3rd Quarter Apartment REIT Review

“Grief is nature’s most powerful aphrodisiac” – Chazz Reinhold (Will Ferrell), Wedding Crashers (2005).

Back in 2005, I watched in disbelief while apartment leases were being broken left and right as residents began to purchase homes at a frenzied pace. While the economy boomed, the apartment industry suffered. Now, some have begun to whisper about the formation of a new bubble stimulated by the zero-rate environment established by the Federal Reserve to prop up an economy battered by the pandemic. In a surreal world where low wage service workers struggle to pay rent, more affluent renters have the sugar rush of cheap money to feed a new home-buying surge. Throw in a desire for more space to work from home and host dinner guests in the backyard, and buying a house… well, as Owen Wilson would say, “just, wow”.

Back in August (which was eight months ago in pandemic time), I decided to look at quarterly results from publicly traded apartment owners to gain insights into where the market was heading. Third quarter results have been posted, so I revisited three of the biggest apartment real estate investment trusts: Equity Residential (EQR), AvalonBay (AVB) and Mid-America Apartment Communities (MAA).

The stocks have continued to trade at discounts to their March peaks and their dividend yields exceed 3%. The announcement of a vaccine breakthrough earlier this week sent the stock prices higher by 10%. The recent price increases have largely erased the deep discounts to net asset values, but they remain attractive as liquid income-producing investments. Their dividends are well-funded, leverage is manageable, and it is hard to envision further downside. EQR is the riskiest of the three because of the company’s high exposure to struggling urban markets, but MAA remains the star of the group due to its focus on sunbelt cities.

The attached article contains brief comments on the quarterly results, a numerical comparison of income and asset values as well as a back-of-the-envelope “stress test” to determine the safety of the dividend payments. Finally, I offer a few observations on the Omaha market where home purchases have caused increased turnover and vacancy.


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Sunbelt Success Continues

Mid-America exhibits the divergence in the apartment industry: urban coastal cities are losing residents and many are relocating to dynamic growth centers in the south. As they had in August, executives exuded confidence in their quarterly call. Occupancy exceeded 96% and traffic was positive. Rent growth was muted due to increasing supply and competition from home purchases but remained positive. MAA is a standout performer because of its concentration in sunbelt cities throughout the southeast and Texas. The stock has nearly recovered its losses for the year.  

Suburban vs. Urban

AvalonBay and Equity Residential noted positive leasing trends during October but reported that rent declines and move-outs exceeded expectations in urban markets, particularly Manhattan, Boston, and San Francisco. Rent declines surpassed 10% in big coastal cities. Occupancy dropped below 90% in central San Francisco – a stunning figure. Meanwhile suburban properties performed well. Overall occupancy at both firms was at the 94% level. At AvalonBay, rents declined 6% for the quarter on a year-over-year basis and 2% on a sequential quarterly basis.  At EQR, rents declined 7.5% for the quarter on a year-over-year basis and 2.7% on a sequential quarterly basis. Collections remained strong – above 97%, but turnover increased. There were some glimmers of hope in the New York City core where major rent discounts and incentives have enticed bargain-hunters to seek upgrades within the market.

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Similar Trends in Omaha

In large measure, the observations made by the leading apartment executives on their earnings calls mirror our experience in Omaha. Occupancy levels which had been above 95% for the past two years have fallen dramatically over the past 90 days – approaching 93% in many areas of the city. Effective occupancy may be even lower as one month of free rent has become a common incentive.

Home Purchases Pressure the Top End

The top end of the Omaha apartment market has been hammered by an acceleration of home-buying. Low interest rates are spurring a race to purchase houses despite rising costs amid a tight inventory and expensive lumber prices. There is a 2005-feel to the environment with a high number of lease-breaks. It has not reached a mania level, but loose credit has allowed buyers to emerge who probably wouldn’t have qualified for a mortgage at the beginning of the year. In certain submarkets, added new apartment supply is also depressing the leasing environment.

More Space

All three firms have noted an increase in demand for larger apartments as working from home seems to have spurred a choice for bigger apartments. Studios are difficult to rent across the country, and Omaha is no exception. EQR reported that many of their Manhattan buildings have experienced transfers to larger units within the same property.

Students and Lower-Income Challenges

EQR and AVB reported serious challenges in their Boston and Cambridge properties due to a lack of students in the area. Omaha is no different. Although UNO has strong enrollment figures, many have opted to remain at parents’ homes. International students are a major driver of central Omaha apartment demand, and they have not returned. Rent delinquencies had vanished over the summer, but have made a growing re-appearance as stimulus payments have been exhausted. Workers in the service sector are seeking assistance once again. Delinquencies are not catastrophic – probably running 1%-2% higher – but the trend is worrying.

Stress Test

Last quarter, I used a hypothetical 5% income decline to determine whether the firms could continue to fund their distributions. I increased the pressure to 10% this time around. The dividends appear safe but would certainly come close to being curtailed in such a scenario. It should be noted that the 10% reduction of rental income was taken from an annualized rental figure that already incorporates two quarters of rental declines. The annualized figures are simply the aggregation of results through September 30, 2020 plus an assumption that 4th quarter results will match those of the 3rd quarter.

Note: This article contains the opinions and observations of the author. No investment recommendations are being provided and no representations are made to the accuracy of the content provided.

Bert Hancock

November 12, 2020

The Pandemic has accelerated many real estate trends. Student housing is no exception.

The Covid19 pandemic has caused distress in hospitality and retail assets, but apartments have largely been spared. However, a subset of the multifamily sector has been placed under pressure: student housing. University enrollments had already been declining steadily over the past 8 years and the pandemic has accelerated the decline. Indeed, demographic trends foretell an ominous future around the year 2026 as the peak level of children born in 2008 pass through college. High school graduations will peak in 2025.[1]

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University enrollments have declined by 1.8% nationally according to the National Student Clearinghouse Research Center. Generally, enrollment is better than many had feared in April with enrollment posting gains at many public four-year institutions. Meanwhile, enrollment at many private institutions has dropped significantly. International enrollment is down 11.2%. Although student participation is better than expected, the prevalence of virtual learning means that many campuses are ghost towns. The loss of international tuition and housing revenue has added to government budget cuts to produce a shortfall in higher education that exceeds $120 billion by some estimates. For further reading, Michael Nietzel at Forbes has a grim look at the budget cuts hitting colleges across the country. I recommend his articles.

