Mid-Year Apartment Report 

This Quarter Is Worth a Lot of Dollars Improved resident retention rates, robust demand in the second quarter boost occupancy and effective rents.

by Greg Willett

In an analysis of apartment market performance results from Q2, MPF Research’s initial calculations point to absorption of another 83,000 units, taking demand for the first six months of the year to nearly 215,000 units.

The apartment market is now on pace for calendar 2010 demand to come in at the second strongest annual volume seen over the past couple of decades, exceeded only when Hurricane Katrina evacuees boosted the absorption tally in 2005.

Obviously, the addition of some jobs is a big part of the demand story, but there’s more to it than that. For example, renters are continuing to return to traditional apartments from individually owned condos and single-family homes offered for lease. Also, some young adults who had combined into roommate living arrangements are splitting up into separate households. And an improving economy means that more parents are willing to guarantee leases in order to kick their perhaps under-employed kids out of the basement.

A new element that seems to be emerging now is that some apartment demand is coming from renters who recently sold their homes. A lot of them were worried that they’d never be able to unload those homes, so making another purchase right away is a pretty scary move.

A really important thing to realize about the overall demand numbers is that most of the leases being signed today translate directly into net additions to the occupied unit count. That reflects that operators are posting record-high resident retention rates when existing leases expire. It makes a big difference when a majority of the new renters coming in the front door aren’t just replacements for others exiting out the back.

With strong demand showing up at the same time that completions have dwindled, the upturn in occupancy is sharp. Stats for June show occupancy at 93.4 percent. That’s a hefty improvement of 1.6 points from the bottom-of-the-cycle number seen at the end of 2009.

Annual change in effective rents is still negative at minus 0.9 percent. But that’s much better than what we had been seeing. In fact, meaningful rent growth actually did occur specifically
during Q2. Effective pricing went up 1.2 percent between March
and June.

The encouraging apartment sector performance seen during 2010’s first half now appears to ensure at least a little bit of overall revenue growth for the calendar year, even if job production proves tepid over the coming months. That’s surprisingly good news for owners and operators who mostly reported basically flat revenue expectations in their 2010 budgets.

Greg Willett is Vice President, Research and Analysis for apartment research firm MPF Research. This report is reprinted from the Market Dynamics column, June 28.

Apartments Leading Real Estate’s Recovery

Consumers’ willingness to rent means multifamily will beat other commercial sectors out of slump.

by Victor Calanog

Reis’ Q2 data show that the apartment sector is on the path toward recovery. Vacancies fell for the first time in two years (from 8 percent to 7.8 percent) as net absorption surged by 44,199 units, the largest net positive addition to occupied stock on record in 10 years.

Approximately 70 percent of this addition to occupied stock came from existing buildings leasing up empty units.

The second and third quarters typically are stronger periods, as most households make decisions to move and lease new apartments during this time. However, these seasonal patterns have not been operative since 2008, when the so-called Great Recession compelled households to suspend decisions to move and lease new space given the tumultuous financial and labor markets. Asking and effective rents grew at a faster pace relative to Q1, rising by 0.4 percent and 0.7 percent, respectively.

Like in Q1, the faster pace of effective-rent increases versus asking rents imply that concession packages are no longer increasing and may be tightening. These reversals came quickly after the massive declines in 2009, when asking rents fell by 2.3 percent and effective rents fell by 2.9 percent (both record annual declines in Reis history). When asking rents fell by 0.7 percent in Q4 2009 (the largest single-quarter drop since Reis began publishing quarterly performance data in 1999), it appears to have signaled owners’ willingness to deal with residents who are now finding jobs and are more willing to rent their own apartments. Combined with stabilizing labor markets, rents that fell “far enough” heralded the turnaround, Reis now observes.

Not every data point for the second quarter was rosy. Newly completed properties came online more than half empty: more than 29,000 units of new apartment buildings opened their doors in Q2 at an average vacancy rate of 57 percent. Still, there is now two quarters’ worth of data showing that the apartment sector may indeed have bottomed in Q4 2009 and may be on the path to recovery. This is consistent with Reis’ outlook that rental apartments will recover first (versus office, retail and other commercial sectors) as the economy and labor markets emerge from the recession.

