That was the question on everybody's mind for most of 2010, as interest rates reached historic lows.

Cap rates for Class A apartments compressed in concert as investors jumped off the sidelines and threw down the gauntlet.

Meanwhile, the limbo stick just kept dropping.

Behind the dip, of course, was the spiraling 10-year Treasury, which started the year at 3.85 percent, but wiggled down to 2.4 percent in October, which meant borrowers were locking in 10-year rates with the agencies in the low–4 percent range—a level unheard of, even in the heyday.

As a result, the acquisition activity came rolling in at year's end in a flurry: Consider that Freddie Mac closed $3.6 billion in multifamily loans through the first six months of 2010, but by the fourth quarter, it was closing $2 billion per month.

“At some point, people will look back and say, ”˜We'll never see those rates again,'” says Mike May, who leads the multifamily division of McLean, Va.– based Freddie Mac.

Unfortunately, the gathering momentum may only be temporary. In less than a month, interest rates shot up nearly 60 basis points (bps). The 10-year Treasury went past 3 percent again in early December, sending all-in rates past 5 percent and throwing a cloud over transaction velocity and cap rate compression as the apartment industry headed into 2011.

“We all knew rates would rise. The question has always been: When?” says Don King, head of agency production for Boston-based CWCapital. “When there's a dramatic upward movement in rates, you will get a fairly dramatic slowdown in transactions. And it's particularly painful while the market is changing."

Despite the rise in rates, experts say underwriting will be more borrower-friendly in 2011, thanks in large part to the return of competition from life insurance companies, mortgage REITs, banks, alternative lenders, even bridge and mezz financiers. What's more, the Federal Reserve's second round of quantitative easing (dubbed QE2), which calls for the purchase of $600 million in Treasury bonds to keep interest rates low, will help in the long term.

Couple that with the simultaneous decline in the dominance of Fannie Mae, Freddie Mac, and the Federal Housing Administration, and 2011 will swing the shift in the pendulum of power between lenders and borrowers even further.

“We've gone from a lender's market back to a neutral market,” says Mark Wilsmann, managing director for New York–based MetLife. “But for core trophy assets in places like Washington, D.C., and New York, the market is very much a borrower's market again—and very frothy."

Trickling Down

The acquisition market's recovery started at the top: Institutional buyers, including REITs such as Equity Residential and Behringer Harvard, looked to core properties with certainty of cash flow. But as those assets were bid up, a trickle-down started to occur as investors searched for higher returns elsewhere in late 2010.

“The market wants a little more yield than those trophy buildings allow, so it's migrating to deals with a trickier rent roll, or buildings that aren't as nice,” says Mike Kavanau, a senior managing director for Holliday Fenoglio Fowler's (HFF's) Chicago office. “And then it migrates further down, until you get people going full bore on B and C properties."

Like most trends, the story started on the coasts. Cap rate compression was soon after being felt in secondary markets such as Nashville, Tenn., and Chapel Hill, N.C., where Class A deals traded in the sub–6 percent range in 2010. But the compression that characterized 2010 isn't expected to continue.

Industry watchers say the suddenly rising interest rate environment of the fourth quarter of 2010, combined with the availability of more product in most markets, will put upward pressure on cap rates in 2011.

“Debt really does, in a lot of circumstances, control pricing on the cap rate side,” Kavanau says. “If you have sustained upward moving interest rates for a period of time, cap rates follow as a general rule."

What's more, for much of 2010, there was a scarcity premium baked into many cap rates. An abundance of equity looking to invest, combined with a lack of quality assets in the marketplace, made buyers willing to pay a premium for the best assets. But as more deals come to market, the more likely that premium is to go away. In fact, there will likely be no scarcity premium in 2011.

“Cap rate compression has pretty much run its course,” Wilsmann says. “Values will be higher in 2011 because of improvements in NOI and not because cap rates are tighter."