The pressure on universities translates into a rough environment for student housing providers. With empty rooms at many campuses, mortgages secured by the housing are now among the rising list of economic casualties. Commercial mortgage-backed securities secured by the loans to student housing complexes have shown a significant increase in delinquencies.

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Source: Trepp Research

Trepp Research has highlighted the Wolf Creek Apartments in Raleigh, NC which serves North Carolina State University and The View at Mongomery serving Temple students in Philadelphia as two of the largest distressed assets, with $43 million and $83 million mortgage balances outstanding respectively.

Fitch Ratings had already warned about the possibility of an oversupply of student housing in 2016:

“Even  prior  to  the  pandemic,  student  housing  was  identified  as  a  subsector  of  concern  in  the  Fitch-rated  CMBS  2.0  universe  since  2016,  due  to  the  greater  performance  volatility  and  operational  expertise      required      compared      with traditional      multifamily.      Both student housing occupancies and property-level  net  operating  income   (NOI)   performance have   lagged   traditional   multifamily.”

In addition to supply concerns, Fitch noted that student housing carries the added risk of nearly 100% annual resident turnover and higher maintenance expenses.

While many retail and hospitality properties may never recover from the pandemic, student housing will likely rebound. However, long-term demographic trends will mean that universities will need to find ever more creative ways to boost enrollment and fill housing.

[1] Justin Fox, Bloomberg, May 30, 2019. Fox relies heavily on the work of Nathan D. Grewe, an economics professor at Carleton College and his landmark study: “Demographics and the Demand for Higher Education”.

Office REITs: Value Opportunity or Value Trap?

Commercial real estate is under pressure. Hospitality properties are in distress and many retail assets are struggling amid restaurant closures and the acceleration of online shopping. Thus far, long-term leases and high-quality tenant rosters have spared Class A office properties from pain. Second quarter results for major publicly traded office real estate investment trusts offer insights into the office markets of large cities, and their discounted stock prices appear to be attractive. 

The second quarter results for three office REITs were reviewed for this report: Boston Properties (BXP), SL Green (SLG), and Kilroy Realty Trust (KRC). 

Boston Properties is the nation’s largest office REIT with over 51 million square feet owned directly, and another 7 million owned through joint ventures. BXP has concentrations of properties in New York, Boston, Washington, D.C., Los Angeles and San Francisco. SL Green owns nearly 30 million square feet in New York City with roughly half-and-half split between direct ownership and joint ventures. SLG also holds nearly $1.2 billion of mortgages, mezzanine loans and preferred equity positions in other New York properties. Kilroy Realty Trust has over 17 million square feet based on the west coast. It has a larger suburban portfolio than the others, and its stock has performed comparatively well.

All office REIT executives believe their companies are well-prepared to weather the shift towards work-from-home arrangements. They have raised capital at low interest rates and bolstered their balance sheets. Lease expirations are minimal in the near term. Stocks are trading at considerable discounts to underlying asset values and offer hefty dividend yields. The ability to sustain dividend payments for the next two years seems likely and the discount to net asset values offers downside protection. Technology companies continue to lease new space. However, clouds hang on the horizon. A reduction in office floorplans seems inevitable. Financial firms may reduce headcounts as they reckon with tighter interest rate spreads and a rising collection of distressed assets in their portfolios. Meanwhile, working from home may not prove to be the revolution once envisioned in April, but certain jobs will remain permanently remote.

Text Box: SL Green's One Vanderbilt opened this week
One Vanderbilt, SL Green

Note: This paper contains the opinions and interpretations of the author. No representations are made regarding the accuracy of the material. The views do not represent investment recommendations. All readers should perform their own due diligence before making an investment decision.

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Occupancy and Collections of Rent in the Second Quarter

All companies collected over 90% of rents during the second quarter. BXP suffered from vacancy at its hotel properties, and both BXP and SLG reported rent collections only slightly better than 50% for their retail square footage. Yet office rent collections were better than feared. BXP and KRC collected 98% of office rents and 96% of SLG’s office tenants paid during the second quarter. Overall occupancy at the end of the June period stood hovered near 93% for all three firms. However, the actual staff presence in the buildings was minimal, with only about 10-15% physical occupancy for BXP and SLG and 25% for KRC estimated during late July.


BXP and KRC took advantage of the decline in interest rates to raise significant capital during the past six months while SL Green sold two assets for over $600 million to bolster the balance sheet. In August, Kilroy raised $425 million in senior notes at 2.5% due in 2032, and Boston Properties issued $1.25 billion in senior secured notes at 3.25% maturing in 2031. Kilroy raised $247 million in a March share offering. No new senior debt was issued at SLG, although a couple of properties were refinanced. Fitch did affirm a BBB credit rating for SL Green but revised its outlook to “negative”.

Office REITs trade at significan discounts to their pre-Covid highs.

Shareholder Benefits

All CEO’s believe that their balance sheets are well-positioned for the next two years. Kilroy increased its dividend by 3% in August and SL Green purchased $163 million of stock during the second quarter.

Leasing Activity

Despite the pandemic, leasing activity did continue at muted levels. All three companies renewed about 1.5% of their portfolio with an approximate retention rate of 50%. BXP signed a major new lease for 400,000 square feet with Microsoft at its Reston, Virginia property. BXP and KRC have minimal lease expirations over the next three years with KRC at roughly 4% per year through 2022 and BXP closer to 6%. Kilroy has 85% of its space concentrated in low and mid-rise buildings. SL Green has minimal exposure in 2020 but faces a worrying 11% expiration level in 2021.

Kilroy and Boston Properties are bullish on markets where technology and life science businesses are showing resilience and even growth during the pandemic. While Facebook, Google and Amazon grab the most headlines, the emergence of laboratory needs in the biotechnology and pharmaceutical industry is equally fascinating. These companies are viewed as more likely to take up new space in coming years as the office environment remains necessary to foster collaboration and company culture. Both firms show interest in the Seattle market while BXP seeks further growth in the technology hotspots near the Los Angeles beaches. A notable bright spot during the doom and gloom of New York City’s pandemic challenges was Vornado’s signing of Facebook to a 730,000 square foot lease in the former post office building near Penn Station.

