New volatility in the debt financing markets and the long upward trend in operating and construction costs are among the topics worrying apartment owners and developers, according to industry leaders participating in Apartment Finance Today’s Leadership Roundtable.
The continuing surge in capital chasing real estate equity positions looks like a decidedly mixed blessing, according to members of the magazine’s Editorial Advisory Board and invited guests who participated in the discussion.
“The biggest challenge we’re facing is keeping discipline and trying not to overpay. To actually buy something that makes sense, in the face of money that is just running through real estate and buying somewhat indiscriminately,” said Richard Kelly, principal of LumaCorp, Inc., in Dallas.
Editorial board members and guests discussed industry trends at a roundtable discussion held as part of the Apartment Finance Today Conference this winter. For this special section of Apartment Finance Today, we present an edited transcript of their discussion, supplemented by current interviews with some apartment industry leaders who were unable to attend.
Andre Shashaty: 2006 was a great year for apartments, with excellent rent increases, strong capital flows, and high property values, but many people are cautious about the 2007 outlook. In your view, what are the biggest challenges facing apartment firms in 2007 and 2008? What are the biggest opportunities?
Michael Berman, CWCapital: The biggest opportunities that we see have been in the value-added sector. The question is how much money is coming into that sector and just how prudent are those investors. Statistics I saw a year ago in the institutional arena show that there was an overhang of something like $50 billion or $60 billion of institutional money that was trying to get into the real estate sector. That obviously has an impact on everything that happens, from capitalization rates to the kind of investments that are being made. As money has continued to come into the sector, it’s pushing everybody. The challenge for us is how to be discerning as we move forward in this incredibly competitive and aggressive market. Our theme for the year is to be selectively aggressive—that is, for the right sponsors with the right business plan for a property combined with the right market dynamics, we want to be particularly competitive.
Kenneth Bowen, Red Mortgage Capital, Inc.: We’ve seen capitalization rates continue to decline while interest rates, they’ve stayed low … There’s an increase in the amount of interest-only being offered. In the conduit world, about 80 percent of the deals being done these days have at least some period of interest-only. It’s a wonderful time to lock in long-term permanent debt, if you’ve got a good growing market, if you’ve got barriers to entry, if you’ve got excellent management. But you’re losing your cushion. We’ve driven debt coverage ratios down from 1.25x to … I’m not sure anybody knows what a debt coverage ratio is anymore. We’re taking away the amortization factor. Amortization was always the best way to mitigate the risk that you cannot identify.
Thom Cooley, ARCS Commercial Mortgage: [Developers are] facing a really big challenge in regard to the cost of production—whether it’s new construction or whether it’s substantial rehabilitation, the costs of production have gotten to where, with the fairly slow growth in rents compared to what we’re accustomed to for the long term, they’re really running up against having their profit worth the effort. Insurance costs are going up faster than rents are going up. Taxes are going up in many markets faster than rents are going up. We’ve got some positive rent fundamentals. But positive just means non-zero. It doesn’t mean great, so I see developers and owners getting squeezed by ... production costs, costs of operation in a market where rents really aren’t keeping up with those things.
William Friedman, Tarragon Corporation: 2006 was a good year for rental apartments, especially in terms of rent increases in markets that have barriers to entry. The flip side of that is that new apartment development in those markets is increasingly unaffordable to a majority of residents in those areas. And the pressure on building, both because of material costs and approval difficulties because of design issues and standards in many markets, means the only type of new construction is really luxury—and not luxury in name, but luxury in terms of who can afford to live there. This is mainly in California and the Northeast, and high-cost areas, but is increasingly going to spread and will have all sorts of implications.
Mel Gamzon, Senior Housing Investment Advisors, Inc.: Industrywide occupancy levels [in seniors housing] are at about 93 percent. Performing loans, according to a recent survey, are at 99.4 percent. Investment opportunities abound in most markets. Development of seniors housing can become a value-added use for your mixed-use ventures. If you want to potentially increase your commercial FAR [floor-area ratio], consider integrating seniors housing into the project. In addition, we’re going to be seeing an increasing number of innovative seniors-oriented condos and co-ops with a range of service options. While the overall condominium market is flat in many markets around the country, the opportunities to attract seniors who have vast home equity resources are enormous. However, the biggest challenge that we face today is the ability to produce new product at price points that are affordable for many seniors. It’s interesting that between now and the end of 2010, there will be an annual, theoretical demand for 30,000 new units built. No way will we see this level of production given the limited availability of prime sites and the escalating costs of new development. Investors should consider this imbalance as a positive sign to acquire or build prime ventures in solid markets.
R. Lee Harris, Cohen-Esrey Real Estate Services, Inc.: We seem to know more about our markets than ever before. We understand what it costs to build our properties and operate them. But Andre, I’d like to introduce a new term, a new real estate term. It’s called “bubble-ized” thinking. And what is bubble-ized thinking? Well that is when we know what we’re doing, and we do it anyway. Let me give you some examples. First of all, there is virtually no risk premium today in our industry—virtually none. [The risk premium is defined as the difference between the yield on highly-secure Treasury bonds and the yield on apartment equity investments.] In the old days we were looking at a 450-600-basis-point risk premium. Now the risks as far as I can tell really haven’t changed in the last 30 to 40 years. But for some reason, these people have it in their minds that they don’t need the risk premium. Primarily, we’re talking about folks from more dynamic markets that are coming into the Midwest because they’ve run out of product that they can buy at reasonable capitalization rates. And they decide to go for properties with 6 percent capitalization rates in the Midwest. But we’ve got a lot of markets with low growth or no-growth where rents are concerned. We’ve got negative leverage situations where people are buying on a pro forma, and to me that’s bubble-ized thinking.
Bob Hart, Kennedy Wilson Multifamily Management Group: I am more of an operator of value-added condo/apartments on the West Coast. I think there’s still great opportunity to do rehab deals even at the capitalization rates we’re talking about. What makes that opportunity is the availability of very high quality, fixed-rate long-term financing. We’re now able to secure low-cost financing with flexible options for prepayment, and that allows you to acquire an apartment deal if you’re willing to hold it longer term. There’s also a lot of opportunity out there to find what I call reasonable equity that has reasonable return expectation. The biggest challenge is getting real economic rent growth, and keeping material costs and expenses for rehab down.
Richard Kelly, LumaCorp, Inc.: The biggest challenge we’re facing is keeping discipline and trying not to overpay. To actually buy something that makes sense in the face of money that is just running through real estate and buying somewhat indiscriminately. The flip side of that is the biggest opportunity: This is a great time to unload your dogs. With all that indiscriminate buying out there, it is a very good time, if you have had a property four, five, six years, you know where the bodies are buried and you’d rather not have it, it is a great time to be moving your lower performing properties.
Charles Krawitz, Lasalle Bank Multifamily Finance Group: You’re going to see over the next year a rush of national platform lenders, Wall Street lenders to the small balance arena. 2007 really is the year of the owner-operator, the seasoned professional who does this for a living. People who thought there was easy money to be had are finding that they are not indeed capable of owning and operating those assets, which creates opportunities for a lot of people in this room that are capable, hands-on people.