In particular, as 2010 drew to a close, speculation abounded that it was indeed cheaper to build than buy in some markets. And with so many buyers acquiring higher-end assets (Classes A and A-minus) at or below replacement value, many wonder how long that dynamic will last. “The natural progression is that competition is going to drive deals above replacement cost,” says William Ross, an executive vice president at Bloomington, Minn.–based NorthMarq Capital. “As eff ective rents start to push up, you're going to start to drive prices up above replacement costs, and some buyers are going to be more reluctant to play."

Opening the Portfolio

Still, forging ahead with very little reluctance this year will be the GSEs, which will continue to win the lion's share of acquisition loans.

That doesn't mean, though, that competition can't give them a run for their money in 2011.

Take life insurance companies. In 2010, a number of large providers, including MetLife, Prudential, New York Life, Northwestern Mutual, Principal, and Nationwide, re-engaged the market. These portfolio lenders were mostly winning large, low-leverage deals in major metros, finding the most success from transactions that fell outside of the GSE purview—prestabilized assets, for instance, or deals in markets where concessions were rapidly burning off .

“The agency underwriting is more backward-looking, so in those types of circumstances, life companies can be more flexible and off er a better execution,” MetLife's Wilsmann says. “And life companies can be more user-friendly in terms of documentation and having flexibility to tailor the deal to the borrowers' needs."

MetLife led the charge—it was the most active life insurance company in 2010, allocating about $1.6 billion to lend on multifamily assets.

And the firm's appetite will only increase. “We expect to have even more money available in 2011 to lend,” Wilsmann says.

On the other end of the spectrum are the commercial banks, which have been giving the market for five-year loans some competition. Many banks spent the past few years purging troubled real estate assets from their portfolios, and they seem to once again have an appetite for balance- sheet lending.

For example, outside of agency executions, KeyBank Real Estate Capital was quiet for a few years. But it intends to start making some noise in 2011. “We've significantly reduced our real estate exposure, and the top of the house says it's time to start using the balance sheet again,” says Clay Sublett, national production manager and CMBS director for Cleveland-based KeyBank. “We're in the market on the balance-sheet side to provide financing for acquisition and renovation."

The company is now off ering LIBOR-based bridge loans—a trend that should gather momentum in 2011. Consider that Wells Fargo dusted off its nonrecourse bridge loan program in 2010, as did Prudential Mortgage Capital. And Berkadia, Walker & Dunlop, Greystone, and CWCapital all say that they plan to bring bridge loan programs to the market in 2011.

KeyBank is also considering off ering five-year, fixed-rate permanent loans off the balance sheet in 2011, a term where many banks are growing more competitive.

“If a borrower wants a five-year deal, there's a good chance a bank may win,” says Will Baker, a vice president at Bethesda, Md.–based Walker & Dunlop. “It may not meet Freddie Mac's exit test, and Fannie Mae's underwriting floor might make it prohibitive to do."

Securitization Stabilization

Simultaneously, the CMBS market is getting closer to once again being a viable execution. Berkadia and Walker & Dunlop recently opened their conduit platforms, and several encouraging signs are gathering for the sector. For example, in mid-November, KeyBank closed its first CMBS deal in more than two years, featuring an all-in rate of 5.75 percent.

“The CMBS bonds have sold well, which bodes well for the return of the product,” Sublett says. “We'll continue to see some continued creep of spread, but will it get to the point that CMBS will compete with the agencies? In the near term, probably not."

Established players such as Goldman Sachs, JPMorgan, Deutsche Bank, Morgan Stanley, and Citibank have also been in the market but aren't winning many multifamily deals. Yet the sector is growing more creative. Many CMBS lenders maxed out at 70 percent loan-to-value (LTV) in 2010, but by the fourth quarter, some were going up to 75 percent. Some firms, like Bridger Commercial Funding, have added a mezzanine program to their CMBS platforms, off ering to go up to 85 percent LTV for multifamily properties.

“Not only are we seeing CMBS lenders be more active, but they're starting to be more aggressive in the marketplace. One of the ways they're competing is with some additional dollars,” says Bill Hughes, managing director of Encino, Calif.–based Marcus & Millichap Capital Corp. “I believe that CMBS lenders will become much more available in 2011."

