The Apartment Finance Today Conference provided industry attendees with opportunities to learn and network during the three-day event April 7-9 at the Arizona Biltmore in Phoenix. 2008 is going to be a challenging year for the multifamily industry, but industry leaders say opportunities are out there. Read more about this year’s event.
Industry Leadership Roundtable
With net operating income growth slowing from last year for even the biggest players in the best markets, industry leaders did not gloss over the challenges of 2008 at Apartment Finance Today's Industry Leadership Roundtable.
The opening event of the Apartment Finance Today Conference featured remarks from Doug Bibby, president of the National Multi Housing Council; Robert White, head of Real Capital Analytics; and David Fitch, CEO of Gables Residential.
The panel generally agreed it is harder to get deals done as the gap between bid and ask prices widens, and that deal velocity has slowed dramatically, leaving many players in a wait-and-see posture.
They said the best opportunity now is to buy up Class C properties, which are having trouble refinancing, and renovate them to bring them up to B status. They also pointed to strong demand for student and affordable housing, especially on the coasts. In other good news, they said construction costs were down and that supply/demand fundamentals are good.
On the financing front, the roundtable discussed the ongoing trend toward more stringent underwriting. They agreed that it's harder to get financing and that relationships with lenders are more important than ever. They said lenders want to see historic and actual rental income data, and are no longer interested in "stories" about the potential for rent growth.
The panel said loan pricing spreads remain higher, keeping mortgage interest rates stable despite declines in the Federal Reserve's discount rate and the rate on 10-year Treasury bonds. They said equity investors are "cherry picking" deals and requiring higher returns.
Several panelists said apartment prices are static or a bit down as sellers are beginning to accept that the market has changed.
AFT’s Annual Forecast for Rental Demand
Though the U.S. economy is slowing, the multifamily industry remains somewhat immune from recession and is primed to thrive in the next five to 10 years, according to Linwood Thompson, managing director of Marcus & Millichap's National Multi Housing Group.
Thompson set out his case for optimism at "FT's Annual Forecast for Rental Demand" during the final day of the conference.
Key economic indicators suggest the U.S. economy is in a recession -- more than 230,000 jobs were lost in the first three months of 2008, and gross domestic product is forecast to drop 100 basis points to 1.2 percent in 2008.
But the slowdown is affecting markets differently. Many Texas markets, such as Houston, Austin, and Dallas, are forecast to see strong job growth of around 3 percent this year, while the outlook is less sunny for stalled local economies like Detroit and Cleveland.
And the apartment industry is primed to weather the storm. "It's the multifamily fundamentals, and not the macro economy, that will drive our business," Thompson said. "We've seen oil climb over $100 a barrel, the [commercial mortgage-backed securities] meltdown, and the single-family housing bubble bursting. But ultimately, it's not enough to impact the multifamily business."
The reason for optimism? First, the supply and demand of apartments is stable and favors increasing rents and appreciation. Over the last seven years, the industry has added about 100,000 market-rate units annually, which is just 1 percent of the national stock. In contrast, Thompson forecasts demand for 400,000 new units per year for the next 10 years.
This constrained supply -- driven by increasing NIMBYism and high land and construction costs -- should translate to national rent increases of between 3 percent and 3.5 percent, and a national occupancy rate of 94 percent, for 2008.
Demographics tell the tale. Thompson expects 5.5 million echo boomers to enter the rental market over the next five years. And immigration should account for another 12 million increase in population out to 2015.
"In a typical recession, supply exceeds demand, occupancies are decreasing, and effective rents are decreasing, and we don't have that taking place in the apartment industry," Thompson said. "I would suggest that, instead, we're in a period of recalibration."
For instance, lender spreads and debt-service coverage ratios (DSCRs) are rising, while loan-to-value ratios and the availability of interest-only financing has dropped. But some of these recalibrations are ultimately based on perception and emotion, not logic. "Lenders and equity providers want you to believe that apartment prices have decreased," Thompson said. "But there is a difference between justifiable re-pricing and opportunistic re-pricing."
Thompson believes that things may turn around quickly for the multifamily industry. "In a normal recession, it takes three years to engage the growth engine; in a period of recalibration, it could turn around in the next six to nine months," Thompson said. "It could change in August. There’s nothing in the fundamentals that says it can’t happen that fast."
Equity Investments: Negotiating Your Best Deal
Developers must search a little harder to find equity these days, but the strongest deals are still getting done, as creative financing strategies begin to emerge, according to panelists of "Equity Investments: Negotiating Your Best Deal."
Like debt providers, equity sources are taking a much closer look at deals these days and adjusting underwriting and return expectations accordingly.
"Four years ago to one year ago, everything was the same -- whether you were in Dallas or Des Moines or Denver," said David Fitch, president and CEO of developer/manager Gables Residential. "Now, there's much more scrutiny about property types, what the submarket is like, and tailoring specific returns."
Many developers are sourcing both debt and equity from pension funds such as CalPERS and CalSTRS, and big insurance companies such as Northwest Mutual, TIAA-CREF, and Prudential are still providing equity, panelists said. "We're talking to life insurance companies now that we haven't talked to in the last five years," said Fitch.
But developers are searching a little harder to find the equity. Developer Trillium Residential has engaged a mortgage banker for the first time in years to find equity. "In the past, the equity found us," said David Dewar, Trillium's founding partner and principal.
With the dollar at a low point and a lack of competition from domestic sources, foreign capital may become a more important source of equity in 2008. "The Australian funds and Middle Eastern funds will be looking at the United States more and more, especially once all of the bad real estate news settles down," said Fitch.
