The art of the simplified portfolio

Author: Wendy Broffman
Published: September 2015

"Simplicity is the final achievement. After one has played a vast quantity of notes and more notes, it is simplicity that emerges as the crowning reward of art." Frederic Chopin

Would you rather have more of something worth less or less of something worth more? Execs at Denver, Colo.-based apartment REIT Aimco pondered that question as the collapse of the housing market and the loss of some 8.5 million jobs during the Great Recession triggered a cultural shift toward renting.

The massive loss of American homes to foreclosure that tarnished the American Dream of homeownership, combined with tighter lending requirements that kept homeownership out of reach for many Americans were just part of the confluence of circumstances that became the catalyst for the greatest rush to rental properties since the late 1960s.

As the economy began its slow recovery, the popularity of renting increased to its highest level since 1998, while construction of new apartments continued at their slowest pace in 50 years. Apartment REITs looked to take advantage of the opportunity to raise rents among those most able and willing to pay-the renter by choice.

Most REITs began to focus on coastal markets, where incomes were higher and perceived barriers to entry greater. Meanwhile, Aimco undertook a transformation that touched nearly every aspect of its business, including its logo, Website, portfolio size and customer makeup.

"The incomes of our customers had been more or less flat for a dozen years and the higher income customers we began to target were better able to pay high and rising rent," said Aimco chairman and CEO Terry Considine, who has been involved with the apartment industry since his college days at Harvard during the late 60s and early 70s.

John Bezzant, who joined the REIT in 2006 and serves as executive vice president and chief investment officer, refers to Aimco's multiyear effort as a distillation process to simplify the portfolio, moving out of assets where the prospects were not as promising, including its "affordable" assets-those with some form of government assistance to residents-into higher quality assets in submarkets with more promising fundamentals. But, because better quality assets cost more, the size of Aimco's portfolio shrank while its gross asset value grew.

Aimco classifies its affordable portfolio in separate buckets. Its "affordable owned" portfolio consists of properties with Section 8 housing contracts and in which Aimco has a direct ownership interest. The second is made up of properties Aimco took through low-income housing tax credit (LIHTC) redevelopment and then syndicated the tax credits themselves, a business Aimco entered in the mid-2000s and continued through 2009, when it began to implement an exit strategy.

"Once we decided to exit the LIHTC development and syndication business, the necessity of holding the affordable-owned communities for that activity was gone, so we commenced in earnest to sell down our affordable-owned portfolio and we are down to less than a handful of properties today," said Bezzant. The company still has general partner interests in several LIHTC funds with more than 50 properties. It intends to exit these interests as tax credit deliveries are completed over the next few years.

The value of change
Aimco's transformation is most dramatic when one looks at the history of the company that became a public REIT in 1994 and grew rapidly over the following years through mergers and acquisitions, eventually topping the NMHC's top 50 owners and managers list for five years. Its slightly different financing structure and diverse portfolio that included a large number of Section 8 units set Aimco apart from its peers.

In the early years of Aimco's growth the REIT roughly doubled in size every 18 months, said Bezzant.

"That was more than an anecdote," added Considine, "it was a fact for eight years."

At the height of Aimco's growth in 1998, the REIT owned 390,000 units in 2,100 properties spread across 72 markets, making it the largest owner and manager of apartments in the nation.

Today, Aimco owns 199 communities in 23 states and the District of Columbia and its 50,100-unit portfolio is comprised of around 50 percent Class A, 33 percent Class B and 17 percent C-plus assets.

Paired trades
Aimco invests through a disciplined paired-trade strategy, a conservative buy and sell tactic considered leverage-neutral and tax efficient because the company only engages in the practice when the projected free cash flow IRR of an investment is greater than the projected free cash flow IRR of the property sold and the company's portfolio is enhanced.

The result is that the REIT's free cash flow margin increased 12 percent from the end of 2011 to the second quarter of 2015, as the percentage of the portfolio invested in A quality assets increased by 65 percent, funded by the sale of virtually all the company's lower-rent C properties and other communities in less desirable submarkets.

"We follow our paired-trade discipline in all our investments, focusing on 12 to 15 target markets and, when we allocate capital, we have several options," said Considine, noting that the most attractive use of capital often is to upgrade properties the REIT already owns, whether through capital improvements or development.

For 2015, Aimco expects to invest a total of $288 million in a combination of redevelopment, development and property upgrades. In Q2, Aimco increased its spending expectation for property upgrades alone from $45 million to $55 million and expects to see some NOI upside from the activity.

