With core in short supply and overpriced, multi-family has become the firm favourite. Other residential sub-sectors are also looking strong, as Stephanie Schwartz-Driver reports

Hoping to escape the crowds and find higher yields, many commercial real estate investors are starting to look outside core markets and properties to find deals. In the first throes of the market recovery, attention was focused on trophy properties in gateway markets, but now some secondary cities and more challenged properties are attracting attention.

The majority of respondents to the Pulse survey, conducted in January 2011 among members of the National Association of Real Estate Investment Managers (NAREIM), said that they did not rate core as the most attractive investment style. Instead, 32% ranked core plus first, and 46% favoured value-added. This is in an environment in which nearly all managers were expecting a significant increase in transaction volume.

"Everyone at first only wanted core. This created bidding wars, with prices going up and cap rates compressed," says Steve Renna, former president of NAREIM, who recently took up the position of CEO of the CRE Finance Council. "Investors have become very discouraged about finding product in the core space."

At the same time, those investors waiting for a barrage of distressed deals are still waiting or are looking at other high-yield opportunities. "Banks held on to those properties that were going to come around," says Renna. "They repositioned loans or worked with tenants on high-quality properties."

"Core deals are hard to come by, and they are increasingly expensive," says Kevin Smith, managing director of Pramerica Real Estate Investors. "People were anticipating that because of the run-up of the 10-year treasury last fall core pricing would level off, but already in the first quarter this year, core pricing has been more aggressive."

"The allocations from pension funds and other investors that have not given up on real estate have to be deployed," says Renna. "This wall of capital just keeps building, putting pressure on managers." At a NAREIM executive meeting at the beginning of March, according to Renna, managers were reporting that they were trying to push investors to think outside core, either spreading out geographically and looking at secondary cities or moving up the risk curve at value-added properties, developing or repositioning acquisitions.

The same thing is happening among REITs, according to Jim Sullivan, managing director, Green Street Advisors, and at a similarly slow pace. "In the search for yield, investors have to move further out, and REITs are looking away from core, because core is very crowded."

Sullivan notes that REITs are particularly well suited for acquisitions outside core. "REITs are better capitalised than a lot of private investors, and they have the infrastructure needed to take on higher risk," to manage properties, reposition them, and lease them.
Sullivan finds, however, that despite having a capital advantage and well-reasoned management teams already in place, REITs are not rushing to take advantage. "REITs are looking outside core properties, but they are doing it at a pace that seems measured compared with the capital they have," he says.

Although there are arguably better opportunities in the secondary markets, Sullivan says there is a continued focus on primary markets. "Many REITs, in fact, are trying to sell lower-quality assets to plough the capital into better-quality markets," Sullivan says. "They do not need to sell to buy, but would like to in some cases, in order to have access to a variety of different capital sources."

In most cases, however, these buyers are proving slow to materialise, although some markets and some property types are more attractive than others. Pramerica is looking outside core, focusing on multifamily in select growth markets. Pramerica looks at those markets that will react better to the economic upturn, such as high-tech markets, for example San Francisco (benefiting from its proximity to Silicon Valley), Seattle and Boston, and those that can demonstrate rapid job growth, such as Dallas and Phoenix, and even Florida.

Pramerica is not alone in its interest in the multi-family sector. In NAREIM's Pulse survey, 52% of respondents expected multi-family to emerge as the most attractive asset class. It is perhaps the only sector that has current fundamentals behind it. It is on track for consistent rent growth: rents in the fourth quarter of 2010 were up more than 4%, and estimates for 2011 rent growth go as high as 6%. Vacancy rates in many markets are historically low, averaging under 7% nationally, and there were only 112,000 new starts in 2010, according to US Commerce Department figures, compared with as many as 280,000 in 2008.

As a result, development activity is rising in some areas, for example in the Sunbelt. In addition, in the PricewaterhouseCoopers first-quarter Real Estate Investor Survey, the regional apartment markets showed by far the biggest drops in cap rates, between 39-73bps depending on region.

The most active markets for acquisitions in the multi-family space are still the major markets - New York City metro, Washington DC metro, and Los Angeles metro - according to Real Capital Analytics, the best opportunities may be outside the major markets. Atlanta, for example, is showing cap rates of around 7.5%, compared with 5.75% for New York City, 6.5% for Washington DC, and 6.3% for Los Angeles.

In addition to traditional multifamily, some niche property types are also becoming more popular among investors, says Renna. Both student and elderly housing - sectors that benefit from at least consistent and sometimes rising demand, sheltered from the economy - are attracting investors and managers. However, the management challenges are very specific.

As confident investors look outside the core cities, it is not totally clear whether lenders will be willing to follow them. Renna says: "The one question asked of me recently is whether investors can raise the money. There is no one answer for that. It is true that the terms are tighter, and it is harder to raise money." Lending criteria are much tighter, and loans tend to be underwritten at present rental income rather than on forecasts.

Smith has found financing to be plentiful. "For the right real estate and the right rent roll, lenders will follow the borrowers," he says. "Also, as investors go into true secondaries and real estate that is not pure core, the commercial mortgage-backed securities market is coming back and that will be the likely financing source for those properties."

Although investors seem to be cautiously optimistic, economic uncertainty is one factor that is dictating their measured pace. Smith notes that "the real estate capital markets have gotten ahead of fundamentals, with the exception of apartments. Other property types are waiting for job growth." REIT pricing, interestingly, is also indicative of continued uncertainty in the broader market, says Sullivan. While REITs are priced pretty fully compared with Main Street real estate prices, they appear a little pricey compared with the broader stock market but good value compared with bonds.

Concern about rising interest rates is also a cloud on the horizon, although core pricing has not yet reflected this concern. "Spreads have declined to the extent that borrowing rates will have to go up on the next significant Treasury bond move," says Smith. "But the timing of that and the severity are difficult to forecast. They will trend up but the question is how fast." While the market can absorb some rise in interest rates, the speed and the extent will determine how buoyant a year 2011 will be. Investors will want to deploy capital as much as possible before interest rates rise.