Below-market upside

It wasn't a typical New York City housing deal—private equity real estate firms investing in Big Apple residential assets tend to gravitate to shiny, glass-clad buildings and ritzy Manhattan addresses. But in late 2005, Apollo Real Estate Advisors made headlines by acquiring an eight-building public-housing complex in the decidedly less tony Soundview section of the Bronx.

The deal, valued at $100 million (€72 million), involved 19-story residential towers bordering the 158-acre Soundview Park, located southeast of the intersection of the Bruckner Expressway and the Bronx River Parkway. Comprising 1.4 million square feet of residential space, the low- to middle-income complex has been namechecked in hip-hop hits, a point of pride for some but not necessarily an indicator of rising property values.

“We started by formulating a strategic plan. Demographic trends including increase in population, the reemergence of the urban cores of major urban areas, the decreasing attractiveness of suburbs, increasing commute times—all of that leads to a repopulation, flight from the suburbs.”

The companies that made up the Soundview project—the Lafayette Morrison and Lafayette Boynton housing corporations— were rechristened Lafayette Estates after being acquired by Apollo. They fell under a New York housing program known as Mitchell-Lama.

Bidding wars over similar developments, such as Stuyvesant Town-Peter Cooper Village in Manhattan and Starrett City in Brooklyn, are testament to a shift in investor appetite toward a road less traveled, in this case, properties tied up with regulatory complexity. Despite seemingly insurmountable bureaucratic obstacles, including a year-long, state-regulated buyout process, private investors have been circling New York's socalled Mitchell-Lama affordable housing developments. These deals are hard to come by and hard to execute, but they offer surprisingly conservative risk-reward profiles.

News of the Lafayette Estates acquisition came as no surprise given Apollo's record of outer-borough acquisitions. But the firms still had to do a special kind of homework on the apartment complex, which it plans on turning into co-ops to capitalize on the rising numbers of people moving to the city.

“We started by formulating a strategic plan,” says James Simmons, a partner at Apollo. “Demographic trends including increase in population, the reemergence of the urban cores of major urban areas, the decreasing attractiveness of suburbs, increasing commute times—all of that leads to a repopulation, flight from the suburbs.”

Apollo acquired the Lafayette Estates for $41,000 per unit, or $53 per square feet—an acquisition price approximately 70 percent below market. The units will be sold to existing tenants for approximately $80,000 per unit and to the open market for approximately $120,000 per unit. Additional government subsidies of $10,000 per unit are available to current residents.

Apollo partnered on the deal with Housing and Services, a nonprofit developer of affordable housing, and global alternative investment firm Ramius Capital Group.

The Soundview project is one among several ventures by Apollo in the affordable housing market. In January 2006, the firm partnered with Vantage Properties to acquire the Delano Village complex in Harlem for $175 million. The seven-building, 1.3-million-square-foot complex between Malcolm X Boulevard and Fifth Avenue, renamed Savoy Park, was 99 percent occupied at the time. All 1,800 units are rent-regulated.

Eight months later, Apollo acquired a portfolio of condominium units at Fairfield Towers, a mid-rise housing complex in the East New York section of Brooklyn, in a joint venture with Taconic Investment Partners. Purchased for $90 million from the Lightstone Group, the 19-building, 983-unit complex along Flatlands Avenue was built in the 1960s under the Mitchell-Lama program and converted to condominiums in the 1990s.

“From a risk-adjusted returns perspective, [affordable housing] is one of the best investments available,” says Simmons. “Rents are well below market, and there is less of a chance for those rents to decline. Because we're investing in improving neighborhoods, we believe the probability is high that we can move those rents closer to market value.”

The buyout process
The process of converting Lafayette Estates from a state-subsidized, rent-regulated complex to one with market-rate housing was not easy. “It is a year-long, public process defined by regulatory oversight whereby we take the asset out of Mitchell-Lama,” says Simmons. “The next step is to submit an offering plan—get it approved—and start to sell and close units.”

Introduced in 1955, the Mitchell-Lama Housing Program, named after Manhattan Senator MacNeil Mitchell and Brooklyn Assemblyman Alfred Lama, was created to encourage the building of affordable housing for moderate-income residents. Private developers in the program were offered property tax breaks and low-interest mortgage loans for up to 95 percent of total development costs. In exchange, they were required to limit profits and regulate rents.

According to the New York State Division of Housing and Community Renewal (DHCR), a total of 269 Mitchell-Lama developments with more than 105,000 apartments were built under the program.

In a provision added to the Private Housing Finance Law in 1957, building owners in the Mitchell-Lama program became eligible to “buy out” of the program after 20 years. After withdrawing from the program, the housing company would no longer be subject to DHCR regulations or the limitations on profits or rents.

The DHCR is responsible for regulating the buyout process. Withdrawing from the program requires submitting a buyout application to the DHCR at least a year before the anticipated date of dissolution. Once it has reviewed all materials, the DHCR authorizes the housing company to proceed and then notifies the public of the buyout. After fee payments including mortgage prepayment and outstanding expenses have been received by the DHCR, it then issues a certification of dissolution to the Secretary of State and a “Certificate of No Objection” is issued to the housing company.