Aimco's geographically diverse portfolio enables it to capitalize on economies of scale that allow for operating efficiencies and bargaining power for expense items. Some efficiencies are obtained by using single vendors across the whole portfolio rather than different vendors for separate properties or markets.

"A good example of a property upgrade is our wood flooring program. It helps our revenue in terms of rent premiums paid by customers who see it as a preferred product, but also helps save capital dollars because wood flooring lasts 15 years versus carpet, which typically only lasts for about two or three. We also save expenses because it's a lot cheaper to mop a floor than to do a professional carpet cleaning every time a resident moves out," said Aimco CFO Ernie Freedman during the REIT's Q2 earnings call in July.

Although not as high-end as wood, vinyl plank flooring also lasts longer than carpet and is a popular choice among renters who see the value in using area rugs for softness rather than living with wall-to- wall carpeting that is harder to keep clean.

Karndean Design Flooring, based in Pennsylvania, provides vinyl plank flooring for Aimco's properties.

Other capital improvements that help the REIT command higher rents include the installation of wine coolers and high-end appliances in penthouse units and the use of more efficient HVAC, water heaters, energy efficient light bulbs and GE appliances, the latter supplied by Aimco partner/vendor Wilmar, one of the nation's largest distributors of maintenance supplies for the multifamily industry.

When it comes to other uses of capital, Aimco is able to increase density within properties it already owns by building new apartment units with little or no additional land cost, as at its recently redeveloped Lincoln Place project in Venice, Calif., where Aimco added 99 new units.

A third opportunity is to purchase new assets. "But in today's competitive market, pricing is unattractive, except where we can add value through improved operations," said Considine.

"Many markets are fully priced and this would not be a time when we would be inclined to 'buy the market.' John (Bezzant) is focused on anomalies rather than buying a particular market or asset at market pricing. So he looks for circumstances where we think there is something that has been missed or where we can add value. Without that, we are unlikely to buy assets from others." he said.

While Aimco historically has not been a huge developer and rarely takes on such projects, "we still look at development as one of the arrows in our quiver when we have the opportunity to work with an experienced local partner on a high-quality location," said Bezzant.

Aimco might, for instance, participate in new development if it is unable to access a target market by either accretive redevelopment or acquisition, such as the REIT's 310-unit One Canal development in Boston or the 91-unit Vivo in Cambridge, both of which are being built for Aimco by local development partners.

"We don't carry much development risk on our balance sheet because we don't want to speculate on land or entitlements, but we will look at the full range of transactions that meet our portfolio goals, from equity participation-where we pay for the building to be built, like with One Canal-to the 115-unit Axiom near Kendall Square in Cambridge, where we partner up with a local developer and take it out upon completion," said Bezzant.

"We are content to invest the bulk of our capital dollars on redevelopment within our existing portfolio, as this is typically a higher-return activity for us. We like to keep our pipeline of development and redevelopment at an annual run rate of three to five percent of our gross asset value and, at that level of investment, are comfortable we are not getting over extended in terms of risk," said Bezzant.

Quality over quantity
The value of Aimco's portfolio shift is evident in the improved quality of the REIT's renters, which have a median age of 35 and are some of the highest earners in the rental pool.

The average income of new residents who moved into an Aimco apartment during the second quarter was $148,000, with a median income of $90,000, up 20 percent compared to the same quarter in 2014, while average revenue per apartment home was $1,760, up 14 percent year over year. Aimco's service record also is at an all-time high, according to satisfaction surveys the REIT conducts among customers.

"We are focused on customer service and that has many facets to it, but, in the end the assessment is made by the customer. We ask their opinion about everything and their responses drive what we do onsite and the customer focus comes from doing a good job on maintenance or from doing a good job upgrading the apartments," said Considine.

Over the past two years, Aimco customers have provided 170,000 answers to surveys revealing steadily rising satisfaction scores.

"In the first quarter, Aimco customers graded us at 4.12 stars out of five and (our teams) are working to earn that fifth star," said Considine.

Having satisfied residents allows Aimco to keep turnover low, which helps control turnover costs that run approximately $2,300 per turn.

Customers are now renting an Aimco apartment for an average of 24 months, up from 22 months just three years ago, and turnover has averaged 48 percent, lower than the peer average of 55 percent.

Diversification versus location
The well-known mantra of real estate may be location, location, location, but Considine believes diversification is the best way to prepare for inevitable market fluctuations.