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DropBox headquarters in Mission Bay, San Francisco

Development Activity

All three REITs have significant development activity which accounts for between 9-15% of the total square footage inventory for each company. While these developments pose risk should they fall short of targets, all CEOs noted that they had adequate liquidity to finish the projects. 90% of KRC’s pipeline is leased while BXP has 74% leased in their upcoming projects. SL Green has higher leasing risk, as was cited in the Fitch ratings downgrade, with 50% of new square feet committed. Among all three companies’ projects in development, the most prominent is the 77 story SL Green tower known as One Vanderbilt – a 1.5 million square foot building near Grand Central Station which is 70% leased and opens this week. The project is a landmark $3 billion asset. The opening generated enough excitement to propel the stock upwards by over 10%. SL Green is also partnering with a Korean pension fund on the $2.3 billion redevelopment of One Madison Avenue. The space is not scheduled for delivery until 2024. Kilroy is in a strong position with its development projects. KRC will soon be opening a 355,000 square foot building in Hollywood fully leased to Netflix and another 635,000 square foot building in Seattle 100% leased to a Fortune 50 company. Another 285,000 square feet in San Diego will come online in 2021 with 91% of the space leased.

Sublease Risks

One of the factors most likely to suppress future rents is the likelihood that surplus space is placed on the market by current tenants. These subleases become phantom vacancy that is nearly always offered at below-market rents. CEO John Kilroy did not view the subleasing environment as overly worrying. In reference to San Francisco in particular, he offered, “Sublease space in the market right now is about 5 million square feet… 2.3 million was added during Covid… to put that into perspective, the direct vacancy rate in San Francisco right now is about 5.4% and sublease is 2.5% of that. To compare that to the dot-com bust, direct vacancy was 8.3% and sublease space with 6.8%.” However, despite the CEO’s comments, Kilroy identified sublease space in its 10-Q, the first time in several quarters such information was broken out. 849,000 square feet in the portfolio was listed for sublease, or nearly six percent of the portfolio. About half the space was noted as vacant. In late July, DropBox announced it would list 270,000 sf for lease, nearly 1/3rd of its offices, in the newly opened Kilroy development in Mission Bay, San Francisco. Meanwhile, Boston Properties was impacted by the bankruptcy of Ann Taylor’s parent company which occupies 340,000 sf in Times Square. It would seem likely that even if a bankruptcy restructuring is successful, surplus space will find it’s way onto the market.

SL Green Challenges

SL Green is the most difficult office REIT to analyze. Nearly half of the company’s square footage is held in joint ventures which are not consolidated in the operating revenues and expenses. The company also has a complicated portfolio of first mortgages, mezzanine loans and preferred equity positions in various properties in New York. SLG also owns many properties encumbered by ground leases.

Indeed, some mezzanine loan positions appear to be under pressure. On September 2nd, it was reported that SL Green bought the $90 million first mortgage for 590 Fifth Avenue after Thor Equities defaulted on a $25 million mezzanine note. The property is a 19 story 100,000 sf building. The mezzanine business cuts both ways for SL Green. A distressed developer who falls behind on their mezzanine financing could present an opportunity for SL Green to pick up assets for the value of the first mortgage. In most cases, these will be bargain acquisitions. Unfortunately, the impairment of a mezzanine loan is in itself a damaging blow to the balance sheet and the need to muster capital to protect a junior debt position could require deeper pockets than the company anticipates.

While two asset sales reinforced cash positions, the failed $815 million sale of the Daily News Building in March offered an indication of the challenges valuing New York office assets in a post-pandemic world after Deutsche Bank pulled financing for the deal. SLG was able to refinance the property in June with a $510 million mortgage from a lender consortium. SL Green is also considering the sale of its two multifamily properties.

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Kilroy’s Netflix campus: Academy on Vine

Investment Evaluation

SL Green has seen its stock hammered by the pandemic. Down by nearly 50%, SLG’s dividend yield exceeds 7%. Boston Properties has faced a 40% decline and offers a yield of 4.4%. Meanwhile, Kilroy lost 35% since its pre-Covid highs and yields 3.45%

In the process of evaluating the stocks, I made simple assumptions. Some may argue that these are too elementary, but the exercise was intended to discover whether the public market is significantly undervaluing the underlying assets by a wide enough margin to provide an element of downside protection. I was not intent on arriving at a precise valuation of the businesses.

My method was to annualize pro forma income simply by taking second quarter revenues and multiplying them by four. This may prove generous in the event further occupancy problems arise; it also is punitive for the companies. For example, the methodology assigns no future income for the Mission Bay/DropBox property placed in service. It also ignores the 70% occupancy of One Vanderbilt placed in service by SLG. It gives no value to the new BXP leasing in Virginia. In all cases, the exercise merely values the development assets at cost. The only upside “help” that was given by the author was a slight uptick in hotel revenues attributed to BXP during the balance of two quarters. 

I capitalized the net income at 5.0% for KRC due to its high level of low and mid-rise buildings, 5.25% for BXP, and 5.5% for SLG. Certainly, before the pandemic, these cap rates would be considered high for trophy office properties in major urban areas. I added the cash on the balance sheet and subtracted debt to arrive at a net asset value. All in-progress development projects were added at cost. Joint venture assets were included in the income statement computations to the extent that they were reflected in the ownership percentages. The result is a 70% value discount for SLG, and a 38% discount for BXP. KRC is selling for a 17% discount. On the income side, I calculated the dividend coverage ratios: BXP stands at 1.6x, SLG 1.7x and KRC 1.8x.

Next, I performed a stress test analysis that reduced revenues by 10%. In the case of SL Green, I also deemed their property loan portfolio to be 50% impaired. Even with this penalty, SLG appears to trade at par to net asset value. Meanwhile BXP would seem to be 24% below value as well. KRC with its under-estimated future income looks to be valued at par after the stress test.  In this example, BXP and KRC could continue to comfortably fund their dividends but SLG would be under pressure to reduce shareholder payments.

Paradigm Shift

While all three companies trade at steep discounts, one can’t help but wonder if the world will look back at this moment and ask why real estate experts underestimated the paradigm shift of working from home. If it worked pretty well for 6 months for most office workers, why can’t it work permanently? If nothing more, workers got 1-2 hours of their days back by not facing a long commute into the city center. This increase in productivity alone is tangible. 