And with a dearth of capital on the market, some creative financing strategies are emerging. Trillium Residential recently received a quote from a large mutual fund looking to provide equity on a new construction deal. "Rather than quote one deal, they wanted to tie a construction deal with one of our stabilized deals to take some of the risk out," said Dewar. "It was the first time I've seen two assets in different stages being tied together like that."
Apartment sellers are saying, "show me the money" when engaging with buyers now.
"Buyers have to demonstrate that they have the financing and not that they'll just put it together on the fly, which was the case last year when all that money was there," said Tyler Anderson, a vice chairman at CB Richard Ellis' multi-housing group. "Today, if I'm a buyer, I'm making sure I get my capital stack completely lined up." Equity is especially difficult to come by for affordable housing deals, as the prices of low-income housing tax credits (LIHTCs) continue to plummet. "The primary source of equity for the last 20 years has been LIHTCs—the rate of defaults are no greater than on conventional deals," said Stephen O'Connor, president of the O'Connor Group, a consultant to the housing and community development industry. "But now, you've got institutions writing off $8 billion, $12 billion in losses, so they no longer need the credits. Institutions are walking away from it."
Adapting to New Debt Financing Realities
Underwriting standards are continuing to tighten, though spreads are beginning to creep down for the first time in months, according to the panelists on the "Adapting to New Debt Financing Realities" session.
A return to historical underwriting standards has characterized the last nine months of the debt markets. Borrowers can get sub-6 percent rates on permanent loans in today's market, thanks in large part to the low benchmark rates such as the London Interbank Offered Rate (LIBOR) and Treasury bill rates.
"If you were an apartment owner and took a trip to Mars for five years and came back to find that DSCR is 1.25x and loan-to-value ratios are low, you'd say, ‘What’s the problem?'" said David Durning, senior managing director of Prudential Mortgage Capital Co. "If you compare now to any other period, it's a good time to borrow money. It’s just that when you’ve been driving 80 [mph], then 50 [mph] seems slow."
In early April, Fannie Mae returned to a 1.25x DSCR and down to 1.20x in strong markets, after dropping its standard DSCR to 1.20x, and 1.15x in strong markets, in 2007. And lender spreads over the Treasuries for both government-sponsored enterprises (GSEs) are starting to creep down after reaching a high of 250 basis points in late March.
"For many weeks now, we've had regular price increases of 5 basis points a week," said Jack Leighton, a regional director for Freddie Mac. "Today, we announced an 8-basis point decrease, which is a big decrease for us."
Recourse is again a common feature on floating-rate construction loans after disappearing last year at the height of the market, noted John Cannon, an executive vice president with Capmark Finance, Inc.
Like the GSEs, institutional capital providers have picked up much business with the conduits out of the game, and their balance sheets are filling up quickly. "On the life company side, there’s a finite pool of capital," said Durning. "We're doing 60 percent loan-to-value or less and spreads of 50 [basis points] over other types of loans we do."
While the market’s perception of real estate investments has been jaundiced of late, the panelists noted that default rates in the multifamily industry are at a historical low, at around 0.3 percent to 0.5 percent. Freddie Mac, for instance, doesn't have a single multifamily loan in default in its Western region, according to Leighton, out of a $16 billion to $17 billion portfolio.
The panelists believed that delinquencies could triple by the end of the year to 1.5 percent. But that would still be a very low rate when compared to other down markets, such as the late 1980s when delinquencies were at 5 percent.
But if benchmark rates increase significantly, there might be more trouble ahead, especially for floating-rate debt borrowers. "Thank God LIBOR is as low as it is," said Cannon. "If LIBOR increases significantly, all bets are off, we're going to see some pain." Still, the lending industry's move to more conservative practices is akin to nursing a severe hangover after a raucous party. "It's like we all just went to a big buffet and gorged for two years straight," said Cannon. "And now we're just trying to digest."
Cap rates will rise this year, and prices will fall on all property types, including apartments.
That’s the prediction from Anthony Downs, a real estate economist and scholar with the Brookings Institution, a nonpartisan think tank in Washington, D.C. Financing will remain expensive, he said, because even as Treasury rates stay low because of high demand, spreads over Treasuries are unlikely to shrink much anytime soon.
"Owners are going to have to adjust their expectations because capital providers aren't going to repeat their stupid mistakes," said Downs.
Although in the short term, financing may be more expensive and tougher to get, the outlook for apartment owners and managers is rosy, he said. That's because a falling homeownership rate and increasing immigration will boost apartment demand at a time when the supply of new apartments is simply not keeping pace. And as anyone who's ever taken an economics course knows, limited supply and high demand are a clear recipe for higher prices -- meaning rising rents are on the horizon in many markets.
For turnaround specialists, there are opportunities in practically every market in the United States, said speakers on the "Bottom Fishing: Making Money with Troubled Projects" panel.
"The fact of the matter is when capital moves out of the market and values begin to fall, you need something to stop it, or everybody continues to lose," said James Martha, who handles strategic planning and investment at Henderson Global Investors, which has $11 billion in capital under management, including $2 billion in direct investments in apartments.
Some of the hallway discussion at the conference revolved around the question of who was raising "vulture funds," Martha said. "I find that vulture has a negative connotation; if you think of yourselves as saviors, I think you'll feel a lot better about your own business."
With the exception of Florida, his firm has found operating fundamentals to be sound, and cap rates to be holding steady, he said. Henderson is an active buyer and seller of Class B apartment properties.