn where you can buy land at half the price.
We have a lot of people who once lived in Williamsburg who now live on the 3rd stop and the 4th stop (of the L train) and obviously you’re book-ended by Bushwick which is exploding right now. There’s just a lot of movement in Brooklyn right now. I think it’s one of the most interesting sub-markets and the growth is by far outpacing our portfolio in New York
Nelson: Joe, is the only way you’ve been able to build for rental doing ground leases or JV’s or can you buy land outright and do rental?
Taylor: Most of our deals are off-market ground leases. 170 Amsterdam is a ground lease, 400 Park Avenue is fee simple, but I’ve underwritten many ground lease deals. I don’t see land owners selling their properties now. I think they want to create a trust and have the benefit of owning something forever and not take the construction risk. However, the condo market is heating up and we certainly won’t compete with a condo developer from a rental perspective.
Nelson: What are the neighborhoods where you see the next leap?
Nussbaum: Within Brooklyn specifically, everyone’s fighting for stuff in Williamsburg. I like the Clinton Hill area, I think Pratt’s a very big driver of multi-family there. We’re very focused on Bushwick and certain areas in Bed-Stuy. In northern Manhattan, western Harlem areas are unbelievable right now. We’re focusing a lot on 110th up to 135th and now even going a little bit further up to 145th.