In a lively discussion before an audience of more than 100 developers and owners from around the nation, Apartment Finance Today magazine’s Editorial Advisory Board painted a positive picture of the outlook for multifamily housing in 2006.
But they were quick to point out that the brightness of the outlook depends a lot on where you stand.
The Leadership Roundtable Discussion was the opening event of Apartment Finance Today’s Developer Conference. Among the participants were Douglas Bibby, president of the National Multi Housing Council in Washington, and Ron Terwilliger, chairman and CEO of Trammell Crow Residential in Atlanta. For a complete list, see box.
In coastal areas and in the Southeast and Southwest, the panelists said last year was good and this year should be great for apartment owners. But for owners in the North Central states, especially Michigan, these are challenging times with little relief in sight. And for companies in hot condo markets that have seen heavy speculative buying, changes are coming which could hurt rentals as well.
“We think this is going to be a terrific year for rental housing. We think effective rents – not nominal rents – but effective rents, will go up in the high single digits in many markets, if not the low double digits,” said Terwilliger. “In fact, in some of the markets we saw last year, they went up low double digits.”
Unfortunately, he added, “many of us were digging out from extremely low rent levels” in 2005, so that as 2006 began, real rents were very close to their 2001 levels.
Most other speakers agreed that owners can expect continued improvement in apartment rents and occupancies well into 2007.
Rental housing is benefiting from still-rising home prices, which are keeping more households from leaving the ranks of renters to buy homes.
If the homeownership rate stabilizes, there would be demand for an average of almost 300,000 market-rate units a year, said Terwilliger.
Several speakers predicted that the homeownership rate will actually decline as recent home buyers who stretched to buy with “creative financing” and high-ratio loans find out they cannot make their payments. The U.S. homeownership rate is 69% but will fall over the next five years, perhaps to as low as 68.5%, said Doug Bibby, president of the National Multi Housing Council (NMHC).
When it comes to financing, Board members said the recent slight increase in 10-year Treasury rates was affecting deal feasibility, but they predicted that interest rates would remain fairly stable this year. They noted that creative financing techniques, such as interest-only loans, were becoming far more important in getting deals done at today’s low cap rates and higher mortgage rates.
Most speakers expected investors to continue to pour money into rental housing, especially if alternative investments don’t become more attractive. However, most also agreed that capitalization rates were bound to increase moderately in the near future.
Still, cap rates will probably remain lower than their historical levels because more data is available on rental markets than ever before and the market has become much more transparent, said Charles Krawitz, managing director of Lasalle Bank Multifamily Finance Group. Because investors are becoming more comfortable with real estate, there is less of a risk premium associated with such investments. As a result, the historical margin of about two points between Treasury bonds and real estate yields has narrowed to virtually nothing.
But, as Krawitz pointed out, a lot has to do with how you run the numbers. “One person's 4% cap rate is another person's 5%,” he said. “A lot of it really has to do with how you view the cash flow of that property.”
Lenders admitted that they had stretched to do many deals in recent years as cap rates fell, but said the risk was justified in most cases and that “watch lists” of problem developments are shrinking.
The challenge in financing properties at today’s high prices is forecasting rents, especially for new development deals. To justify deals and show a reasonable exit strategy, you need to “aggressively trend rents at least in the next couple of years because it's hard to sell a 5% yield,” said Terwilliger. “We're trying real hard to convince our investors to trend rents for four years and believe those yields will get back up to 7%, 7.5% or 8%.”
Most panelists expected apartment construction to remain subdued due to high construction costs and intense competition to acquire suitable sites.
“What would really hurt us is if we had a big boom in apartment construction, especially on the high end, and another softening market, and then we're going to see some trouble,” said Tom Szydlowski, CEO of the Reilly Mortgage Group in McLean, Va. “But right now, everything we see in the demographics, everything we see in the cost, everything we see in the economy says it's pretty hard to see when that's going to happen.”