Still, despite the mountains of paperwork, the Mitchell-Lama buyout process has not presented itself as a significant obstacle to investors. “The number one challenge is finding [these properties],” says Jeff Barclay, a managing director at ING Clarion, the US investment management arm of ING Real Estate. “Once you own them, the number one challenge is executing the strategy, which is why we have operating partners. So the challenge is finding the right operating partner.”

The 20-year contract expiration is one of the reasons investors have been interested in properties governed by Mitchell-Lama, says Stuart Saft, a real estate lawyer and partner at LeBoeuf, Lamb, Greene & MacRae. The options available for properties after they are bought out from the Mitchell-Lama program is a matter of age and the year the property was built, says Saft. Properties built after 1974 become rent stabilized after leaving Mitchell-Lama, meaning owners may only raise rents by a certain percentage each year. Properties built after 1974 become “free market.”

Additionally, according to Saft, under New York's “luxury decontrol” law, if an apartment's rent has increased to $2,000 a month or the tenant's income exceeds $175,000 for two consecutive years, at the end of the lease the apartment becomes free market—as anyone who has spent anytime in the New York real estate market quickly learns.

Neighborly unrest
According to the DHCR, of the 269 developments built under Mitchell-Lama, there are currently 184 developments with approximately 73,000 units left in the program—85 properties have dissolved and left the program so far.

“The market has been so hot in New York City, there has been an enormous loss of affordable housing in New York State and the Downstate market,” says Deborah Van Amerongen, commissioner of the DHCR. “There has been very heated interest in the market, especially after the focus on Starrett City which was such an enormous unit.”

Van Amerongen is referring to the Starrett City housing complex on Jamaica Bay in the East New York section of Brooklyn. Built in the mid-1970s under the Mitchell-Lama program, the 140-acre complex is comprised of 46 buildings with 5,881 units. New York real estate investment shop Clipper Equity signed a contract earlier this year to purchase Starrett City for $1.3 billion, but the plans were derailed in April when, following its review, the DHCR refused to approve Clipper Equity's proposal citing reasons including a flawed affordability plan, the possibility of rents being raised to market levels and concern that the deal would set a precedent for other Mitchell-Lama purchasers.

Other deals in the space have been more successful. In one of the biggest real estate deals in US history, New York property group Tishman Speyer, in a joint venture with BlackRock, acquired the Stuyvesant Town and Peter Cooper Village complex in Manhattan from Metropolitan Life for a staggering $5.4 billion. The 110-building, 11,232-unit complex, built in the late 1940s by MetLife, sits on 80 acres along the East River.

Other firms, including Apollo and ING, had high interest in the Stuyvesant Town-Peter Cooper Village property. “We were very active in pursuing Peter Cooper Village,” said Jeff Barclay, a managing director with ING Clarion, the US investment management arm of ING Real Estate. “There are probably very few properties of that size and scope.”

In March, London-based investment group Dawnay Day purchased a portfolio of 47 buildings in East Harlem for approximately $250 million. The buildings include 1,137 residential and 55 commercial units. The firm established a new company, Dawny Day US Real Estate Management, based in New York, to manage the Harlem portfolio and is currently assessing similar types of US acquisitions, according to the group.

Also in March, ING Clarion acquired the 1,400-unit Eastchester Heights apartment complex. The acquisition was made through a joint venture with Taconic Investment Partners and purchased for approximately $120 million, according to Barclay.

The spate of recent Mitchell-Lama buyouts have inspired concern from tenant groups seeking to preserve their community and keep rents low—a potential political obstacle that private equity real estate firms looking at affordable housing investments need to keep in mind.

Housing lawyer Saft says that landlords can engender goodwill with current tenants of a Mitchell-Lama building by providing a realistic timeline for rent increases. He says new owners can “faze in rent increases over four or five years—a reasonable period of time— for tenants who demonstrate they can't afford market rent right away.”

The influx of capital in affordable housing is not without its merits. Many of the properties built under the Mitchell-Lama program have fallen into disrepair in the intervening years, according to Saft. “Mitchell-Lama was a terrific way of developing housing, but the owners' return was limited to 6 percent a year,” he says. “There was little motivation for landlords to upgrade the properties.”

Private investors, on the other hand, are more likely to make capital improvements on the buildings, particularly as they raise rents and attract new tenants. “There is no limit on returns for landlords after leaving the Mitchell-Lama program,” Saft points out.

ING Clarion's Barclay is optimistic about activity in the affordable-housing sector. His firm has invested in affordable housing in New York and he says he sees the investments as a way to boost the economy.

“[These investments] are a strong vote of confidence in the New York economy,” he says. “Many institutional investors focus on the luxury end of the market—properties that typically draw its demand from not only New York buyers but also foreign owners and buyers. We think investing in this type of asset helps New Yorkers and the economy.”

Indeed, the surge in New York City real estate prices has cast a softer light on neighborhoods that were once written off—and plenty of firms are now acting on an attraction to affordable housing.

New York's rent stabilization rules should not be viewed as inherently bad for investors, Barclay says. Return on investment in stabilized buildings, though never a sure thing, can be expected as the stabilized rents eventually increase to market levels.

“Our institutional investors look for both stability and growth,” Barclay says. “[These projects] predict returns reasonably well—not only steady but growing returns. There is strong demand for these properties because rent stabilized apartments are below market rents by definition. They can grow to market level relatively predictably—just let things take their natural course.”