Tug Of War --- Image by © Images.com/Corbis
Tug Of War --- Image by © Images.com/Corbis
Todd Quam/Digital Sky
Todd Quam/Digital Sky

Last year, the

executives at Kettler, an apartment owner and manager with 9,000 units based in McLean, Va., wanted to sell two properties in the Washington, D.C., area. At the time, they thought they had the assets priced reasonably at a cap rate in the six percent range in the still-going-strong D.C. market. But when they put the properties out on the market, the only traction they experienced was the frustration of a stalled market. Today’s buyers won’t go lower than a 7 percent cap rate.

“They [buyers] would make offers and come back and retrade and retrade and retrade,” says Leslie Furst, senior vice president of finance at Kettler. “The truth is, they just didn’t know what it was worth.”

The buyers in Washington, D.C., aren’t alone. Nationwide, apartment sales fell 62 percent in 2008 to $37.3 billion, according to Real Capital Analytics, a New York-based research firm that focuses on the capital investment markets for commercial real estate. That pace continued in January 2009, with only 50 apartments sold, totaling less than $600 million. Many apartment owners say the stunning decline is the direct result of a lack of sufficient capital. They wouldn’t be wrong.

However, the problems facing deal makers today are akin to an iceberg. Buyers looking at factors such as rising vacancy rates and a growth in distressed assets have assumed, rightfully so in many cases, that apartment values are going down. On the other hand, many sellers feverishly cling to the belief that their properties have retained the sky-high values that they had grown accustomed to in the frothy years of 2005 and 2006.

“For things to happen, there needs to be rough consensus, and individual firms must have conviction that there’s available capital and that market X or Y will do such and such,” says Gregory Mutz, CEO of AMLI Residential, a Chicago-based apartment owner and operator with 22,844 units. “When you have this uncertainty—God, it’s brutal! There’s a reluctance to make a decision.”

And that means it’s difficult for anyone to know the price of any asset. “We have so very few closings that there are no real comparisons at this point,” says Nick Ingle, director of capital markets for Hendricks and Partners, a Phoenix-based broker.

As 2009 progresses, one thing is clear: The word “value” means very little in this environment. Loan-to-value is an irrelevant metric, and the worth of an asset is no longer measured by the potential of long-term returns. As a result, today’s buyers, sellers, and lenders have had to develop a new form of math to determine where exactly these revised values will fall. Here’s what’s influencing their decisions.

The Buyer: Showing Reluctance

Despite the precipitous decline in deal flow—particularly with fewer than 50 apartment buildings sold nationally in January—there are still buyers lurking about.

“There is plenty of capital out there at certain pricing levels,” says David Schwartz, managing member of Waterton Associates, an apartment owner and manager in Chicago with 13,587 units. “We’re actively bidding in a 7 percent or 8 percent cap range on real numbers, and we’re not able to get anything. I think there are others like us. It will be sellers dropping their prices, and then you’ll start seeing transactions clear.”

Schwartz’s sentiment is a common one among buyers. Why buy now when prices will continue going south? Opportunistic buyers see struggling apartment developers and owners staring down the barrel of a loaded gun on commercial mortgage-backed securities (CMBS) they took out during the height of the market, and they are waiting to pounce on those discounted assets. “Buyers are licking their chops,” says Todd Goulet, senior vice president with Cleveland-based KeyBank Real Estate Capital.

The promise of greater future discounts is obviously one reason buyers are having second and third thoughts about making offers at today’s prices. With so much uncertainty in the market, it’s hard for borrowers to know what the values of the assets will be in five months, much less in five years.

“We used to see a lot of people come to us wanting to reposition a property with a target of selling it within five years,” says Chad Ricks, first vice president out of Love Funding’s Dallas office. “I don’t see that anymore. I see people come to us with a hold strategy. People are uncertain of what the exit is.”

Without an accurate exit cap rate, buyers can’t predict an internal rate of return (IRR). “You can’t buy an IRR,” says Ryan Akins, regional director for The Bascom Group, a multifamily operator based inDallas. “Your institutional investors don’t know what IRR they require. And, even if they could give you a target IRR, you’d have to [first] choose an exit cap rate.”

Instead, buyers want to make a return in their first year. They can’t wait years for a payback. “They want to quickly get to a return on their equity in year one of 10-and-a-half years,” Goulet says. “It takes some time during your hold period to get above a 10 percent yield. They’re going to get 50 percent or more yield from cash flow versus cap rate compression. That’s what’s really going to drive the deal.”

