BILL WITTE: First of all, some leveling off is healthy. When you have 20%, 25% year-over-year rent growth in parts of the Bay Area, 10% to 12% in Los Angeles—that's not going to go on forever at that rate. The second thing is we often hear about national data, but a lot of what's going on depends on markets and submarkets. In California, where we're most active, the Bay Area is kind of furthest along in the cycle, and yet there is still some growth. That's going to level off. The L.A. area is not quite as far along. So you have to be careful when you apply this matrix. But as long as there continue to be spreads between Treasuries and other alternative investments and interest rates, and as long as interest rates stay relatively low, you've got a lot of capital chasing this product.

JEFF DAY: One of the things you have to look at is that this year was a little better than last year, too. Treasuries went up 135, 140 basis points in the April-May-June time frame. Anytime that happens in the marketplace, it's going to cause everyone to step back onto the acquisition platform. Fannie and Freddie overshot and slowed down in the summertime. That took a lot of capital out of the marketplace. So from the sales activity standpoint, I think there was an adjustment period during which everyone had to reassess whether it's cyclical or secular.

On the demand side, I'm very bullish. Interest rates obviously are going to continue to go up at some point. That will impact home ownership even more than it's been impacted to date. It's really more a function of affordability than anything else. Certain markets are probably of interest, but all three of us are either empty nesters or close to it. What we're facing is the bid that you pay your kid to move out and live in an expensive apartment because you don't want them moving back home. I think there's an untapped source of capital for rents that keep going up, which is all of us parents that don't want kids at home.

AYGOREN: For now, lenders and equity sources seem to be showing signs of restraint, putting the curb on the risk of overdevelopment on a broad basis, but there are some parts of the country that have seen a lot of new and planned deliveries. Are we at risk of a bubble in terms of development?

GRAF: I am probably more optimistic than most when it comes to this. One of the earlier panelists said our start rate is probably in the 300,000 range. That's high relative to what it was before the recession, yet on an historical average, that number is pretty much the norm. There are a couple markets that get a lot of discussion about this, one of those being Seattle. With all this construction going on, it's just devastating. We got a new book of business in the Seattle market. We probably have 12 or 15 lease-ups under way, and some of those are with early development projects. Some of those are maybe just coming to market now. From our perspective, in every one of those cases we are ahead of pro forma rents, on which we are aggressive. We're ahead on a velocity standpoint in terms of our monthly flow of leases, as that's a market that obviously has jobs.

Another market you hear a lot about is Washington, DC. I, for one, am not a firm believer that on a long-term basis the federal government is going to reduce in size and scale. So that's one of the big drivers in that market. The other aspect is that while development may be proposed, I'm not sure everything is on the boards.

WITTE: That's a good point. In some of the more advanced markets like the Bay Area, some apartment sites are likely to go condo or get turned into other product types. Construction costs and cap rate compression will also control supply somewhat, especially in the coastal markets.

AYGOREN: Apartments felt the impact of the condo boom and bust in several ways. With homeownership now making its modest comeback, condos are once again an option. Bill, you do condo work. How do you decide whether to build condos versus rentals, and where?

WITTE: While we develop both rentals and condos, we prefer rentals. We're not generally merchant builders. We tend to keep what we develop, so that lends itself more to rental product. But we tend to operate in very high-barrier-to-entry and high-value areas. And oftentimes, land prices, the size of a project and other factors force you either to not build or to switch from rental to condominium product. It's just an economic analysis for us. We're seeing that already now in West L.A., San Francisco and Manhattan.

One thing I will say about condos, though, is people tend to lump them with for-sale single-family housing, in terms of development. The dynamic is really much closer to building multifamily rental product. We are doing high-density condos; you can't phase them. Homebuilders might build to a 10% to 15% margin, where you can phase the project. With high-density condos, if you're not getting a 25% to 35% margin, it's a tough deal because you're taking a lot of risk. It's really better to have a high return. If you have an outside investor, the IRR is going to eat you alive. You have to carry it for a while. We have a high-rise in Century City that's completing sales now. It's actually doing well, but it opened right after Lehman Brothers went down, and people sat on their wallets for a year or two.

