Credit: Matt Wood
Earlier this year, a deal became available in Miami from a large Wall Street bank that interested Ric Campo, chairman and CEO of Camden Property Trust, a REIT based in Houston. The project was financed in the fourth quarter of 2006, but the loan wasn't securitized. By the time the bank decided to securitize the loan, which carried an interest rate of 5.25 percent, the market had disappeared. “In today's market, that loan is deeply under water,” Campo says.
So the bank cut the $90 million loan into two pieces. One was 70 percent of the original loan; the other was 30 percent. “They offered both of those loans to the market trying to sell the loans,” Campo says.
Campo considered the smaller of the two loans, but wanted a lower price than another bidder. That buyer didn't close, either. “They ultimately pulled the deal because the numbers were fairly stupid,” Campo says.
Campo isn't disappointed, though. He sees more of these deals—the discounted mortgage debt behind foundering real estate projects—coming on the market soon. So do other multifamily executives. The Mortgage Bankers Association (MBA), based in Washington, D.C., is the national association representing the real estate finance industry, and says that the 30-plus day delinquency rate on loans held in commercial mortgage-backed securities (CMBS) rose 0.05 percentage point to 0.53 percent between the first and second quarters of 2008. The 60-plus day delinquency rate on multifamily loans held or insured by Fannie Mae rose 0.02 percentage point to 0.11 percent, while loans held or insured by Freddie Mac fell 0.01 percentage point to 0.03 percent.
Such opportunities won't come from the same place. Some will be existing, overleveraged structures, while others will be in the process of being built out. But apartment owners considering buying debt on distressed properties and projects need to know what they're getting into. Otherwise, they will be unable to achieve the high returns—or the opportunity to buy the properties outright—that these transactions offer.
OPPORTUNITY RISES
The same thing that doomed many single-family home buyers could easily quash apartment owners—cheap and readily available debt requiring frightenly little upfront cash. And that creates an opening for owners with cash in the bank to step in and accumulate mortgages.
Many were the commercial mortgage-backed securities (CMBS) loans made in 2005 through the first half of 2007. “The underwriting standards between 2005 and 2007 were quite loose,” says Haendel E. St. Juste, an analyst and co-head of the residential group at Green Street Advisors, a Newport Beach, Calif.-based research and consulting firm concentrating on publicly traded real estate securities.
Further complicating the picture is that many of the rent projections people made during underwriting may have been too optimistic. Now, you have people with high-risk loans and declining cash flow.
“Most people who currently have debt maturing and who have had debt on those properties for a very short period of time have seen a decrease in cash flow or a change in valuation,” says David J. Neithercut, president and CEO of Equity Residential, a Chicago-based REIT that owns more than 147,326 apartment units. “They will have a real challenge dealing with that debt maturity.”
Given these twin problems, many of the loans originated between 2005 and 2007—estimated at around $200 billion altogether—had five-year maturities and will come due between 2010 and 2012. Asset owners won't have many places to turn if they can't pull the necessary capital out of their own pockets. “There will be a lot of pain for some as loans become due with obligations that likely exceed asset values,” St. Juste says. “I don't think the market into which we'll refinance that paper will be deep enough.” Merchant builders may suffer an even shorter fuse. With the universe of buyers dwindling rapidly and credit drying up, they may be forced to hold their new projects and refinance. But even though they contributed 5 percent (often from fees) to these deals and their equity partner generally contributed another 20 percent, it still may not be enough to save these projects.
“The developer doesn't have money, and the mezzanine guy doesn't have money, so they just sell the piece of paper to someone at a serious discount,” Campo says. “They will be forced to sell the mezzanine debt at a cheap price or subordinate their mezzanine to new money to keep them alive.”
RISKS AND REWARDS
Soon, you'll have a lot of apartment owners who will need capital to keep their properties afloat. And there are some people out there with the cash to help them.
Those who have seen this are at the ready. “There is a tremendous amount of distress in the market today, and savvy investors with capital have positioned themselves to respond,” says Frank Apeseche, CEO of Berkshire Property Advisors, an apartment owner and investor based in Boston. “This has been going on for the past 180 days but will clearly accelerate as investors gain comfort that the bottom is near. Normal mechanisms for pricing and executing real estate deals have been jettisoned and replaced with models for distressed investing.”
On one side are the private buyers who have been amassing capital (though recent market woes may have hurt them significantly). Berkshire is already buying distressed debt, while companies such as Northland Investment Corp., an apartment owner based in Newton, Mass., are considering jumping into the arena as well.
Apeseche, head of a private company that will close a $600 million fund early next year that hasn't been allocated yet, says both opportunity funds and hedge funds (those that remained healthy) are looking at buying distressed paper.
“There are lots of funds sitting on the sidelines,” says Tim Beaudin, chief property operating officer for AIMCO, a Denver-based REIT with 188,672 apartment units. “Those guys tend to be more aggressive and take bigger swings at the ball.”
Then there are the REITs. Campo—armed with Camden's two recently closed funds with combined equity commitments of $375 million—is prepared to scoop up the debt under these projects or provide an infusion of capital, provided he can get a good return.
That's why Campo is looking at the less direct—and possibly riskier—route of buying the debt or providing the loan to the owner. There are advantages in pursuing such a strategy. Returns can be much higher, but that return has a price. “If you see opportunities at 15 percent or 16 percent, it's for a reason,” St. Juste says. “It's because of risk.”
In some cases, it may be simpler to buy the asset outright. But often, the owner won't sell for just any price. That's what Campo found during the last downturn. “When you made a low-ball offer, people capitulated,” Campo says. “And people were unwilling to take their losses. There wasn't a great opportunity to buy stuff cheap. The question is whether that happens this time.”
Then there's the chance of the owner defaulting and the opportunity to assume ownership of a property at a deep discount. “If you're the debt holder and the equity gets whacked out, you may come into control of an asset [or a company] via this debt investment as opposed to acquiring the equity,” St. Juste says.
ACTION ITEMS:DEBT AHEAD
Buying debt at an apartment property is risky. Here's what to remember before jumping in.
- 1. Measure risk. Taking on lending can be a risky proposition. Just ask the banks that have either gone out of business or gotten swallowed up this year. “I'll look at the property and see [that] it was worth $100 million a year ago, the bank lent $90 million, and I will have $75 million in it,” says Ric Campo, chairmain and CEO of Houston-based Camden Property Trust. “Is that a reasonable gap for me to take the risk of owning that piece of paper?”
- 2. Know the property. If your goal is owning the asset, make sure foreclosure is a possibility. “We would consider buying in if the long-term fundamentals are good, there are no construction defects, and we had clear rights as the lender and would end up owning in the near term [assuming the debt is in default with the foreclosure process well on its way],” says Michael Lynd, president of The Lynd Cos., a multifamily owner and manager based in San Antonio.
- 3. Stay competitive. Once the market hits the bottom, you need to have your own house in order. Experience with complicated transactions doesn't hurt, either. “As we come out of this, the companies that are operated well and have good balance sheets will give you an advantage,” says Tim Beaudin, chief property operations officer at Denver-based REIT AIMCO.