PERSON OF THE WEEK: This week, MortgageOrb spoke with David St. Pierre, president of private-equity firm Legacy Capital Partners. The Lyndhurst, Ohio-based company has changed its focus over the last couple of years, from investing in commercial real estate development deals to injecting capital into undervalued assets. St. Pierre discusses the motives behind this move and his overall impression of the commercial development market.
Q: When did you decide to shift away from investing in traditional development deals to focusing on investing in undervalued assets? What specific signs did you see in the market that indicated it was time to re-direct your capital?
David St. Pierre: We began the shift out of investing in traditional development deals in mid-2008. At that time, it was not a smooth transition from development deals into investing in under-valued assets. There was a period during which we remained on the sideline, not sure of where or how to invest our dollars.
The challenge was that, as the capital markets were freezing up and the overall economy was faltering, it was impossible to assess the value of any assets, and it wasn't clear how undervalued an asset was, because everything appeared to be undervalued based on where valuations had been no more than 12-18 months prior.
It was clear that valuations were dropping throughout 2008 to a degree that it no longer made sense to focus on investing in new development opportunities. There was no way to justify the economics of building a new apartment project for $125,000 per unit when you could buy an existing project at $75,000 per unit.
At that time, the question was no longer ‘Do you build or buy?’ The question became ‘Do you buy at $75,000 per unit, or would the value of that project be $60,000 per unit six months later?’
There have been a handful of new development deals that we have seen from June 2008 until today that we thought may have some merit (primarily because they were in very high-barrier-to-entry markets), but with no construction financing available, the probability of them getting off the ground has been nonexistent, so we have not spent too much time on these opportunities.
In mid-2009, we made the decision to begin actively looking to invest in the acquisition of existing assets based on the underlying trends in the multifamily market. Despite the fact that the apartment sector's national vacancy rate rose in the third quarter of 2009 to 7.8% – the highest it has been since 1986 – and with unemployment at 9.8% – a 26-year high – we felt the strength of the underlying trends justified investing capital.
First, renter households increased in 2009 for the fourth consecutive year, and the demographics for future housing demand, especially for-rent multifamily housing, remain strong, with the largest generation of Americans reaching adulthood (aged 20-29) over the next decade.
In addition to the overall demographics, homeownership percentages have declined and are expected to continue to decline as a result of the recent residential housing bust, which is creating additional renter households.
New development of market-rate apartments has been declining since 2000, and the significant pullback of development capital has squeezed the projects under way to record lows. The lack of new development projects becoming available for lease will exacerbate the supply/demand imbalance for the near future.
Q: Many observers believe commercial property values will bottom out this year, with some calling bottom for certain asset types already. What sort of timeline do you foresee for property values?
St. Pierre: We feel that the multifamily asset values have already reached bottom or are very close. As far as other property types, we do not feel the bottom will be reached in 2010, and maybe not until the second half of 2011.
Retail and office valuations are far more unpredictable than those of multifamily, given the fact that the full impact is not yet known. In a multifamily asset, the 12-month lease provides a much quicker indication of the impact of the economic downturn. With retail and office properties, the lease terms are typically longer-term and, although tenants may continue to remain in their space today, as soon as their lease expires, they may vacate or downsize, further impacting a property's value.
We believe the upward trends in multifamily are far more predictable and certain than with the other asset classes. That is not to say that the multifamily market will not continue to struggle during the balance of 2010, but we do believe it will be the first asset class that will recover.
Q: In the ‘traditional’ development market, when might we expect to see a return to normal levels of activity? How will the new ‘normal’ differ from the old?
St. Pierre: Normal levels of traditional development activity will not begin to return until at least 2012, and when it does, the new normal will be more conservative, with greater levels of pre-leasing and more real-cash equity invested in the projects.
That said, we do expect to see select development projects that will present compelling investment opportunities. In fact, we are currently underwriting and analyzing a couple of new student housing developments and a few grocery-anchored retail centers.
Q: When selecting undervalued assets in which to invest, what criteria do you use to determine the best opportunities? Is there a typical profile for your preferred properties?
St. Pierre: When we are looking at investing in undervalued opportunities, we are looking for current cashflow with value-creation potential. We are focused on opportunities where the value creation can be achieved not by speculating on future cap-rate compression, but from the ability to drive increased net operating income, based on realistic and conservative assumptions.
In many cases, the ability to increase revenue is based on a substantial renovation program that will significantly improve the overall quality of the asset and justify increased rents, so long as they are supported in the market.
We are looking for opportunities that will generate 8% or greater current returns and that will increase to low teens in 24 months. Overall, we are looking to achieve 18% to 22% internal rate of return on a seven- to ten-year hold.
Q: What are your predictions for commercial mortgage-backed securities (CMBS)? News of some recent deals has been promising, but how much CMBS market activity do you think we'll ultimately see this year?
St. Pierre: There is no question that the news of JPMorgan Chase's and Bank of America's securitizations late last year were signs that the CMBS market might be returning. RBS' recent sale of the first multi-borrower pool of assets since 2008 is a very good indication that the commercial mortgage-backed securities market may be back.
That said, although the activity will increase, I do not think the overall activity for the year will be that strong. To me, what is promising is not the ultimate dollar amount of the activity as much as the fact that there is any activity at all. It is one sign of liquidity starting to return to the paralyzed and frozen real estate capital markets.