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HOMING OUT

Investors divesting of multifamily are reinvesting in retail

By Steve Bergsman

For 45 years GDC Properties has developed, managed and invested in apartment communities, mostly in Florida, Georgia and the New York metro area. GDC’s Web site is all about “our communities” and “come live with us.”

Then, two years ago, Hawthorne, N.Y.-based GDC abruptly shifted gears, acquiring four supermarket-anchored shopping centers. Last year the firm went on a spree, buying some $300 million worth of shopping centers.

With apartment prices climbing, some real estate observers expect institutional and individual investors alike to cash out of multifamily properties in favor of other asset classes, especially retail. Among those already doing this, GDC and other institutions are scooping up shopping centers, while individuals usually opt for single-tenant, net-lease stores.

GDC says it would have preferred to stay in multifamily, but for opportunity and a consequence of that opportunity. First, a ravishing appetite among investors for apartment buildings that could be converted into condos drove down capitalization rates (annual income divided by cost of property), which effectively forced owners to sell because the deals were so lucrative.

Once those assets sold, however, investors needing to avoid the tax hangover had to do 1031 exchanges, reinvesting in a similar asset that defers capital gains taxes. When GDC did its 1031, it chose to reinvest its capital in retail, which had higher cap rates.

“You have to understand, this all relates to the relative frothiness of the apartment market,” said William Ingraham, president of GDC. “We sold into the condo craze. We sold to people who didn’t care about apartments as income properties; they just wanted to convert apartments to condos. Cap rates were irrelevant &151; they ended up being in the 3 percent range.”

GDC had no great desire to get into retail, Ingraham says. “But we had 1031 exchanges to make,” he said, “and we looked across the landscape and saw that retail caps were significantly higher than apartments, sometimes double, and we made the decision to invest in shopping centers.”

Multifamily cap rates declined more than any other property category in 2005, according to the National Real Estate Index. The nationwide average for top-notch apartment communities fell 120 basis points to 6.2 percent, although there were much lower yields to be found within certain markets and subsectors.

As GDC Chairman Samuel Ginsburg noted last year, “We are taking advantage of today’s cap rate arbitrage and allocating capital out of apartments into commercial property.”

Ginsburg will not be lonely. “Capital flow driven by ease of management and more attractive cap rates from the hottest apartment markets into single-tenant, net-lease properties will increase nationally,” writes Bernard Haddigan, managing director of Marcus & Millichap’s national retail group, in the firm’s 2006 Real Estate Outlook report.

Individual investors who got into multifamily in the mid-1990s have seen a lot of appreciation, says Haddigan, and it is time to cash out. “They are probably not going to buy another apartment building,” Haddigan said in an interview. “Instead, they may go out and purchase five Walgreen drug stores.”

There are three key reasons why an individual investor will jump at the chance to buy single-tenant, net-lease retail. First, today’s investors are older and are no longer looking for great appreciation, says Haddigan, preferring instead the steady cash flow that comes with a long-term lease.

Second, single-tenant retail is not management-intensive, eliminating the need to worry about clogged toilets or renter turnover, he says. And third, they are better deals. “There is so much money chasing apartments, the cap rates, which reflect purchase price over net income, could be in the 4 percent range on an unleveraged basis,” Haddigan said. “The best single-tenant deals have cap rates of 6 percent to 7 percent.”

In the fourth quarter, the average U.S. cap rate for a garden apartment had fallen to 5.8 percent as the average price per unit settled at $90,000, according to Real Capital Analytics, a New York City-based research firm. For a mid-high-rise apartment, the cap rate dropped to 5.1 percent, and the price per unit shot up to $254,000. For in-demand cities such as Palm Beach, Fla., or San Diego, average cap rates sit below 5 percent. “Cap rates for multifamily vary from region to region, property to property,” said Dan Fasulo, Real Capital Analytics’ director of market analysis. “Class-A properties in many of the major cities are turning in sub-5 percent cap rates, which is amazing,” Fasulo said. “Think about it &151; if you were an investor, why would you buy an apartment community with a 5 percent yield, when you can go out and buy a 10-year Treasury that is now at 4.5 percent? Why the headache of an apartment community for the 50-basis-point difference?”

Actually, it would make sense for one of only two reasons: either the investor is going to raise rents, which for most cities would be difficult, or the project is going to be converted to condominiums and then sold off.

Although the investment market for apartments logged a record-breaking year in 2005, according to Real Capital Analytics, there are signs that the frenetic pace may be slowing. Sales in the fourth quarter were down from the quarter before, for example. Even sales to condo converters slowed: about 46,000 units in the fourth quarter, down from 64,000 units in the third.

“There is only a finite number of apartments suitable for conversion, so the wave of condo conversion will slow down,” said Fasulo. “If that happens, cap rates on apartments will rise a little bit.”

A more attractive apartment market could not come too soon for Thomas Lewis, CEO of Realty Income Corp. The Escondido, Calif.-based REIT buys and manages primarily single-tenant retail properties leased to chains.

Unfortunately, Realty Income has had to shift away from single-store deals to portfolio transactions and ventures with developers and private equity firms, because of the flood of 1031 investors into the market over the past three years.

“The vast majority of all net-lease transactions are done in one-off deals by individuals on a 1031 tax exchange,” said Lewis. “When you have so many buildings at the lower price ranges, such as $800,000 for a Jiffy Lube, anybody that has sold a duplex apartment, wants to protect gains and not do active management can roll into a net-lease property that could be fast-food, convenience store or video rental.”

One-off deals are extremely tax-motivated, Lewis says, but what really bothers him is that the 1031 tax exchangers generally are sloppy buyers, rushing into transactions and buying at low cap rates; this has smacked the market down so much that properties selling at cap rates of 9 or 10 percent a few years ago are now at 6 or 7 percent.

That is still better than apartments, however. If an investor sells an apartment building in Palo Alto, Calif., at a 4 percent cap rate and then buys into a single-tenant retail deal in Omaha, Neb., at 6 or 7 percent, all else being equal, that is the cap rate arbitrage.

In net-lease deals, the retail tenant is responsible for everything from taxes and insurance to roof maintenance; in apartment ownership, the only thing you can count on the tenant being responsible for is damage.

The relative ease of maintenance is very attractive for older individuals who do not want a hands-on investment, sources say. In the past 20 years or so, baby boomer investors have built a tremendous amount of wealth trading into larger and larger multifamily properties, says Larry Corkins, associate director of National Multi Housing Group, a division of Marcus & Millichap.

These aging investors now want investments that are less management-intensive, so they are using 1031 exchanges to switch to more-passive single and multi-tenant net-lease properties around the U.S., Corkins says.

“The volume of my apartment-to-retail business has increased every year,” said Corkins. “Last year I completed five 1031 exchange transactions in four different states with investors seeking a management-free, credit-tenant investment that provides a stable cash flow.”