But now, with the late 2008 surge in vacancies, banking on rent increases is risky business, too. Buyers are now basing their decisions off of rents from the trailing 12 months or even 90 days. In fact, it’s probably more realistic to expect rents to stay flat or even fall. That’s pulling prices even lower.

“We would trend almost every market down a little bit to a lot this year,” Mutz says. “If you go to your partners and project that rents will rise 3 percent or 4 percent, most people would laugh at you and say they’re not going to do the deal.”

The Seller: Wanting out

Even as cap rates have risen to 200 to 250 basis points in many markets across the country, one question still remains: Do sellers realize that it’s now a buyer’s market? Six months ago, they probably didn’t. But now, they’re starting to recognize the reality. Look at Novi Ridge, a 204-unit, C-plus property with deferred maintenance in a B market in Novi, Mich. The property sold in January for $9.05 million after being listed as $13.6 million.

But not everyone sees price erosion. “It’s already there, but sellers haven’t acknowledged it,” says Matt Wanderer, principal for Alterra Capital Group, a multifamily owner based in Miami. “Those last few years of peak values have been lost.”

Foreclosures offer the most obvious example. Take La Privada at Scottsdale Ranch, a 350-unit Class A property in decimated Scottsdale, Ariz. In late 2005, the property sold for $79.6 million; in 2006, it sold again for $94.9 million. In 2007, it was foreclosed upon, and in February 2009, it sold for $32 million—almost a third of its 2007 price, according to Hendricks and Partners.

With this kind of price decimation, it’s easy to see why sellers have trouble disposing of their assets. Much like homebuyers today, they may have to compete with the foreclosure down the street. “Cap rates have gone up, and the underwriting criteria has tightened dramatically,” Furst of Kettler says. “We’re trying to be realistic sellers.”

If sellers haven’t acknowledged reality, rightly or wrongly, their banks may soon be splashing cold water on them. With mark-to-market accounting regulations, banks are required to constantly value their assets based on the sales prices of similar properties nearby. As a result, if a property is sold in distress, that lowers the value of well-performing properties nearby. Suddenly, those assets may lose so much value that they’re undermining the owner’s coverage ratios and sending them down the path to foreclosure.

“It’s like a never-ending, vicious cycle,” says Donald Phillips, owner and managing director of Phillips Development and Realty, a Tampa, Fla.-based contractor that built more than 3,000 units in 2008. “The people who have paid off all of their properties are the only people that will stay standing.”

However, despite being faced with this dire situation, some sellers won’t adjust. “It depends on who the seller is,” says Christopher Feeley, senior vice president at Minneapolis-based NorthMarq Capital’s Washington, D.C., office. “If it’s a long-term, private owner, they have no gun to their head. They can sit and hope for the market to recover.”

But Waterton’s Schwartz cautions that not all of those sellers will wait out the market. “The low-leverage, low-basis seller—someone who has owned since 1999—has low debt, can sell at these prices, and be OK with it,” he says. “Your other option may be waiting out another three to five years until you have some recovery in value. That may not be such a great option for certain sellers.”

He may be right. Certain sellers are under the gun. Usually, these are the people who choose to lower their prices to get assets off their books—a behavior that will push industry- or market-wide valuations down even further. At this point, those with the most pressing issues may be construction lenders who have products opening and need a permanent loan.

“Most developers don’t want to move from construction loan to permanent loan,” says Dustin Slack, vice president of McShane Development Co., a Rosemont, Ill.-based developer that has 1,500 units in development. “These are not good times to do that.”

If they can’t get financing, these developers and builders will need to sell or turn the keys over to the bank. So will owners of existing assets who have loan maturity rapidly approaching. “The fact that an owner doesn’t know who they will refinance with in two-and-a-half years means they have to look at worst case scenarios in terms of their sale pricing,” Wanderer explains.

Pension funds are also facing a great deal of stress, though they won’t comment publicly on how they’re changing their valuations. In fact, valuations are so fragile right now that the California State Teachers’ Retirement System (CalSTRS) and the California Public Employees’ Retirement System (CalPERS)—two of the country’s largest pension funds with significant investments in multifamily real estate—declined to comment for this story.

Many are pulling their money out of apartments and looking for more liquid, stable investments, such as AAA bonds or AAA CMBS senior paper, Feeley says. “They have other avenues where they can put their money,” he adds. “The things that can sell within their portfolios are apartments. In those particular cases, those owners have owned two or three years at most. Now, they need to monetize some of their assets to pay redemptions. Some of them are taking significant losses.”