Of course, as the weeks have dragged on, frustration has set in with the arrangement. JP Morgan CEO Jamie Dimon has summoned traders back to their desks and recently noted a decline in productivity among employees at the banking giant. Zoom meetings can’t replace the 80% of communication that occurs through body language, and even a micro-second lag on a call is maddening after the third time someone interrupts. The office is a vital asset in our knowledge and information-based economy. Ideas and culture are the engines of growth. But data entry, call centers, accounting and routine back office functions seem to need nothing more than a good workstation in the den along with a high-speed data connection. Office leases will take 2-5 years to expire, but what if all companies simply reduced their footprints by 10%? My stress test may prove to be too light.


Kilroy and Boston Properties are the most appealing investments. The balance sheets have been fortified and leasing activity for the companies’ new developments is robust. Kilroy’s exposure to suburban markets offers a hedge against central business districts in major cities, and BXP has a well-diversified geographic portfolio. Meanwhile, despite the steep discount, SL Green appears to be the riskiest of the three REITs. The concentration in New York City is worrisome. While some may argue that the risk is reflected in the added discount, it is worth noting the SL Green executives had been appealing to investors as recently as the fall of 2019 that the stock traded at an unjustified discount of 25% to its peers. A risky mezzanine portfolio and the complexity of its joint venture arrangements could pose future challenges.

The most encouraging future for office properties lies in the technology and life sciences industries. Despite recent sublease announcements, Both Kilroy and Boston Properties are aggressively pursuing these vanguard companies with visible degrees of success. Meanwhile, the transformation of New York City into a technology hub is well under way. The question is now raised: can technology employment grow fast enough to replace the shrinking office needs of remote workers?

Bert Hancock, September 15, 2020


Appendix: Exhibits

Investment Opportunities in Apartment REITs

I have listened to the second quarter earnings conference calls for three of the largest apartment real estate investment trusts: Equity Residential Trust (EQR), AvalonBay Communities (AVB), and Mid-America Apartment Communities (MAA). Together they own over 250,000 apartments. I was struck by the generally positive tone in spite of our troubled economy. I have assembled a research report that you may find interesting.

Apartment REITs Remain Near March Lows

If you’re pressed for time, here is the HEADLINE: 
Using reasonable assumptions, apartment REITs are currently trading at discounts to the underlying value of their assets. In my estimation, at the current moment, purchasing a liquid security with low debt backed by the best multifamily properties in America yielding 4% is a better prospect than buying an apartment complex yielding 6% with 75% leverage.   


All three REITs reported collections from April to June that were ahead of projections made during the crisis moments of March. All experienced a decline of about 2% on collected rents. The unemployment insurance program and $1,200 stimulus checks certainly helped. Our experience in the Omaha metro area has been similar. Collections declined by 1% during the April-June period and even lower during July in our area. Executives claimed that June and July leasing activity had returned to 2019 levels. Resident turnover was 2-3% below the same period in 2019.  


All companies took advantage of low interest rates. AvalonBay issued $600 million in bonds at 2.5%, Equity Residential received a $495 million secured loan at 2.6%, and Mid-America issued $450 million in senior secured notes at 1.7%. All companies have healthy cash positions and exhibit better credit ratings than during the 2008-09 recession. AvalonBay felt confident enough to authorize a $500 million stock buyback program. Low rates were not entirely a favorable factor: AvalonBay and Mid-America each noted that occupancy was hindered by home purchases driven by low interest rates. This trend has also been evident in our market.


All three companies have cancelled new development projects with expectations of weakened rent growth and a belief that construction costs will decline as most commercial and hospitality projects are suspended indefinitely. AvalonBay had noted that construction costs in major coastal metros have declined by 5-7%.


Equity Residential and AvalonBay have the majority of their portfolios located in major metropolitan areas on the coasts. The contrast in performance between urban and suburban markets was profound. AVB and EQR have 33% and 25% of their units in urban central business districts, respectively. Equity Residential and AvalonBay faced difficult headwinds in their urban properties. New leases in urban areas posted rent rates as much as 8% below earlier quarters, and renewal rents dropped by 1%. Vacancy levels approaching 9% were reported in central business districts of San Francisco, Boston and New York. The increase in work-from-anywhere employment has been compounded by a loss of foreign workers and college students in these areas. EQR noted that while 4% of revenues are attributable to commercial tenants, only 60% were paying rent – an ominous sign for central business district retail performance.

Executives at EQR and AVB were encouraged by positive summer leasing trends at their suburban communities. New lease activity was strong enough to help overall company-wide occupancy levels exceed 94%. Overall, company-wide quarterly revenues were down 2.4% at EQR and roughly flat at AVB.


Mid-America operates assets in the sunbelt: The Dallas metro, Atlanta, Nashville, the Carolinas, and Austin all feature prominently in their portfolio. MAA executives were ecstatic with their results. Effective rents for new leases at MAA were up 3.4% for the quarter. Occupancy exceeded 95%. Overall revenue for the quarter was up 1.4% over 2019 at MAA. Executives were confident that migration trends toward sunbelt metros would continue, and had seen evidence of acceleration.


All three companies are trading well below February levels. EQR trades at a 40% discount to the February high, AVB is down 34% and MAA is 20% lower. Meanwhile, EQR and AVB sport dividend yields in excess of 4% and MAA has a yield of 3.4%. In a world of zero percent Treasuries, the dividends are appealing.  

The three apartment giants appear to be trading at a discount to their net asset values.

I present a table on the attached pdf comparing the three companies. Some of you may take issue with my simple methodology, but I think the calculations fairly portray a set of businesses that may be undervalued. For annualized revenues, I doubled the first half of 2020. Executives generally opined that markets had stabilized, so I am taking their remarks at face value. I included a $50 per unit capital reserve in my estimates to arrive at a pro forma net operating income level. The results show that all three companies have adequate dividend coverage between 1.38x for EQR to 1.78x for MAA.

I employed a 5% capitalization rate to arrive at a value. Some could argue that this is a low number on a risk-adjusted basis, but as the cost of funds drifts below 3% the cap rate seems reasonable. Cap rates in space-constrained urban markets were well below 5% heading into March. The results indicate that public market discounts to net asset values range from 6% for AvalonBay to 20% for Equity Residential. 