Understanding Underwriting

Indeed, the fourth quarter of 2010 was manic from a transactional perspective, bolstering hopes that 2011 would improve on those gains.

Integral to how the coming year unfolds, however, will be the changes in underwriting seen over the past year across all the available capital spectrums.

Take the GSEs. Most agency lenders don't expect any big changes in the way Fannie Mae and Freddie Mac underwrite deals in 2011. Debt service coverage ratios of 1.25x will continue to be the minimum, and LTVs of 80 percent will continue to be the max.

Still, the GSEs have signaled a willingness to go outside of their credit boxes for the right deals. “There are more waivers being granted now, a little bit more flexibility, a little more IO,” says Walker & Dunlop's Baker.

“There's more willingness to sharpen your pencil to win a deal at the agencies than there was a year ago, now that more competition is creeping back."

This year, Freddie Mac plans to make its refitest—a stress test that looks at the ability to refinance at maturity—more transparent to its lenders and borrowers. “I think the test is going to be more liberal in terms of the interest rate assumptions, or other exit assumptions, and that should allow for more IO right off the bat,” says HFF's Kavanau.

Meanwhile, life insurance companies have grown more and more competitive each passing month. By the fourth quarter of 2010, some were stretching up to 75 percent LTV and off ering IO terms. On shortterm loans, firms such as MetLife and Principal were beating agency pricing in the fourth quarter.

CMBS lenders, too, are closing the gap with the GSEs. Spreads continue to contract for CMBS loans, improving between 60 bps and 90 bps from October to November. That's a significant movement. Most CMBS loans were about 70 bps over a Fannie or Freddie execution on the allin rate in early December. But the pricing trend is heading in the right direction.

Climbing Up

In 2010, multifamily started to look good to investors again. Buyers believed that the sector's woes were largely in the past and that both the availability of cheap capital and strong risk-adjusted returns of apartments presented a good bet. And this year will be more of the same. “The amount of broker opinions of value and assignments that we're getting suggests that we'll have a very good transactional market in 2011,” HFF's Kavanau says.

The bonanza of deeply discounted distressed deals never really materialized, flummoxing all of those opportunity funds that found themselves returning equity to investors. But there may be a bigger flood of distressed assets this year, particularly as the FDIC continues to work its way through troubled bank holdings.

The FDIC concentrated on stabilizing the largest banks first. But the subsequent pace of smaller bank failures has overwhelmed the FDIC, resulting in delays in closing “zombie” banks, some of which probably should have been shuttered a year ago. KeyBank, along with Midland, has signed up as an exclusive servicer for the FDIC, processing the loans that come out of bank foreclosures. “And the FDIC is basically telling us to buckle our seat belts for 2011,” says KeyBank's Sublett.

Continued smaller bank closures are the biggest trend yet to unfold.

“These community banks are chock-full of B-minus or C-quality multifamily properties,” Sublett says. “So there will be more distress sales this year on the lower-quality, smaller assets."

Overall, 2011 will likely see a rebound in transaction velocity and values.

“The growth, although relatively slow, is sustainable and should build from this point forward,” Hughes says. “It seems like we're at the bottom of the big hill on the roller coaster, and let's just hope it keeps going up.”   

//Additional data compilation by Les Shaver  


Finding capital for a value-add/acquisition-rehab deal was a tough task last year.

MANY MULTIFAMILY LENDERS are still shell-shocked from the acq-rehab boom seen at the height of the last upturn. Many of their balance sheets are weighed down by ambitious value-add plays that never delivered the expected results.

But as fundamentals continue to improve in many markets, more lenders are growing comfortable with the idea of underwriting rent growth. “More people are talking about it now because there is finally some debt available for it,” says Bill Hughes, managing director of Encino, Calif.–based Marcus & Millichap Capital Corp. “Six months ago, no one had enough confidence in the marketplace to take the risk of a property stabilizing. Now, there are a number of different financial institutions, typically private funds, that will provide that kind of financing."

