Why garden apartments have growing institutional appeal

The competition for garden-style apartments is reaching fever pitch for private real estate players active in the space.

Prices have been surging for existing garden apartments, low-rise complexes that tend to span wide swathes of land in suburban areas. In this heated environment, Chicago-based multifamily specialist Waterton is doing something it has never done before in its 25-year history: investing in ground-up development.

Traditionally a value-add fund manager, the firm plans to invest roughly $150 million of equity into the construction of new apartments throughout the Sunbelt corridor of the US, PERE has learned. It will draw from its Waterton Residential Property Venture XIV fund, which closed on $1.5 billion last year.

Including debt, the initiative will deploy between $500 million and $600 million, Waterton chief investment officer Rick Hurd tells PERE.

In some markets, the firm has observed capitalization rates fall to 3.5 percent for acquisitions in this sector, whereas new developments have been able to achieve a cap rate of 5.5 percent.

“That spread is very attractive to us,” Hurd says. “In certain markets, we are seeing all-in acquisition costs for existing deals to be at or even exceeding the cost to develop new, and we’d rather buy a new property with no obsolescence, no outdated facilities and a lower cost basis than where some of these transactions are trading today.”

The cap rate compression observed in the transaction market is the result of more groups looking to buy into the property type, Hurd says.

“I’ve never seen it this competitive when we’re out trying to bid on deals. It’s very, very aggressive,” he says. “You’re seeing the trade-out rents high and that’s benefiting the development side of the business right now.”

Many managers, however, are not pursuing a development approach like Waterton and have opted to invest through acquisitions instead. Martha Peyton, managing director of real assets applied research at Netherlands-based Aegon Asset Management, noted that a development strategy requires a lot of land and close proximity to big job markets, both of which are expensive and hard to come by.

“The most attractive garden apartments projects are in markets where you don’t have a lot of land, you don’t have a lot of opportunity to build, where it is difficult to get planning approvals to build, and that creates really tight markets and puts a floor under rents,” she says. She adds that she did not believe the replacement cost analysis to be particularly relevant for this sector, given the high degree of variability in land cost and location.

Garden growth

Still, the appeal of garden apartments for institutional capital is undeniable. In the past two months, Blackstone has used its non-traded REIT to acquire two listed groups that focus on garden-style apartments. It purchased Bluerock Residential Growth REIT, which owns 30 apartment communities consisting of 11,000 units, for $3.6 billion in December, then followed that with a deal to buy Resource REIT, which owns 12,600 units across 42 properties, for $3.7 billion in January.

Smaller managers are getting in on the action, too. Santa Monica-based Turner Impact Capital, a $1.4 billion investment firm, bought a 1,155-unit garden apartment complex in Glendale Heights, Illinois from Rockwell Property Company this week. It was the largest transaction on record in suburban Chicago, according to the brokerage JLL.

Several factors have contributed to this industry-wide shift, Peyton tells PERE, but the list starts and ends with performance.

In a white paper released last month, Peyton found that garden-style apartments had a total return of 21 percent during the one-year period ending September 30, 2021. That was the second-highest rate of any property category behind industrial, which exceeded 30 percent, she found, citing the NCREIF Property Index. Overall residential returns were 13.4 percent and the all-asset rate was 12.1 percent.

The sector has been boosted by the pandemic in several ways, Peyton says, pointing to the outflow of renters from urban high-rises, increased housing formation trends among millennials, a shortage of suburban homes and an overall affordability crisis building in the housing market.

Hidden gems

The category’s outperformance of the broader real estate market is nothing new. It has posted higher returns than all other property types except industrial over the past 20 years, according to NCREIF data.

Garden apartments have also had a more favorable cap rate over the past two decades than other multifamily types, at 5.5 percent versus 4.9 percent for standalone low-rise buildings and 4.7 percent for high-rises, per Peyton’s report.

Despite the recent uptick in demand, garden apartments have been relatively untapped by institutional capital to date. Of the more than $200 billion of apartment assets in the NCREIF Property Index, $120 billion were high-rise while garden-style made up just $60 billion. Of the 94,000 garden apartment properties in the US, funds only own about 6 percent, while developers own 43 percent and individuals own about 20 percent.

Peyton says institutional participation in this market has been limited, in part because it is easier to deploy more capital into urban towers. But perception has played a role, too.

“Garden apartments are not glamorous,” she said. “They don’t show well in photographs.”