Despite the recession, the multifamily industry is, in some ways, leading a charmed life.
The availability of affordable debt from Freddie Mac, Fannie Mae, and the Federal Housing Administration has kept cap rates from rising further, making the multifamily industry the envy of other asset types. “Fannie and Freddie are providing the grease that’s lubricating the whole multifamily business,” says Simon Wadsworth, CFO of Memphis, Tenn.-based Mid-America Apartment Communities.
But there are other forces at work helping to limit the corrosive effects of the recession on the sector. Floating-rate debt has been incredibly affordable this year, which has helped to keep many short-term floating-rate loans from going into delinquency.
Indeed, floating-rate debt can be a very effective hedge against downturns. When floating-rate benchmarks like LIBOR or SIFMA decline, so do rents, helping firms to offset a decrease in NOI. And when those floating-rate benchmarks tick up again, rent growth is also on the rise, helping to offset the higher rates.
These days, cash is king. And the lower debt service payment on floating-rate debt is one way that multifamily firms are maximizing cash flow. The strategy is particularly suited for a business that re-prices its rents every 12 months: office or retail properties with long-term leases are less likely to reap the short-term benefits of floating-rate loans.
AvalonBay has increased its level of floating rate debt every year for the past four years as a hedge against downturns. In 2005, just 2 percent of its capital structure was in floating-rate debt; today, it’s about 11 percent to 12 percent, or 1.2 percent of the company’s overall value. “We consciously increased our use of floating-rate debt knowing it’s a good hedge in terms of being positioned for a downturn,” says Thomas Sargeant, CFO of the Alexandria, Va.-based firm. Since rental revenue and short-term interest rates are highly correlated, “revenue declines that occur in a downturn can be partially offset with lower interest costs,” he says.
Mid-America Apartment Communities keeps an even larger part of its capital stack floating: About 20 percent of the company’s $1.3 billion in debt is variable rate. “We’re increasingly going to be using floating rate,” Wadsworth says.
Private real estate firm (and former REIT) Gables Residential has also become enamored with the low LIBOR rate. The Atlanta-based company supplements its $250 million revolving line of credit with construction loans, most of which have three-year terms with two one-year extension options. “That can really get you five years of financing,” says Dawn Severt, CFO of Atlanta-based Gables Residential.
Those extensions are all getting exercised. Gables now has about a third of its debt stack in variable rate. “From a cash-flow perspective, we’ve really benefited from the historically low LIBOR rate,” Severt adds.
Still, LIBOR and SIFMA spiked to unprecedented levels at the end of September 2008. LIBOR reached nearly 7 percent, and SIFMA rates on seven-day variable rate bonds shot up to nearly 8 percent. “When overnight LIBORs were going up last September, that gives the CFO with hundreds of millions of exposure in floating rate some pause,” says Jay Hiemenz, CFO of the privately held, Phoenix, Ariz.-based Alliance Residential. “It’s been great to be in floating rate over the last near term; at a half-point it’s cash-flowing quite nicely. But that may not always be the case.”
Though a short-lived phenomenon, the episode reveals the importance of interest-rate hedges such as caps and swaps. To create a swap, an outside investor guarantees a fixed-interest rate to the borrower. The investor agrees to pay the difference when the floating rate rises higher than the guaranteed rate and receives the difference when the floating rate is below that rate. Interest rate caps are another derivative where the buyer agrees to a certain strike price, say a LIBOR rate of 2 percent. That buyer would get paid at the end of each period in which the rate goes above 2 percent, for instance.