Finally, I reduced my revenue assumption by 5% to determine the impact on values and dividend coverage. In this exercise, all three were comfortably able to maintain their shareholder distributions. Current share prices were roughly in line with net asset values in this example.

There is no question that the pandemic will continue to negatively impact the economy. Indeed, it will be interesting to see if MAA bosses are less optimistic on the next call as Covid cases sweep across the south. I do believe there will eventually be meaningful negative impacts on white collar employment that has thus far been spared the brunt of the layoff pain. Could revenues decline by 10%? It is very possible. I do not subscribe to the conventional wisdom that “everybody needs a place to live, so apartments will be just fine”. Young professionals under the age of 30 can find their parents’ homes just as welcoming as they did during the 2008-2012 period. However, I do believe much of the downside risks have been reflected in the current share prices. These three companies boast some of the finest apartment assets in North America. Their balance sheets are strong and the dividends are well-covered. 

Please let me know if you have any comments or criticisms. I am interested in all perspectives. A disclaimer: These numbers represent my opinions and should not form the basis of any investment decisions.

Let’s hope for a vaccine. Take care.


Tax Reform: No free lunch for apartment owners

Rural Nebraskans suffered from heavy flooding this past March, so the IRS allowed residents of many counties to extend their filing deadline to July 31st. As we wind down this uniquely painful tax season, it’s time to reflect on what has been a most unpleasant set of surprises unleashed upon many real estate investors by the The Tax Cuts and Jobs Act of 2017.

The tax reform law was a boon for corporations. It reduced the average tax rate from 29% to 21%. Pass-through entities such as limited liability companies (LLCs) and S-Corporations also stood to benefit from certain deductions, the most common of which included a 20% deduction on net income. Although the law had been passed in 2017, much of the guidance was written throughout 2018 and even into early January of 2019.

When the dust settled earlier this year, it became apparent that the new law contained limitations on deductions that sent accountants and property investors scrambling for cover.

Real estate owners have been able to use depreciation charges to shelter taxable income. Depreciation is the non-cash expense that owners are allowed to deduct from operating income which represents the deterioration of a physical asset as it ages. In the case of apartments, the standard method is to divide the asset cost (excluding land), by 27.5 years and deduct that amount from reported net income on an annual basis. On a $1,000,000 building, the annual deduction is around $36,400 per year.

Real estate owners are also allowed to deduct mortgage interest from net income (principal can not be deducted). Therefore, many real estate partnerships, especially in the early years of operation, reported negative earnings to the IRS once depreciation and interest were subtracted from operating income. Individual investors with passive income from other investments were able to shelter this income with losses from real estate.

The 2017 law essentially invalidated the ability to report a net loss to the IRS for most real estate partnerships.

As of tax year 2018, if an apartment building runs a net loss after depreciation charges and interest deductions, it is thus deemed to be a “tax shelter”. Consider the words tax shelter to be the accountant’s equivalent of a football referee seeing a questionable call on the field and requesting a video replay review. Once the net loss was evident under prior accounting principles, accountants presented their clients with one of two choices: Either switch to an alternative depreciation schedule (ADS) of 40 years instead of 27.5 years, or limit interest deductions to 30% of net operating income. The new rules mean that ability to generate a reported loss to the IRS has all but vanished. Sheltering passive income with passive losses from real estate is now virtually impossible.

In fairness to Congress, their intention was good: reduce the desire for investors to maximize leverage in order to maximize the deductibility of interest. By reducing the tax benefits of heavy borrowing, you reduce risk in the system.

Here’s rough sketch of what taxable income looked like before and after the tax reform law:

Under the old law, a taxpayer actually reported a loss to the government. Today, the investor makes a choice. In Option 1 where the depreciation charge is reduced under a 40 year schedule, the tax would be about $2,000. In the second case where interest expenses in excess of 30% of net income are added back, the tax is around $3,500. The Tax Cuts and Jobs Act of 2017 is actually a tax increase for many leveraged partnerships.

Which option would you choose? The longer depreciation term looks more appealing, however there are two caveats: Once you elect to take the ADS, you can never go back. Second, the interest deductibility limitation is painful in the short run, but those unused interest deductions are carried forward and can offset future income. So, an investor with a longer perspective may opt for the interest limitation. A last note of caution: the interest deductibility limitation gets even more strict in 2021. During that tax year the deduction is limited to 30% of net income AFTER depreciation.

There are several very important loopholes in this law. The most egregious example is that a pass-through partnership with limited partners that do not exceed a 35% ownership threshold are exempt from the deductibility limitations. This clause unfairly penalizes pass-through companies with a high number of partners.

Now, before we conclude, I have to provide you with this disclaimer: I am not a tax expert. My examples are very generic and are purely for illustrative purposes. You absolutely should not rely on this information and you must consult with a tax professional for guidance.

So, does real estate still offer tax benefits?

Yes. The ability to deduct depreciation and interest may not be as generous as in years past, but they are still deductible. Depreciation is particularly beneficial because it is a non-cash charge. Tax advantages remain, but the noose has been tightened.

Aksarben Village, 15 years in the making, is nearing the finish line

March 3, 2019: By Cindy Gonzalez / World-Herald staff writer

Noddle Cos. estimates that private investment within Aksarben Village has topped $630 million. Those involved since the onset say the project, boosted by tens of millions of public dollars, has exceeded expectations. Office and research space has doubled the amount projected to be built; the number of hotel rooms and residences also have surpassed early predictions.


To better understand the land evolution near 67th and Center Streets, one can step back 25 years to when elite horse racing died at the longtime entertainment venue. Controversy soon erupted as diverging interests vied for control of Ak-Sar-Ben land then publicly owned by Douglas County.

One group wanted to restart racing in an effort that some suspected would lead to casino gambling. Business leaders resisted, instead supporting a sale to First Data Resources, which was looking for space to grow.

First Data bought the northern 140 acres of the Ak-Sar-Ben grounds in 1996 and subsequently donated a large chunk to the University of Nebraska for a high-tech learning campus featuring the Peter Kiewit and Scott Technology educational institutes and student dorms.

As community leaders in the mid-2000s pondered what to do with remaining land to the south, HDR’s Doug Bisson stepped up to say Omaha had the chance to be at the forefront of an emerging “new urbanism” trend of creating walkable neighborhoods inside cities.