While Aimco may have joined its REIT peers in targeting higher income renters, its portfolio remains the most diverse among them by not limiting its markets to both coasts.

Thirty-one percent of Aimco's NOI is derived from coastal California (soon to increase to around 33 percent as some redevelopment projects there are completed), 25 percent from the Mid-Atlantic, 15 percent from the Northeast, 10 percent from the Midwest (70 percent of that is from Chicago alone) nine percent from Southeast Florida and 10 percent from the Sunbelt.

Maintaining footprints in the Sunbelt, Southeast Florida and the Midwest helps Aimco avoid concentration risk.

"Every market will become overbuilt. It's just a question of when because that's how markets work. They tend to overshoot and then correct and our business strategy is to acknowledge that and be diversified so that we are invested in markets with different cycles and timing.

"So today our largest market is Washington, D.C. and it's been in correction mode for the last four or five years and yet our other markets that are in expansion mode have provided handsome returns. But there will be a future as there has been a past and Washington, D.C. will be in ascendency and it will be offsetting slower growth elsewhere," said Considine.

Recent acquisitions highlight the success of the REIT's diversification strategy, like last year's purchase of the 324-unit Saybrook Pointe Apartments in San Jose.

Aimco paid $118.4 million for the B class property and expects a levered eight percent IRR after property upgrades and operational improvements. The asset was 97 percent occupied at close of escrow.

Prior to acquiring Saybrook, Aimco was under-allocated in the Bay Area, deriving only five percent of its NOI from the market, but eventually wants to be invested there on a long-term basis at around seven to eight percent of the portfolio.

Aimco also would like to expand in Seattle, where it recently completed redevelopment in Q2 on the 135-unit, 2900 on First in the Belltown submarket, and in New York, having entered Manhattan with the purchase of five assets in 2003.

Considine's philosophy on diversification also extends to price point. He believes building tends to occur and continue in a market until it is no longer profitable, while new supply typically is delivered at the highest price points. Therefore, Aimco's portfolio of A, B and C-plus quality assets provide insulation from overbuilding.

Debt differences
Aimco recently shifted its strategy to maintain and grow a pool of unencumbered assets by repaying maturing mortgage debt. The REIT's use of non-recourse debt and preferred stock as its financing tool differs from most of its peers and helps protect it from asset-level issues.

"We have always used property debt versus corporate debt for several reasons. One, it is generally lower cost. Two, it is safer and three, it sometimes permits longer duration.

"For example, we have a 40-year loan on our balance sheet that would be very unusual in corporate America. It's a bit more cumbersome, but I place great value on predictability and caution, so at a time like this, when interest rates might fluctuate, we are relatively insulated because we have long-rated average maturities, limited exposure to refunding risk and not much pressure generated by fluctuations in the bond market," said Considine.

Aimco's only recourse debt at June 30 was its revolving credit facility, which the REIT uses for working capital and other short-term purposes and to secure letters of credit. At quarter-end, Aimco had outstanding borrowings on its revolving credit facility of $47.5 million and available capacity of $514.9 million, net of $37.6 million of letters of credit.

The REIT's conservative financing strategy and improved portfolio has resonated with several ratings agencies, which have increased Aimco's rating to investment grade.

Considine admits he would consider, if warranted, the possibility of selling assets and holding the proceeds in cash or using them for further deleveraging, but the REIT's predisposition is to stay fully invested in real estate.

"When you think about Aimco as a REIT," said Bezzant, "we are fully invested in real estate. That's what we get paid by our shareholders to do-to own real estate for them and return to them the profits by so doing. Our paired trades are an equation and we compare some very specific metrics, starting with our free cash flow internal rate of return, which is our primary investment metric.

"We want to invest up so obviously we're selling the lower anticipated IRR over a 10-year hold period and buying a property that delivers a higher IRR, but we also look at current cash flow on the properties and the growth rate for the submarkets the properties are located in, both historically and for the next five years. We look at median household incomes and median home values in the area of the properties to be bought and sold, as well as revenue per unit as part of the trade. At the end of the day, we have positive match movement," he said, adding that Aimco looks to recycle between five and 10 percent of its gross asset value annually, somewhere in the range of $500 million to $1 billion in a typical year.

Considine believes that Aimco's greatest challenge today is to "remain balanced-appropriately aggressive when the markets are good, but cautious about the inevitable overbuilding, market downturns and economic volatility that will occur, while maintaining our cultural values that allow us to be effective and fulfilled as we do our work," he said.