Apartment/Condominium Strategy

As yield-hungry investors and converters are bidding cap rates below six percent in many metro areas, one must be highly selective in pursuing either of two opportunities: 'Buy and hold', and selective condominium conversions. The 'buy and hold' strategy focuses on acquiring properties with relatively high economic vacancies (vacancy plus concessions) that are well located in in-fill areas or other areas of scarcity (e.g. waterfront) and/or present long-term upside through significant renovations or powerful demographic trends. Yields in the high teens can be achieved simply through the improving fundamentals of rental markets, with the entry vacancy and the exit capitalization rates being the most important determinants of yield. This 'buy and hold' portfolio will have a holding term of 3 to 5 years with three potential exits: a bulk institutional sale, individual sales and selective condominium conversion on a property by property basis. Acquisition candidates for 'buy and hold' will include:

• Well located projects in in-fill or other areas of scarcity that create natural barriers to entry.
• The local economy is historically strong and diverse.
• The local economy is trending above average population increases, due to industry relocation or as a result of the baby-boomer cycle.
• There are positive spreads between ten year financing constants and entry cap rates.
• The properties' economic vacancy (vacancy plus rent concessions) is at or above the market area.
• A potential exists for the property to be repositioned through improvements
• Underwriting exit cap rate equal to pre-2001 historical cap rates for the asset class and market area.

While we have focused successfully on the "why rent when you can buy", entry level housing scenario for condo conversions, our focus is turning to a less interest rate sensitive condo buyer commonly known as the Baby Boomer. Baby Boomers are coming of age for retirement and will represent a huge demand for multi-family housing as their life styles shift from a family orientation to an Empty Nester orientation. According to the US census bureau, Americans turning 65 years of age will increase by seventy-five percent in the next ten years. This market will seek multiple housing options, more travel and lower maintenance responsibilities. As this population ages, residing near first class medical facilities will be a priority.

The goal is to seek higher than average returns by converting the apartments into condominiums. Although increasing interest rates can slow housing sales, we think the Federal Reserve will keep short-term rates low and any increases will lag behind economic growth until inflation is clearly evident. Slow or no employment growth is more of a problem for sales than interest rates. Potential conversion candidates will include the same criteria as the 'buy and hold' candidates with the following additional criteria:

• There is a high conversion potential due to unit configuration and location.
• The project has less than 300 units or can be converted in stages.
• The basic building systems and structure do not require substantial capital expenditures, versus image-enhancing capital.
• The loaded cost of owning a condominium is nearly equal to the cost of renting.
• The price of ownership is well within the medium income range of the local population.
• Area condominium sales are trending positively for similar price ranges.
• The project (or initial phase) can be sold out within 24 months.

Project development will emphasize capital preservation with an eye to the downside risk by:

• Emphasizing curb appeal and image enhancement; first stage capital improvements will be limited to basic building systems and "curb appeal" enhancements.
• Pricing early sales at a discount to market to create momentum in the market place.
• Strong pre-sales prior to closing on units, usually 20 to 30 percent.
• Making sure condominium dues are below competitive properties. This will require upgrading basic building systems and structures to excellent conditions.
• Constantly evaluating the current interest rate environment and sales momentum. In a rising interest rate environment, it might be more prudent to abandon a conversion and seek ten year financing.

Management Strategy

Prospect works with local partners on all projects. While Prospect alone handles acquisition, asset management, capital and debt, we also assemble and lead a local team for each project, believing that local knowledge is very important in real estate. Accordingly, Prospect seeks out and employs the best local partners in each market area, but continues to take a very active roll in all responsibilities and decisions. Our local partners generally have very reputable property management entities with strong renovation or construction resumes. The local partners are expected to manage the day to day operations, be the general contractor for any renovations and advise on local trends and issues. The local partner is expected to invest along with Prospect in the property as well as be a co-guarantor on any notes or obligations that Prospect is guaranteeing. Utilizing this management structure ensures a focused and 'invested' local presence.