At the time, he was a neighborhood representative on the board of the Ak-Sar-Ben Future Trust, a nonprofit that by then had acquired the former horse track and coliseum.

That idea of resurrecting the familiar grounds with a mix of residences, retailers, offices and entertainment resonated with community officials including Ken Stinson, chairman of the future trust. Said Stinson back then: “We were trying to do things that we couldn’t find in a cookbook.”

A handful of developers, with Noddle Cos. as lead, accepted the challenge to transform the 70 acres into a kind of pedestrian-friendly, mixed-use hub that was becoming the rage in urban parts elsewhere across the country, Bisson said.

Noddle recalls drawing up, in 2005, the first site proposal for what would become Aksarben Village. Actual construction launched in 2007 with the thought that it could take about 12 years to fill out between Center Street on the south, the University of Nebraska at Omaha’s south campus on the north, and from 63rd Street west to the Keystone Trail.

Looking back, Bert Hancock of Alchemy Development, who was among those original developers, said one of the most stunning results is the village’s allure as a home for corporate bases. “While I think everyone envisioned a strong employment base, the headquarters of HDRGreen Plains, Blue Cross, Right at Home, etc., have elevated Aksarben Village’s status as a major corporate center,” he said.

HDR’s near ten story headquarters located in Aksarben Village accompanied by a neighboring building with restaurants, businesses and offices near Mercy Road and south 67th Street in February.


Earlier this year, engineering and architectural firm HDR held the grand opening of its 10-story global headquarters leased from the Noddle-Bradford partnership. Across the street, a five-story office building is rising and in January will be corporate headquarters for Right at Home.

That 100,000-square-foot building, a project of Magnum Development and McNeil Co., will have room for other tenants and retailers on the ground floor. It joins a city block within the village that also features a 10-screen movie theater, restaurants, bars and Pacific Life offices.

Other newbies headed to Aksarben Village:

A 110,000-square-foot, multitenant office building is to rise behind the new HDR headquarters, facing Frances Street, probably later this year, Noddle said. “We own the land, there is demand,” he said, though adding that construction won’t start before he secures an anchor tenant. The HDR parking garage will be enlarged to accommodate additional vehicles.

Noddle Cos. this year also plans to start building the village’s first for-sale homes. Called 64 Ave, the seven town houses along 64th Avenue north of Center will be about 1,600 square feet apiece, rise three floors and have two-car garages. This would be Noddle Cos.’ debut in the residential construction market.

Set to open this summer is the food, retail and entertainment alleyway between the HDR headquarters and its parking structure. The plaza will be called the Inner Rail, a nod to the area’s history as a racetrack. It’s gotten city approval to be an “entertainment district,” which will allow alcoholic drinks in the plaza.

Alchemy Development is to build two more housing projects, bringing on 124 units and $18 million in investment, to the southeast and northeast corners of the HDR headquarters block. One is to start this year, Hancock said. Alchemy already has 227 apartments at the village in Pinhook Flats and the Cue. (Broadmoor Development also has built hundreds of apartments at the village.)

Yet to be developed, Noddle said, is about seven acres next to HDR that’s reserved for its possible expansion, and a few other scattered pieces.

An aerial view of our new project in Aksarben Village


HDR Tower, Aksarben Village

We are excited to announce our newest apartment project in Aksarben Village. The building will feature 62 studio, one and two-bedroom units. We expect completion in early 2021. This building will be adjacent to to our other projects Pinhook Flats and CUE Apartments.

We welcome our newest neighbors: 950 HDR employees now working at the the new eleven-story HDR Headquarters.

Pigeons, Chickens and Interest Rates

There was a hilarious video making the rounds on social media last week that featured a pigeon strutting around a barnyard with a puffed up chest and its head cocked high in the air. The pigeon was imitating a flock of brown chickens who were parading about, pecking at the seeds on the ground. I did what anyone would do when presented with such fantastic barnyard comedy: I pressed the screen and gave the pigeon a heart sign.

I sought deep meaning in this pigeon strutting about. It must be some kind of zoological phenomenon. Genetic mirroring or telepathy. Do pigeons have ESP? I have little knowledge of the biological world, and much less about the psychology of pigeons, so I gave up this notion. Instead, I decided this pigeon must have something to do with interest rates. A natural conclusion.

I couldn’t help but wonder which bird was better off. The chickens were destined for one of those plastic containers with the transparent lids sitting under heat lamps, but they would end up on someone’s dinner table. A meal for a happy family. A short life, but a useful one. The pigeon seemed free. It could fly off at the first sign of the farmer. But it’s death was certain to be grisly: Picked apart by a marauding hawk or flattened by an onrushing vehicle.

You can delude yourself into believing that your fate is different, but the end result is the same. In the long run, we are all dead. So goes the old economist joke. Interest rates are the great equalizer and the tombstone of many speculators are marked with a percent sign. Rising interest rates don’t care much if you’re a pigeon, chicken, or real estate developer. Yes, it’s one hell of a stretched analogy, but I’m running with it.

If you have borrowed a lot of money (something real estate developers love to do), rising interest rates can foul up (or fowl up) any investment equation. To see why, let’s look at a hypothetical building that generates income from rents. After paying expenses, the owner is left with $1,000,000 per year in net operating income. How does one value such a building? The equation is fairly simple, you take the net operating income and divide it by an interest rate known as the capitalization rate, or “cap rate” for short.

The cap rate is a weighted average cost of capital. It weighs the investor’s desired return on his or her equity invested as well as the borrowing cost of debt. The cost of debt is more than simply the interest rate. It includes a factor for the amortization of principal. The resulting cost of debt is known as an annual constant.

In November of 2016, the 10-Year Treasury Yield stood at 2.15%. Lenders usually price their loans at about 2% above the Treasury (known as the spread). So, in November of 2016, the rate was 4.15%. Once you add on the amortization of principal (let’s use 30 years as the amortization term), the annual constant was 5.90%. What was the hypothetical the cap rate? Assuming the developer sought a 7% return on equity and the equity comprised 25% of total capital, the resulting cap rate was 6.175%. What’s $1,000,000 of annual income worth? $16.2 million. The developer was able to borrow about $12 million and made up the balance of the funding with equity of around $4 million.