By contrast, we have a 150-acre project we're about to open in Santa Monica. We just started sales, where I think we're going to be heavily oversubscribed. So it's really a function of pricing pushing you into a value that can't be supported by rentals, but a good enough location to justify that high value. So with today's low cap rates, the $4- to $5-a-foot rental property is going to cap out at the price that would require a very significant sales price to justify doing condos.

GRAF: Earlier, you mentioned conversions. We're involved in what was a failed condo project in the Pearl District of Portland. We were hired by the lender to come in and lease it up, get it back on its feet, which we did. It was very successful in a short amount of time. That was about two years ago. For the past year, there's been an ongoing discussion over whether to keep it as a rental or convert it back to condo. Recently we've begun selling units and had great success. So we're now converting them back to the original intended use—condominiums. That's not going to work in every market, but will work in some. Those will probably range from $400,000 to $800,000 per unit for middle-of-the-road-type product, so we'll see how it goes.

WITTE: One other comment I'd make is that because we are a long-term rental owner and builder, when we design a rental unit, it's not the same type of unit we build for condominium use. We don't flip from one to the other; they are different products. Now, there are projects being built both in L.A. and San Francisco that were designed as condos yet are being rented now because they perceive a better market, but those will sell as soon as prices pick up a little. But it's not like you design an 800-square-foot rental and then decide to sell it as a condo. To us, at least, it's a very different product.

AYGOREN: What's the financing climate for condo product?

WITTE: In the last cycle, every multifamily site out there was viewed as a potential condo. There are a lot of failures. There's dozens of 40- to 60-unit projects in L.A. that either got partly built or didn't get off the ground and were going to be condos. In that regard, I think if you're positioning as a condo, unless it's a very unique location, you're going to face a much more skeptical lending community and a really high equity requirement.

But, again, we're seeing this in San Francisco. There are projects moving forward. There's sufficient money. There is construction financing. You do need a good slug of equity. But the market seems to be there, and in markets like Manhattan, it's advanced to that stage. When we financed our Santa Monica project at the end of 2011, we got a 65% loan-to-cost construction loan, but the project underwrote as a rental. That's the key—that is, if the lender can convince itself that the project could be rented, that it could still get out of it, but it's the high-value locations. The second thing is a lot of lenders wouldn't touch a condo before. Today, I think that's changed somewhat.

GRAF: That was part of the process on the Portland project that took two years. Easily a year of that was really trying to figure out what the ultimate financing source was going to be because it had been a failed condo. So the list of lenders who wanted to come in and sign up again on something that didn't work, albeit for different times and different reasons, was pretty short. And as time has gone on, that's become much more viable, much more accessible to the ultimate buyers.

AYGOREN: Let's talk investment in general on the rental end. It's still a competitive climate out anyone looking to make transactions. Do you think there's a bubble there in terms of pricing? And how do you find the right transactions to go after, and where?

GRAF: The second question is easy for the right transactions. The bubble is an interesting comment. From my perspective, there's still tons of capital chasing multifamily deals and there's been an increase in foreign sources. These are countries where the concept of multifamily as we know it has just not been very acceptable, yet we're seeing tons of dollars coming in from the Dutch, from the Germans, Canadians, Chinese—let alone the domestic dollars that are out there.

Is there a bubble? It's easy to look in the rearview mirror and see what pricing was and what you should have done back then. We look around and say, “Gee, pricing is crazy.” One of our clients closed on a high-end asset in the Seattle market for north of $600,000 a door. How do you make sense of that? But when you look at the quality of the property and the quality of transaction, there's a lot of capital. While you might argue that some things are overheated, in the long run if you believe in the demographics and the space going forward, that's why there's so much capital chasing the deals. I don't believe it's a bubble. Are there things that are overpriced? Of course. There's always that case.