An audience member asked the board about the merits of “vulture opportunities” with broken condos. Forget about it, said Daniel Epstein, chairman of the ConAm Group of Cos. in San Diego. “There are one or two people that have raised some funds for it. Of all the real estate that I've been associated with, there isn't anything more complicated than a broken condo conversion,” said Epstein. “It's a management nightmare.”
Offering a report from Washington, D.C., Bibby said partisan bickering was causing legislative gridlock. “Let me talk about what we think is going to happen in the current session of Congress: not much of anything legislatively.”
He predicted that Congress would act to provide relief from the alternative minimum tax and leave the current tax rates on capital gains and dividend income unchanged. In regard to the estate tax, Bibby said he expects it will be reformed but not permanently repealed, and that NMHC is lobbying to make sure the current provision allowing for a step-up in basis for real property is continued. Under tax legislation passed in 2001, the estate tax is set to expire in 2010, and then go back into effect a year later. The Senate is currently discussing possible legislation to reform the estate tax rather than repeal it, as the House favors, and NMHC is optimistic it might pass this year.
As for federal government efforts to house the families displaced by hurricanes in the Gulf Coast, Bibby was direct: “Having FEMA run a housing program, both in the short-term and the long-term, was an unmitigated disaster.” He criticized the Bush administration for refusing to use housing vouchers administered by the Department of Housing and Urban Development to pay rent for the displacees in private apartments rather than relying on FEMA and its trailers and hotels and cruise ships.
The following are abbreviated excerpts of the panelists’ comments. For a more complete transcript of the conversation, go to www.housingfinance.com.
We are in a good time right now for the purchase of multifamily properties in terms of the outlook for net operating income [NOI] growth. There are plenty of reasons to think that rental income will increase through the burn-off of concessions, through increased occupancy, etcetera.
It's still difficult in terms of finding acquisitions that are clearly home runs at the price that you need to pay today. There’s a big move toward a lot of interest-only financing, which is necessary to make financing work at the lower cap rates. The question is, how long an interest-only period, and by the time amortization kicks in, will you then have enough NOI growth to pay the amortization component, too?
We've done a fair amount of condominium lending over the last six months – new construction, conversions, mezzanine, as well as whole loans. So we're keeping a pretty careful eye focused on what's happening in the condo world. We have pulled back from the aggressive lending that we were doing.
Cap rates, I believe, are unsustainable where they are. It's pretty clear to me that cap rates generally are a little bit lower than they should be. In particular, I think we've seen aberrations in the multifamily sector due to the condominium markets, what it’s done to the price of land per unit and so on in many markets. It has created aberrations that I'm not particularly comfortable with.
We certainly have seen improvements in occupancies, decreases in concessions. Values are higher than ever, cap rates are lower than ever, and the one saving grace to all of this is that there's just been so much equity going into acquisitions. It's really been what's made lending, for most of us, tolerable on these acquisitions.
As rates are ticking up, 25 basis points in the most recent month or two, 50 basis points since this year began, we've definitely seen our pipelines affected. So what that means is deals that we have under application, if they have been under application for a couple of months, [have] economics [that] may not work quite as smoothly as they did when we first took them in, and that presents a lot of challenges to us.
Certainly, every loan that we're working on is what I refer to as “hand-crafted.” Sometimes I feel like a little cobbler making each shoe one at a time because each deal just has to be so custom tailored to win the business.
Freddie Mac had a record year in multifamily financing last year, but what's interesting is that [our] market share probably went down a little bit in terms of multifamily financings.
Every economist I've heard this year has talked about the strong fundamentals, and I think if we look at the multifamily watch list at Freddie Mac, we've had a big watch list largely as a result of [projects lacking] enough cash to really cover the debt service. And so we put a lot of these properties on the watch list, but they still have been performing because of all the equity as a result of the low cap rates. We're now taking properties off the watch list because there's more rent, and I think we all agree that those fundamentals are improving. So we're optimistic about 2006 multifamily financing.