This doesn’t imply that recovery will be linear. As labor markets and consumer confidence waxes and wanes given continuing challenges both on the domestic and international front, recovery in apartment fundamentals may be muted, especially if economic recovery softens considerably in the traditionally weak fourth quarter.

Victor Calanog is Research Director for Reis.

What Owners Can Expect in the Second Half

by Mike Kelly

As apartment owners roll into the second half of 2010, many are trying to fully understand the dynamics of the sales and debt markets.

Through our national reorganization practice we see details and trends on a large swath of apartment assets.

Following is a recap of trends we saw in the first half and details on what owners can expect from the second half.

First-Half Recap

1. Little supply of quality assets on the market. Properties in urban markets are achieving cap rates similar to those in 2007.
2. Occupancy rebounded more quickly than most apartment analysts predicted.
3. The agencies are still the dominant lender. Freddie Mac appears to be gaining the most market share as some Delegated Underwriting & Servicing (DUS) lenders have slowed. Life companies are more active but the absolute amount of new loans placed is small.
4. Concessions have flattened and shrunk in many markets.
5. Commercial Mortgage-backed Security (CMBS) servicers have been extending more loans and taking back the assets with poor financials or fundamentals.

Second-Half Predictions

1. Many more assets will hit the market with an attempt to close transactions before year end. Investment funds originated in 2004-2007 are going to use this window to pare their portfolios. With tightening rent rolls and competitive debt markets, many deals that were under water at the end of 2009 will suddenly return some equity to the fund.
2. A sale also demonstrates the funds’ “expertise” in not selling at the bottom—a point they hope will resonate with new investors in newly raised funds.
3. Occupancy will remain pretty tight across the country, and the real gauge to the health of the apartment market will come in Q4 as the comparisons to prior years and the prior quarter will become more difficult due to the many outside factors influencing rental demand over the past year.
4. Effective rents will remain strong going into Q4. However, will owners be able to start aggressively increasing net rents (either through lower concessions or pure rent increases in yield management systems)? Or will they break and start offering new concessions if there is any hint of a soft market?

Fannie, Freddie Lead Debt Markets

1. In the first half of 2010, many of the Fannie Mae DUS lenders were more conservative, as they were trying to understand the risk and balance sheet impact of adding new deals to their existing platform. Freddie Mac took advantage of this and now appears to have captured a bigger share of the market. Freddie Mac’s new Capital Markets Execution product has become a staple in many new acquisitions. Fannie Mae should have a strong return in the second half as the DUS lenders become more aggressive.
2. Freddie Mac has announced a new mezzanine program that is providing the refinance bridge to many existing assets. The new mezzanine will piggy-back onto the Freddie Mac CME program, providing financing up to 90 percent loan-to-value based upon a 1.05 combined debt coverage ratio. Four lenders are currently in the program and they will bid on and be the end provider of the mezzanine debt. Additionally, the four groups are able to negotiate different current and accrued pay rates on their loans, which will offer additional options to borrowers. This is an excellent program for the current market. It works better for refinances than for new acquisitions because of the current, low cap rates.
3. CMBS will start to enter the apartment market, but competing against the agencies will prove too difficult, and CMBS providers will spend most of their time and money lending to high-quality office, retail and industrial assets.
4. Life companies will lend on some high-quality assets, but they also will find greener pastures in other asset types.
5. The flow of new deals will test the origination platforms, as many financial firms have shrunk their staffs.

Mike Kelly is President, Caldera Asset Management LLC. He can be reached at mkelly@calderaassetmanagement.com.

Will Tight Cap Rate Market Last?

The long awaited flow of property transactions is starting. Equity providers and sponsors will take the current uptick in fundamentals as an opportunity to sell some of their non-core holdings. There is
enough money and debt to absorb most new deals.

Servicers are doing the right thing in extending loans for deals that have life and can eventually repay, while foreclosing on others that have very little chance of repaying, either due to poor markets, physical conditions or bad sponsors.

Servicers also are beginning to take on better assets through foreclosure, and they have spent 2010 making their sales processes more efficient. Because debt appears to be plentiful and competitive, the real question facing apartment investors will be, “How long will this tight cap rate market last, and will the ultimate supply of product start to force cap rates back up?” –M.K.