WITTE: I would worry more if underwriting criteria were changing dramatically, like what happened in the last cycle. But I don't really see that, even for the most desirable product. You still need real equity; the appraisals are more conservative. So the dynamics that drove the last bubble don't appear here. There is plenty of capital, but it's not clear that there is a surplus of dumb capital.

DAY: Even well into the 1990s, I don't think multifamily was considered an “institutional asset.” Office and industrial were. There's been a secular shift of the types of investors involved in multifamily today versus 15 or 20 years ago, and those are more relative value investors as opposed to secular investors. And as yield-starved as capital is today, even at the relatively tight cap rates, it would take a pretty substantial change in the dynamics of the risk-free rate and alternative fixed-income investments.

Having said that, when you look at the way a lot of our clients are structuring acquisitions today, it's been much more a function of near-term cash flow than longer-term value creation, specifically addressing the concern over treasuries over the whole period. That's especially why it became such an important factor for a number of acquisitions over the past two or three years. That's how people were getting an IRR during the first three to five years.

AYGOREN: There's been a lot of talk about secondary and tertiary markets and lower-quality class B product. The idea of value-add investment has gained traction again, especially as prices for core product have increased. At the same time, the definition of “value add” or “opportunistic” has become loose. How would you define what's truly “value-add”?

DAY: As a lender who did a lot of value-add lending during the last cycle, there were a lot of deals that were called value-add that really just were a function of cap rate compression between 2003 and 2008. So people that fancy themselves savvy rehabbers and rehab lenders turned out not to be.

You have to be very careful when you go into a market. Just because you can improve a property and put $5,000 to $8,000 a unit into it and justify a certain rent, it very well may be that the submarket doesn't have enough tenants to support that rent or that the tenants don't want the kind of changes you're putting in place.

WITTE: This cycle seemed to begin with buyers piling into core assets. Then cap rates got too low, so people started building. Now a lot of people are going to value add because it's the relatively less touched part of this asset class. We're not really in that space, but those who are report having trouble finding product. It's not easy; there's compression from the ground up, too. In another part of our business, we build and renovate a lot of affordable housing, and the cap rates on sales of those properties were amazingly low.

GRAF: The definition is interesting because while they call this panel “the view from the top,” I think the reality is it's been a long time since we've actually seen the cycle. It used to be that value-add was kind of applying a little lipstick and some rouge, maybe do a few things on the exterior and a little bit on the interior.

That's certainly still part of the definition, but it also encompasses things like adaptive re-use. It could be an office building in a core market that gets converted to multifamily product because the office market isn't great, but the multifamily market is. Or it involves financial reworking to create some value in a portfolio, or it could be a difficult or troubled portfolio. There's all sorts of different versions of value add, and there are a variety of different players looking to do it.

Yet those value-add deals, while they're out there, are tricky. In the previous cycle, what was considered value-add probably wasn't. We kind of convinced ourselves that they were, and they didn't work, and they got caught in the downturn. It's about being able to find the right property at the right price point and add the right kind of improvements. Obviously, the key is getting the rent lift for the value. It's a lot easier on paper than it is in reality.

DAY: I think a lot of people used that value-add story to get 85% or 90% financing as opposed to 75% or 80% financing, and there really was no intention of doing this rehab, and that happened in a lot of cases.

AYGOREN: Everyone's feeling the pressure of the economy. Renters in particular may not have the wherewithal to pay high-end rents, which is what has been getting built the past few years. Where do you see the market trending? Are there as many opportunities to build luxury as before, or are you looking more toward catering to demographics these days, considering the stagnant job growth and economic uncertainties?

WITTE: There are plenty of opportunities—maybe too many opportunities—to build luxury. But with higher end prices and higher construction costs, the presumption is that you can just keep going up and do high-rise development. In fact, there's a proposal in Downtown L.A. now to require high-rise development along the Figueroa Corridor near South Park so that the land isn't underutilized. From a planning point of view, it makes sense. From an economic point of view, it may not make sense.