THE Lender: Hunkering Down

Right now, everything ultimately revolves around access to capital. And that includes valuations. “As principals, we have to adjust our offering prices as far as new acquisitions and valuations,” Wanderer says. “We have to adjust whenever Fannie, Freddie, or our balance sheet lenders decide they’re making changes.”

The challenge is that those changes—which can include anything from changing loan-to-value ratios to asking for more equity—aren’t minor. As risk has gone up in all sectors of real estate, lenders have adjusted. And much like buyers, lenders are becoming more realistic in their underwriting.

“There is less reliance on appraisals and more reliance on recent income statements,” says Tim White, president of PNC ARCS, a division of Pittsburgh-based lender PNC. “If we look at appraisals, we find that sales have lagged over the past 12 months. There’s a possibility that the appraisals will reflect a thin sales market and too many distressed sales.”

Instead, White is focused on the trailing one- and two-month income statements of the property. Ricks says Love Funding’s horizon is a little longer. “We’re not being aggressive on the rents,” he says. “Now, we’re more protected by using historical data from three to six months ago.”

But even looking at the past few months of performance at a property may not be a reliable gauge for lenders. “Vacancies are increasing and rents are decreasing,” Goulet says. “You have declining NOI, increasing cap rates, and more conservative lending criteria to get a new loan.”

Take all of these conflicting factors collectively, and you get lenders having their borrowers put more skin in the game. Ultimately, this dynamic influences valuations over time. “Every lender is definitely more conservative and requires more collateral and some sort of guarantee that they didn’t have before,” Ricks of Love Funding explains. “They may have lent up to 80 percent on the additional collateral, but now that may be 60 percent. Everyone is a little more conservative.”

White says it’s still possible to get 80 percent loan-to-value and 125 percent coverage ratios in most parts of the country. Eventually, he sees loan-to-values moving to around 75 percent and possibly 70 percent in weaker markets.

Fannie Mae and Freddie Mac declined to comment for the story—in part because they were in the midst of valuing their own assets for their quarterly reports—but lenders say the agencies are showing more restraint by looking at factors such as falling incomes and the increases in bad debt and vacancies at apartments, according to lenders who work with them.

Ultimately, the push for more equity could push valuations down even further. “Equity is not going to come to a project if it can’t generate a positive return,” White says. “Equity will require a greater return than loan dollars. That will translate to a higher cap rate—if that happens in enough locations and enough times.”

Cap rates have actually been rising for a while now. Feeley says that in gateway markets such as Boston, New York, Washington, D.C., Chicago, and Los Angeles, stabilized assets are currently in the high 6 percent or low 7 percent range after bottoming out at less than 5 percent in 2007. In secondary and tertiary markets, they’ve moved into the 9 percent range after falling to 5 percent or 6 percent at the market’s peak. He eventually sees values falling 15 percent to 25 percent.

As lenders continue to tighten and sellers adjust their pricing, White expects to see additional fallout—valuations at more than 150 basis points off where they are now. “Those would be the cap rates that we historically thought were customary,” White says.

But until the market levels off, where valuations will end up is still anybody’s guess. [M]

There are three key factors affecting today’s valuations.

1. Availability of capital. If buyers can’t access capital, they can’t compete for assets. And if owners can’t refinance, they may have to sell at discounts to avoid foreclosures. Put these two trends together, and you have price depreciation.

2. Fundamentals. In most markets around the country, rents are going down and vacancies are rising. Since buyers can no longer bank on appreciation when they sell, they’ve become more concerned with fundamentals. If the fundamentals are failing, they can’t pay as much for an asset.

3. Distressed sales. When owners and apartment developers can’t refinance or trip their covenants, selling at distressed prices is often the last remaining option. Buyers see these forced sales in the future and will wait to buy until they get rock-bottom prices.

Bridging the Gap

Actual sales prices and cap rates at these properties were below their initial values.

Quail Chase

Market: Sacramento

Sales Date: December 2008

Listing Price: $14.3 million

Listing Cap: 4.75%

Sales Price: $9.1 million

Sales Cap: 6.8%

Source: Apartment Realty Advisors

Novi Ridge

Market: Michigan

Sales Date: January 2009

Listing Price: $13.6 million

Listing Cap: 4.6%

Sales Price: $9.05 million

Sales Cap: 7%

Source: Hendricks and Partners