Permanent Debt Outlook for IROs

Need $2 million or less? Challenges continue, but more options may be on the way.

by Mike Bryant

In the first half of 2010, the multifamily housing debt capital landscape generally was positive. The second half of the year promises more of the same and even shows signs of further improvement. The multifamily housing asset class continues to be the darling of the real estate industry, especially when compared to other property types in the commercial sector that are still struggling to recover from the effects of the global financial crisis of the past few years.

Multifamily real estate debt capital can be divided into two baskets—small balance loans, which typically are $2 million or less, and loans of more than $2 million. Borrowers such as independent rental owners (IROs) looking for small balance loans to finance their multifamily properties faced more challenges in the first half of the year than those seeking larger loans. But although challenges will likely continue through the end of the year, there is reason to expect the situation to improve.

Mortgage REITs, Fannie Mae, Freddie Mac, HUD/FHA, commercial mortgage-backed security (CMBS) aggregators and other lenders generally are geared for larger debt transactions. Most are set up to process loans on a volume basis to justify the fixed overhead, and it is much easier to do this when an organization is making larger loans. It takes as much underwriting expertise and due diligence to process a small loan as it does for a larger loan. The CMBS arena typically wants all loans to be over $10 million. However, with increased competition in this sector, some lenders have begun adjusting minimum loan levels downward to increase deal flow and earn spread premiums.

That has left IROs, investors and developers with financing options limited to a handful of smaller banks requiring full recourse provisions or a few Fannie Mae shops that have an interest in pursuing loans under $2 million. Lenders offering financing under the Fannie Mae DUS (Delegated Underwriting & Servicing) product line, however, face a loss-sharing risk with Fannie Mae for the life of the loan that may reduce a lender’s willingness to offer this product. For example, a $1 million Fannie Mae DUS loan would have a continued top-end risk piece of $200,000 (20 percent) that stays on that lender’s books until the loan is paid in full. In today’s environment, most commercial real estate lenders have become risk-averse, and the idea of holding a top-end risk piece on the books for years to come may not be met with a lot of enthusiasm by investment committees.

There are some exceptions, however, and the lenders that operate in the small-balance loan space are looking for well-positioned, stabilized deals. They generally avoid C and D quality properties, as well as value-added transactions. Debt capital for C and D quality multifamily housing deals under $2 million is very tough unless the borrower is willing to sign a personal guarantee at a local bank.

Even A and B quality multifamily housing product under $2 million has a limited pool of willing lenders, not to mention spread premiums that are 75 to 200 basis points more than the larger loans. As multifamily housing debt opportunities increase, the under-$2 million debt deal will eventually attract new lenders because the space currently has limited competition and great spreads.

The over-$2 million multifamily debt deal attracts a wide range of lenders such as mortgage REITs, Fannie Mae, Freddie MAC, HUD/FHA, regional and national banks and insurance companies, as well as the new CMBS aggregators who have recently started competing for this business. The increased competition in the over-$2 million debt deal gives borrowers the advantage of being able to shop more lenders, not to mention the flexibility to select terms that are not always available with the under-$2 million debt deal option.

In summary, although the multifamily housing debt landscape is improving through increased competition, Fannie Mae, HUD/FHA and Freddie Mac should continue to lead the pack in multifamily housing lending through the end of the year. What’s more, Freddie Mac recently added a new mezzanine program that includes four pre-approved third-party providers, and Fannie continues to look at mezzanine opportunities with their sole mezzanine partner.

The under-$2 million debt arena has a lot of room for additional debt providers to enter the space and make attractive yields. Although challenges will likely continue through the end of the year, competitors should bring more liquidity to the less-than-$2 million space and move capitalization rates down in the future. Continued illiquidity should be expected for C and D quality properties, but it’s likely the sector that contains the greatest yields for proven, hands-on operators.

Mike Bryant is Senior Vice President/Branch Manager, Mortgage Banking, for Berkadia Commercial Mortgage, Dallas. He serves on Freddie Mac’s Seller Servicer Advisory Council (SSAC). He can be reached at mike.bryant@berkadia.com or 214/363-0038.

Views expressed in this article are those of the author and are not to be construed as representing the views of Berkadia Commercial Mortgage LLC.

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