One thing we've tried to do is look for joint venture opportunities with land owners, where you can be buffered a bit from a sticker shock of having to write a big check immediately. A lot of these sites have a title at risk. In California, certainly, that takes a while to get to, and all of a sudden you are in a different part of the cycle.

The other thing we're seeing, especially in the Bay Area, is re-trading. People tie up a site, do their due diligence, and realize construction costs went up literally in the past two weeks. The numbers don't quite work. So it's really a mixed bag.

GRAF: From a pure rent standpoint, it's a real issue. It's obviously a more prevalent issue in the Bay Area. But if you think about $4- to $4.50-a-foot rental properties—the number of people that can afford that is limited. Wages in the Bay Area are certainly higher than other places, but they're not that much higher.

For a 1,000-square-foot unit, that's $4,000 a month. That may not be a frightening number in New York, but it is in Dallas. And how deep is that market? We're going to enter, if we haven't already, a period at which there's going to be resistance, especially from a practical standpoint.

I'm not suggesting we can't continue to grow and evolve, but it's an affordability factor. Can people afford their rent? While I think they can, in some of these properties when we go out and do due diligence for our clients, we're seeing multiple families living in those units just to be able to afford to live in that area.

WITTE: One way the market has been responding to that is with smaller units. It's very much a New York phenomenon that we're now seeing on the West Coast. People are even talking about microunits. And if it's transit oriented and there's amenities, there's a lot of demand. So people are dealing with affordability in different ways. The numbers just can't keep going up. They certainly are going to level off once this slug of supply hits.

AYGOREN: Staying on financing for a minute, the Mortgage Bankers Association has estimated that the GSEs provided fewer than half of all new financing for multifamily in 2012. That number is expected to stay the same or hover around 35% this year, but that's down from a whopping 85% in 2009. That means that we've seen a plethora of new financing sources coming to the market. How does that change in the market?

DAY: Among the most interesting groups that have been surprisingly aggressive are the banks. Their loan-to-deposit ratio right now is at the worst level it's ever been. They're very hungry to get interest-bearing assets with favorable capital treatment on their books. So what used to be a relatively small niche market, predominantly in California and in New York, has really broadened, and there are a number of super-regional and national platforms that have done a pretty good job of figuring out how to deliver both floating- and fixed-rate debt.

Now, CMBS is not a function of whether or not the liquidity is there. For banks, it's more about liquidity. The money is there. It's just a mater of how expensive it would be if we took Fannie and Freddie out of the equation. Because of the base costs of funds right now and because the loan-to-deposit ratio is where it is, my guess is it's going to be pretty good for the banks for the next three to five years. But if we do see that secular change in the yield curve upward and deposits are more expensive to keep, that will probably change.

GRAF: A significant part of our portfolio is for third parties, and nearly every client of ours is active in transition. We've seen a move away from the GSEs and I think it's because there are other alternatives that have been very aggressive.

AYGOREN: What's keeping you up at night? What's your biggest concern?

DAY: From my perspective, it's really more at the macro level. We are in extremely uncertain times as it relates to the inability of the government to execute anything. We've got the Federal Reserve and Treasury actively involved in managing the economy in ways that we've never experienced before, and we don't understand the unintended consequences of that. And honestly, I don't think the economy is nearly as robust as the stock market seems to indicate, and I think we're on some pretty fragile and untested ground.

WITTE: In addition to the economy, I'm concerned about the complete dysfunction of the government at many levels because that means uncertainty. With uncertainty, it's very difficult to predict where policy is headed and difficult to make plans since we're making investment decisions on, for instance, development that may be three to four years down the road.

GRAF: My answer would be the same. It's the economic uncertainty, and what does that mean for us going forward? How do you plan and how do you operate your business with that set of rules that seemingly is changing?