Today, the 10-Year stands at 3.24%. The annual constant is 6.63%. Holding the desired return on equity at 7% results in a weighted average cost of capital of 6.72%. Dividing $1,000,000 by this cap rate results in a value of $14.9 million. This is a decline of 8%. The developer borrows $11.1 million and invests equity of $3.7 million. All is well and good. The value declined, the debt declined, and the equity required declined in tandem.

But what happens when the building was built in 2016 and now its time to refinance a construction loan in November of 2018? We said the developer initially put up $4 million for a $16 million building. The debt amount of $12 million made up the difference. Now the building is worth $14.9 million. The bank will only loan $11 million. The developer must make up the difference between the original construction loan and the new permanent loan. An additional $1 million of equity is required – a massive 25% increase.

This horrifying situation is already playing out on the global stage. Today’s news brought reports that Chinese developers face $55 billion in debt renewing in 2019. Already Chinese Evergrande, perhaps the world’s biggest developer, witnessed a $1.8 billion bond issue go begging. Fortunately, the majority owner Hui Ka Yan was able to personally put up $1 billion to salvage the deal. Meanwhile Indian developers facing a glut of luxury condominiums have watched short term funding costs surge. Investors have pulled $30 billion out of the money market accounts of non-bank institutions that fund such developments. Indian developers are suddenly in a mad dash for capital.

Pigeon meets hawk. Chicken meets guillotine.

Apartment Development has a Big Lebowski Moment

By now, just about everyone knows the boiling frog metaphor. The business parable now sits among the regal pantheon of Vince Lombardi quotes, TedTalks about body postures, and the mystical epiphanies which occur when you gaze deeply in your Steve Jobs mirror. So let’s take the boiling frog story and give it a new level of sophistication. We’ll call it the Big Lebowski moment. This moment occurs when you are chilling out in your bathtub, just like The Dude. Your candles softly glow, the water is nice and warm, and you probably just had some help to induce your tranquil state.

The Dude Abides

For real estate developers, this can be like the construction phase of the project. You’ve done the heavy lifting of designing the building and gaining approvals from the city. You’ve negotiated the contracts and obtained your financing. You sit back a little and marvel as your dream leaps off the paper (or digital file) and becomes reality. This building is really happening. Sure, you will worry about the rogue subcontractor, the deadlines that may ebb and flow, and the weather, but if you’ve set yourself up with a well-planned project you will enjoy the next 18 months.

Once construction winds down, the stress starts kicking in. Will my glorious creature be the pony that every child wants to ride or do I have an old nag who buries its nose in clover when a rider approaches? Or, even worse, did I open one of those dodgy carnivals in a parking lot of a vacant retail strip center and my ponies just got quarantined by the Douglas County Health Department? Rents get adjusted, special lease incentives are offered, sweat beads appear on your brow and the pulse quickens. In Big Lebowski terms, The Nihilists have just arrived while you’re sitting in the tub, and they’ve started to break your stuff in the living room.

It gets worse. The Nihilists have brought a weasel with them (Hey, is that a marmot, man?). They throw the weasel in the bathtub. All hell breaks loose as the furry ferret turns into a screeching water snake keen on drawing blood from a sensitive region of the body. The tranquil tub becomes a frothing cauldron. For real estate developers, the angry weasel represents their debt. Real estate projects are highly dependent upon leverage. Most developers borrow 70% to 80% of their total project costs. Rising interest rates can threaten even the best developments.

Most construction loans have an interest-only period that terminate about 24 to 36 months after the start of construction. The end of the term is often referred to as the “conversion date”: the date at which the loan resets. On the conversion date, the interest rate adjusts to the current market level and the developer must begin paying some principal on the loan. For the past five years, rates have been in an innocuous range around 4%. Conversion dates came and went without much trepidation. Now, rates have risen dramatically. Many construction loans that were marked at LIBOR plus 3% two years ago will soon reset in a new and very weasel-ish world of 5% rates. One-year LIBOR sat at 1.73% in June of 2017, today it sits at 2.74%.

Well, that’s not so bad, you may say. After all it’s only 1% higher than it was a year ago. Yes, but the problem is exponential: your cost of money just went up by 20%. If you borrowed $10 million to build 100 apartments, you now face an additional $100,000 per year in interest expenses. On a per unit basis, that’s $83 per unit per month that you need to generate. From where I sit in Heartland, USA, $83 per month is a substantial amount of money. It’s probably a 10% increase on a one-bedroom apartment. My sister lives in San Francsco where they step over $100 dollar bills like soiled pennies, but here the number is the difference between two tanks of gas or an upper deck seat to see Kendrick Lamar. In other words, its a problem.

In a market facing over-supply, the pressure could become intense. Apartment construction has exceeded rates of household formation for the past six quarters. Higher interest rates will add to the challenges and pose a threat to developers in a way that has not been witnessed since 2007.

The interest rate environment places the Federal Reserve in a complicated position. The effective Federal Funds Rate is 1.75% and a 25 basis point increase is expected this week. Right now, markets place a probability of 41.7% on rates landing in the range of 2.25% to 2.5% by the December 2018 meeting.

Source: CME Group

There are three problems with this outlook:

  1. The 10 Year Treasury Yield stands at 2.96%. A surge in short term rates would almost certainly invert the yield curve – a signal that portends most recessions. The 5 Year Treasury is already at 2.80% which demonstrates a flattening yield curve.
  2. LIBOR rates track short term Fed Funds rates. Most short term financing is set on LIBOR plus a spread. If you extrapolate my example above regarding apartment rents to the entire economy, I do not believe that borrowers can cope with another 1% increase in the cost of short term funds.
  3. Increased rates will draw capital to the US and strengthen the US Dollar. The foreshadowing of this momentum has already set central banks into a frenzy of currency market intervention in Turkey, Brazil and Argentina. If the Mexican Peso joins the crowd, you could have a full blown currency crisis like 1994 or 1998.


The Mexican Peso (MXN) has fallen dramatically against the US Dollar (USD) since April. Source XE.com Currency Charts

Therefore, Jerome Powell must walk a tightrope. He must work to reduce inflation pressure and curb lending excesses, yet the risk of a recession rises with each quarter-point increase. He surely does not wish to create a lending crisis.