While the GSEs clearly dominate the debt market, they've shied away from the repositioning market. The GSEs' acquisition-rehab programs have basically been put on the shelf as they continue to furiously process deals for stabilized assets. This means that most of the acq-rehab business being discussed now is on a small scale— bringing a B-plus asset up to an A-minus, for instance. The rehabs that change the nature of a property—bringing a Class C to a Class B, for instance—have a much more difficult time finding financing.

“We won't make that loan; we're not going to speculate on that type of transformation,” says Mike May, senior vice president at McLean, Va.–based Freddie Mac. “In fact, some of our largest problem assets are exactly that."

Yet, many private-sector lenders are growing more confident with the ability to get a pop in rents through rehab, particularly as bridge loans become more available. Active providers today include Ladder Capital, BB&T Real Estate Funding, Starwood Capital, GE Capital, Canyon Johnson, and A10 Capital—and all of them have seen a shift in their focus for 2011. “Bridge programs have been around, but now we're seeing bridge product move into the arena of value-add,” Hughes says.


Two predictions from: THOMAS W. TOOMEY CEO UDR Highlands Ranch, Colo.

”¢ Portfolio sales won't be likely: “The lenders all say volume will be up, but whether or not that means portfolio-level financing is available, we're still going to see tight underwriting and slow processes. So I don't see any portfolio transactions getting done. One or two, fine, but no big tidal wave."

”¢ IPOs, however, will be: “There is probably room to get three IPOs out, and one or two of them might be a re-IPO of a prior public company. I'm not aware of anyone that has any sentiment of selling into a big deal. I see companies going public as much more likely."

Three predictions from: JAY JACOBSON National Acquisitions Director Wood Partners Atlanta

”¢ Value-add development is a growing opportunity: “I am more interested in significant rehabs of properties in excellent locations: Strategic redevelopment is what we are calling it. We will focus on location-driven deals rather than traditional value-add ”˜let's fix a kitchen and charge $20 more a month' deals. We've never been big believers in that model."

”¢ Alternatives to GSE financing will emerge: “The banks are stepping in softly with their top-tier clients and customers, but life companies on the permanent side are becoming a fairly significant source of capital for people and have become a good alternative to the GSEs. Even if something [dire] happens to Fannie and Freddie, I think the life companies, at least on the acquisition side, will probably make up the void, which means, of course, they'll be able to charge more and rates will go up a little bit."

”¢ Distress will be a thing of the past: “I think the distressed assets have already been sold off to the market—that business ran its course in 2010. If a bank is still holding a note, it's because they have likely worked out issues with the sponsor or they just decided to wait out the recovery. The banks that waited over the past year have seen their valuations increase and have seen the markets save them. Likewise, you'd think some of these huge CMBS servicing companies are going to get tired of asset managing the portfolios they have, but I have not seen anything but B and C product come out of that sector. They are holding on to the really good stuff because they can make money off of it for themselves and their clients."

Two predictions from: MARK ALFIERI Executive Vice President Behringer Harvard Dallas

”¢ Hold periods will change: “Given the rent and NOI expectations of the next few years, I would say that holding periods have the potential to be shorter, but if the NOI growth does not materialize, then a typical seven- to 10-year hold will be the average."

”¢ Deal volume will explode: “I expect transaction volume to increase 30 percent to 40 percent in 2011, and that volume should increase as the year unfolds."

A prediction from: STEVEN FIFIELD Chairman and President Fifield Cos. Chicago

”¢ Development will return full-force: “Wells Fargo, Bank of America, US Bank—all of these guys are back in business, even if they are only looking at opportunities in Washington, D.C., Boston, San Francisco, and the like. Some life companies are even looking at financing new construction. I think the big story a year from now will be that development is back."

A prediction from: WILLIAM ROSS Executive Vice President NorthMarq Capital Bloomington, Minn.

”¢ Rent growth is driving acquisitions: “The growth in rent rolls isn't a lovely little increasing graph—it is a major spike. And that's where we expect to see the most purchasing activity: in markets where occupancies are good at 90 percent-plus, but [also] where rents have been crushed and are poised for substantial, year-overyear, $50 to $70 increases."

//Interviews by Chris Wood