Our $10 billion portfolio covers the nation. It has a concentration in the mid-Atlantic regions. What we have found is improved fundamentals all over, less so in the Midwest, though, than on the coast and in the southeast.
We've seen the improved economy, strong employment helping out here, and we see a lot of strength in the lower and middle areas of the market. The high-end on the rental side has not rebounded as much, except in markets where there's a lot of condo conversions.
Berkshire Residential Development is part of Berkshire Group. We started this development group January 6th of this year. We believe that there's play in the development market for apartments, and that's the reason we started this organization. We're in markets right now from Washington down through Florida. We are competing in areas where excessive condominium growth has been going on, but we're starting to see some pull back on that, and we're starting to see some opportunities there.
The housing that I lend on is very much your bread and butter apartments.
There certainly seem to be a lot of people out there that are afraid of buying condos and moving into single-family homes because we potentially have hit the top of the market, and that is benefiting occupancies, the buildings that we tend to lend on.
It used to be that a 1.20x debt-service coverage deal [with an] 80% loan-to-value [ratio] was aggressive. And then all the folks from Southern California started doing 1.15x debt-service coverages on projected market rents, and that has certainly eaten into our business. And we have responded with offering a mezzanine product to allow us to go to a 1.07x combined debt-service coverage and be more competitive on leverage.
R. LEE HARRIS:
I'm going to give you somewhat of a Midwestern perspective. I've heard a lot of talk about California and southern Florida and you name it, but I haven't heard anybody talk about the Midwest. In the last six months we have assumed management and/or receivership involvement in 2,500 units of commercial mortgage-backed securities and agency deals that are going south. In Michigan, Illinois, Iowa, Ohio, Indiana, Kansas, we're seeing some B-piece investors getting hammered pretty good on some of these deals.
We're seeing market values versus loan amounts at ratios of up to 45% to 55%, which is pretty grim. And we're actually seeing some deals that are coming apart after just two to three years. So you figure out how well the underwriting was [done] on those kinds of deals.
Finally, we're seeing increased costs levied by municipalities as user fees. This is becoming an alarming trend. Examples: fire inspection fees, rental license fees, occupational license fees, pool license fees, storm water, and the list goes on.
The industry is under siege. We've seen situations where these fees are as much collectively as $100 per unit per year. So it's something that we have to be careful about.
The seniors’ housing industry has finally gotten its sea legs. It's taken two decades, but the good news is we are here. This is an industry that over the past two decades has gone from infancy through adolescence with lightning speed and with lots of mistakes.
The good news is we are at maturity or close to it. We're still making a few mistakes, but the tough times are very much behind us.
A few key statistics for you to consider:
Consumers today are spending in excess of $65 billion a year in the market-rate seniors housing industry. It's a lot of money.
Secondly, overall, according to the American Seniors Housing Association, our industry is at a 92% occupancy level. Pretty impressive when we take a look at what occurred back in the mid- to late '90s.
Operating margins are [at] another all-time high. Our most aggressive cap rates today are right about 6.5%.
We also feel that we are on the front end of a new generation of this industry – one that is based on all that has occurred in the past. We now have a significant amount of both debt and equity that is available in this business. It's more patient. Due diligence is more rigorous, and most important, supply and demand in most market places throughout this country are in equilibrium.
So the kind of growth that we're going to see in the next year to two years is going to be moderate growth. It's not going to be excessive. Supply and demand are still in great shape.
I'm sitting around this table, and there's so much euphoria. We're running about 60,000 units in 20 states. We're in at least 35 or 40 different markets and I, at this point in time, don't see the reason for euphoria.
[Supposedly,] everyone is going to be satisfied with lower yields forever. I don't believe in that. I don't think anything is forever. We were buying $300 million a year of product up to three years ago. Then we got to $100 million. Then we got to $50 million, and the last year we did one deal. We did one $25 million acquisition because I won't be a buyer at a 5% or a 6% cap rate. If you buy at a 6% cap and you have NOI growth of 3% and five years later … you exit at 7% and a half, it equals the purchase price that you paid five years earlier.