The problem peaked in 2007. Valuations on just about every kind of commercial real estate were stretched to unsustainable levels. Apartment owners believed that prices would grow inevitably and, as a result, pushed valuations to their highest levels in the industry’s history.
Consider what unfolded with San Francisco–based Lembi Group, one of the Great Recession’s biggest multifamily busts. The company spent more than $1 billion between 2003 and 2007 acquiring properties, borrowing up to 95 percent of the purchase price on some of its assets, according to The Wall Street Journal. By the cycle’s peak, the company had gathered a portfolio of 307 buildings and more than 8,000 apartments.
Ben Thypin, senior market analyst for New York–based Real Capital Analytics (RCA), says 65 percent of the company’s problems were related to refinancing at values that were too high. When the world stopped turning, it was left holding the bag. “Lembi is interesting because it seemed like they’d owned apartments in San Francisco for a long time, but they clearly took out a lot of loans at the top of the cycle,” Thypin says. “They went on the hook for larger values than what the property was worth.”
The danger in overvaluation—and overleveraging as a result—comes to play when the debt comes due. “The biggest danger in today’s market is going to relate to the ability to obtain sufficient funds for refinancing,” says Nick Ingle, director of capital markets at the Phoenix office of Hendricks & Partners. “If the property value is overestimated internally, it could lead to some unpleasantness when the existing debt matures and cannot be satisfied with proceeds from traditional sources.”
Still, the dangers of overvaluing vary widely by the type of owner that holds the assets. For a long-term private holder, it may not be that big of a deal. “For a private owner who is focused on cash flow, overvaluing an asset is not too material, especially if the property has a low debt load,” Ingle says.
For REITs, too, overvaluation isn’t a death sentence, but it certainly could prove harmful. “REITs, despite being an FFO [funds from operations] vehicle, could face some material movement in their valuations if investors decide their asset valuations are too optimistic,” Ingle says.
In fact, Paula Poskon, a senior research analyst with Robert W. Baird & Co., a Milwaukee-based wealth management, capital markets, asset management, and private equity firm, says that in 2006, REIT valuations went through the roof as the public players overzealously advocated that their stock prices were too low.
“A lot of companies allowed their growth strategy to get ahead of itself and didn’t keep up with their balance sheet,” Poskon says. “It was a low–interest rate environment, so they borrowed and borrowed because their stock was too cheap. Leverage got out of hand. Then comes the credit crisis, and you have a whole slew of companies that had to issue equity just to survive.”
For now, the firms that are still around have definitely survived, unlike companies that overvalued their assets, were highly levered, and faced near-term maturities. “So many of these private guys levered up with very little equity,” Poskon says. “Their construction financing came due, and they couldn’t find permanent financing. At least public REITs still have access to capital and cost-of-capital advantages.”
And that’s what saved some of them from some pretty prideful activity in the last cycle. —L.s.