Should Private Equity Invest in Residential Real Estate?

When new owners took over an apartment building in the New York City borough of Queens, they promptly set about filing eviction notices, suing nearly half of the building’s tenants — some of them multiple times — within the first 16 months. That amounted to 965 court proceedings against 2,124 apartments, compared with just 50 court proceedings in the final year of the previous owner. The complaints alleged that the tenants were subletting illegally or had not paid their rent or security deposits, even though the tenants often had records proving otherwise. To the tenants, it seemed as though every possible legal vulnerability was being sought out in an effort to force them out.

This kind of activity — flushing out low-rent tenants and replacing them with wealthier new renters — has been a staple of strong real estate markets for years. What was different over the past few years was how widespread this Dickensian business model had become, largely fueled by Wall Street money seeking high rates of return. Another difference was how much the general investing public — through university endowments and pension funds — became party to such morally dubious schemes. Consider it another footnote to the Gilded Age we just passed through.

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This investment trend, which flourished from 2005 until the financial crisis hit in 2008, threatened a cherished pillar of urban policy — affordable housing, which has long been regarded as essential for maintaining vibrant diversity in our cities. The victims are among the huge numbers of Americans (estimated at close to 100 million before the latest housing boom promoting homeownership) who rent their primary residences — poor, working-class and even middle-class folks — who have been overshadowed in the deluge of media coverage of the debacle in single-family housing. (Affordable housing refers to that costing no more than a third of a family’s income.)

But as private equity funds seized on the rental market in major cities in recent years, all this was jeopardized by the need to generate fat returns of 15%-20% per annum. Worse, this business model was based on a dirty secret — expelling as many existing tenants as possible. This is the thuggish reality behind otherwise respectable-sounding prospectuses offered to investors to explain how they could service high debt on mortgage-backed securities. “The borrower anticipates to recapture approximately 20%-30% of the units [roughly within the first year] and 10% a year thereafter,” explained a prospectus for a portfolio of buildings in upper Manhattan being bought by Apollo Real Estate Advisers (now AREA Property Partners), with a primary mortgage from a Credit Suisse subsidiary. The normal turnover rate in cheap or moderate rent-regulated apartments in New York City is 5.6%, according to data from the New York City Rent Guidelines Board.

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“From a public policy standpoint, you can make a strong case that it is not desirable [for Wall Street money to be in this market], and equally strong you can say that housing regulators or authorities in New York and most other cities have been asleep at the wheel for the last five and 10 years — this stuff is going on everywhere,” says Guy Cecala, CEO of Inside Mortgage Finance Publications, a stable of industry newsletters, who worries that the very idea of affordable housing is under threat.

But these securitized transactions were considered a legitimate business strategy by investors, who typically focus on the cash flow from these deals, not the fine points on how cash is generated. “These could have all been brothels or sweatshops underlying them, and nobody would know that either,” says Cecala, who notes that “one of the reasons for buying securities … is supposedly you don’t have to worry about any of that; someone else is supposed to have signed off on the legality of the transactions, the business practices, everything.”

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Those packaging these investments say they regarded them as aboveboard, though their defense is less than robust. Key players included leading banks in tandem with some of the biggest names in real estate and private equity, none of whom would have missed that high tenant turnover was the main motor for profits. “We truly went into this trying to turn housing that was run very, very poorly by slumlords into affordable working-class housing, and to be portrayed like this is somewhat upsetting, to be quite frank,” says Richard Mack, who works at AREA Property Partners, a $9 billion partnership, with his father William, who got his start in 1963 with a 5-acre plot of New Jersey swampland. The turnover targets were perhaps “more aggressive than people think they should have been,” but he says, “Life is too short for us to have done this, with this small a part of our portfolio, if we didn’t actually think we were doing the right thing. Whether or not we executed as perfectly as we could — I’m sure that we made mistakes — our true intention here was to make money by doing good.”

Tenants pried from their homes would see it differently. In a typical Queens building, hired legal guns were able to achieve 23% turnover in the first year of new owners, or about double that of a typical building in Manhattan, where the culture of tenant rights is stronger, according to a new study by affordable-housing advocates, the Association for Neighborhood and Housing Development. The study focused on New York City, where Wall Street money made the most inroads — capturing about 100,000 units (out of the city’s 2.5 million), or about 10% of the city’s rent-regulated apartments before the real estate bubble collapse.

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In this process, the report explains, the investor-owners were helped by the fact that many transitional neighborhood tenants were new (and possibly undocumented) immigrants, whose lack of English fluency and legal representation put them at a disadvantage in housing court, where deals are typically hammered out with owners’ lawyers before ever reaching the judges. Those actually executing these orders were often conflicted about it. “Having a large property owner as a client is great for the volume of work, but if you ask me about it morally or ethically, well, I’d rather not say,” admits a housing court attorney who asked not to be identified.

Others are inclined to give big investors the benefit of the doubt. “If people are really stretching the law — doing outright harassment to remove tenants — that’s not a good thing, but I don’t think that most big institutional investors knowingly will target deals like that or knowingly target deals with partners where they think that might happen,” says Andy McCulloch, senior residential analyst with Green Street Advisors, a property research shop.

In the end, though, many new owners have been unable to meet their overly ambitious rent roll increase targets, and many of these investments are in danger of buckling under the high debt servicing costs. Finance industry watch lists are already full of private-equity-financed deals in danger of default. That has local officials scrambling to find “preservation buyers” who are willing to take on these properties with the expectation of a more modest 7%-8% annual return.

“I do think it is a problem … and that’s why we are putting our resources to bear to try to correct the problem before it becomes a bigger problem than we can tackle,” says Rafael Cestero, commissioner of New York’s Department of Housing Preservation and Development. “Ownership of rental properties in New York City is a long-term proposition, and if you do it right, you can make a fair profit, but trying to make a short-term investment is where you can get yourself in trouble.”

Nowhere was that more true than in the ill-conceived investment to turn the twinned 11,000-unit middle-class housing complex known as Stuyvesant Town and Peter Cooper Village, built originally to accommodate World War II veterans, into luxury housing, for which limits on yearly rent increases are chucked in favor or whatever the market will bear. The prospectus offered by the lead investors, Tishman Speyer and Larry Fink’s asset-management fund BlackRock, imagined evicting 50% of rent-regulated tenants in just a few years. But tenants fought back and won in a court decision that also undercut plans for using city tax abatements to further sweeten returns on apartments pushed into luxury decontrol. The upshot, according to a recent Deutsche Bank analysis, is that the property, purchased in late 2006 for $5.4 billion, “would fetch less than $2 billion if sold into the current dislocated market.” It added that the most natural buyer was MetLife, the insurer and original owner, in part because it represented “patient capital.”

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