The intersection of interest rates, inflation and housing is even more complicated. Most measurements of the CPI show that housing costs are the major driver of inflation. I highly recommend reading the Bloomberg piece on the topic. There is some frustrating irony here: my industry, the one most susceptible to the risks of rising interest rates, is also the cause of the inflation which requires the Fed to raise rates. It’s a logical spiral that circles the drain like dirty water in a candlelit southern California bathtub.




Does Omaha need any more apartments?

A couple of years ago I published my views about the supply and demand of multifamily rental housing in the Omaha metropolitan area. My conclusion was that softness would appear by late 2017 due to an acceleration of supply. I have been pleasantly surprised by the continued strength of the market. Occupancy levels are at 95% or better in most parts of the city.

Unfortunately, the day of reckoning has only been postponed, not cancelled. I believe 2018 will be the first year since 2010 that landlords will be caught short-handed. While I don’t see vacancies rising to the 10%-plus levels we experienced during the dark days of 2004-06 when just about anyone with a pulse was purchasing a house, any pullback in occupancy will feel painful simply because we haven’t been exposed to much adversity in recent years.

Omaha has become large enough now, at nearly 950,000 people, that submarkets can have widely disparate experiences. Northwest Maple Street is an entirely different beast from the Blackstone neighborhood. However, on a macro level, a decline in occupancy of 2-3% seems possible.

There are two reasons why my prediction of market softness has been delayed until 2018. Omaha has grown faster than I thought and developers have been mindful of delivering units at a slower pace.

On the supply side, it’s hard not to ignore the revival of midtown Omaha. Over 1,200 apartments are under construction or just opening south of Dodge and east of 72nd St. Prudent builders released units to the market more slowly than anticipated, however, and the real impact will be felt in 2018 and 2019 when major projects in Blackstone, Aksarben Village and other midtown neighborhoods hit the streets.

On the demand side, population and employment growth have been stronger than I thought possible. We have exceeded 1% population growth for the past few years with a high degree of contributions from international and domestic migration.

My theory has been for many years now that Omaha can absorb 1,200 apartments per year without disrupting decent rent growth in line with inflation. During the recession multifamily permits dropped precipitously to just over 300 units in 2009. Pent up demand and pinched supply signaled a robust market from 2010 – 2016. Now supply is exceeding the 1,200 unit “magic number”. By 2019, Omaha could experience a glut of 2,000 apartments. In the grand scheme of all rental housing, this amounts to about a 2-3% weakening in occupancy levels. This is not disastrous when taken in the context of the metro area.

The pain will be be felt at the top end of the market. The 2,000 unit overhang will attempt to command units nearing $2 per square foot due to the massive building cost and land inflation since 2013. Geography matters. East Omaha will suffer the brunt of the weakness. Developers are correct to recognize the trend towards urban living. It’s unfortunate that they all decided to recognize the trend at the same time.

Like most booms, the story is more about cheap money than it is about demographics. There was a moment this past summer when the 10 year Treasury bond yield began to head towards 3%. Cassandras who had been warning for years that hyperinflation was lurking just around the corner and gold was a safe haven, suddenly began to sound like they were on to something. But as the summer waned, the Treasury dropped to nearly 2% again. It is only about 2.3% now. This rate reprieve has given green lights to many new projects.

Forecasting interest rates is a fool’s errand, but what can not be disputed as we enter our 10th year of extraordinary central bank intervention in the money supply, is that asset price inflation has been rampant. Stock market multiples are as high as they were during the dotcom bubble. If you call a broker looking to purchase an investment property today, you will go straight to voicemail.

The problem is not one of America’s sole making. The Federal Reserve is planning to decrease its purchases of agency bonds and Treasuries. Under normal circumstances, this would signal a dramatic rise in rates. But America does not operate in isolation. Japan, Europe and China have been increasing their supply of money at an ever faster pace. If the US Treasury rises to 2.75%, a fund manager in Zurich will surely be buying when the alternative is less than 1% domestically. The yield on American bonds can not escape the gravity of sub – 2% yields elsewhere. The international market for capital won’t let this US diver come up for air.

The truly international scope of cheap money infects housing as well as securities. Try bidding on properties in San Francisco, Sydney, Vancouver or Toronto and you’ll see what I mean. Even in Omaha, the numbers are distorted. When developers can continue to borrow money at cheap rates, the estimate of risk gets diminished.

I identify five major risks threatening the Omaha apartment business today: The first is the persistently low interest rate cycle. As mentioned above, the cheap cost of capital is giving green lights to developers who might have otherwise tapped on the breaks by now. The second is student loan debt. Young people are the lifeblood of new apartments. They are under tremendous financial pressure today due to the enormous amount of college debt that’s been incurred. While we have a robust economy with local unemplyment rates hovering near 3% today, a slowdown in the economy would stall wage growth and diminish the affordability of high rents. Student loan debt has surpassed the eye-watering level of $1.4 trillion dollars. Yes, that’s trillion with a “T”. Number three is the challenge facing university enrollment. UNO has been growing but is nowhere near it’s target of 20,000 students by 2020. Small colleges are shrinking or disappearing (Grace University is the most recent casualty). National college enrollment peaked in 2011. Fourth, the possible limitations on international workers from the current administration could dampen population growth. Omaha grew by 9,800 people in 2016 and over 1,000 represented international migration.

The fifth challenge facing apartments deserves its own paragraph. The apartment market must also compete with its big brother: the single family home market. The very slow recovery in single family home starts has worked in the apartment market’s favor. Peaking near 6,000 units during 2005, the supply of houses has only now climbed back above 3,000 on an annual basis. The lack of inexpensive new homes has prolonged the renter experience. But this trend will reverse if the economy stays strong and wages continue to grow. Single family permits are on an upward trajectory. When coupled with multifamily permits, the  entire supply of housing is exceeding levels not seen since 2008. The same low interest rates that help apartment developers are the double-edged sword that drives house affordibility.

What’s more, I do not subscribe to the belief that there has been a permanent paradigm shift away from homeownership. Young people still want to start families. When they have children, and if they have the means, they will move to Elkhorn and Sarpy County where pristine schools beckon. Homeownership will probably never return to the insanity of the mid-2000’s but the dream of owning a home did not vanish from society. Millenials may have delayed their family expansion, but the overwhelming human instincts of procreation and self preservation have not ceased. And there’s no place better than a good suburban home for this most American of pursuits.