The Great Recession, which brought millions of people into apartments, reshaped the way the industry invests, builds and underwrites assets.
When Steve Fifield thinks back 10 years, one number—167,000—stands out.
Fifield, Founder and CEO of Fifield Cos., has seen a lot of numbers in his career. He developed 6 million square feet of apartments and offices worth over $7 billion in seven different markets.
So, what is the significance of 167,000?
It was the number of jobs hemorrhaged in The Windy City in 2008, when Fifield was in lease-up stages for its 350-unit Echelon Tower at K Station in Chicago.
“That fact [the number of jobs lost] is hardwired in my memories,” he says. “Even though we dropped our rents and gave concessions, we felt lucky we were able to lease 20 units a month. In 2010, when the economy was recovering and the apartment market was back, we were leasing 40 or 50 units a month with no concessions.”
At least that project recovered quickly. Fifield was also developing condos when the financial crisis hit.
He had a $120 million loan on a project in Las Vegas. There, he had to extend his construction loan for three years and drop prices 40 percent to sell-out the project.
“We lost all of our developer capital,” Fifield says. “Our pension adviser investor lost about half of the money that they had advanced us.”
In hindsight, Fifield was fortunate. He had enough equity to weather the financial crisis and built 3,000 units in the past five years.
“What kept us from going bankrupt in 2008 and 2009 was that we weren’t overleveraged,” he says. “It is better to joint-venture with other institutions and family offices and keep your debt levels lower—at 65 percent of cost. That way, when you have adjustments in the market, you can ride through them.”
But the event, which spread like a contagion in September 2008, changed him, like it did to many others in the apartment business.
Initially, there was pain, particularly for merchant developers or those who took out CMBS loans when occupancy and the capital markets dried up, creating buying opportunities for opportunistic apartment owners.
But falling homeownership rates eventually helped drive apartment occupancy, which boosted the sector in the eyes of investors worldwide. As those investors have come into the apartment market, they have pushed prices upward, which is now creating concern that values are not sustainable, even with the economy humming along with a 3.7 percent unemployment rate (a 48-year low), wages rising faster than inflation (the 3.1 percent annual wage bump reported in November was the highest since mid-2009) and more than 2 million jobs added per year since 2011.
If prices do fall, lessons the industry (and its lenders) learned about having more leverage and stronger balance sheets from The Great Recession should limit the damage when the next crisis comes.
The credit markets had already grown difficult for home buyers by September 2008, when the financial system seemed to be teetering on the brink of disaster after the federal government took over struggling Fannie Mae and Freddie Mac and Lehman Brothers collapsed. But after that, lending basically came to a halt. Decisions made afterward compounded the issue.
“The Dodd-Frank [regulations] and a lot of other changes made the mortgage lenders much more conservative and cautious and that helped cause the homeownership rate to drop from 69 percent [to below 63 percent in 2016],” says Greg Mutz, Chairman and CEO of AMLI Residential.
In the second quarter of 2018, the homeownership rate sat at 63.4 percent and roughly 23 million people became renters during the past decade.
“We have seen a marked reduction in homeownership levels from pre-recession peaks, which has driven a very robust growth period for multifamily rental rates and occupancies,” says Bobby Lee, President and COO of JRK Property Holdings.
Between 2006 and 2014, more than 9.3 million homeowners saw the foreclosure sale of their homes, surrendered their home to a lender or sold their home through a distress sale, according to the National Association of Realtors. Eric Bolton, CEO for MAA, contends those foreclosures spurred a change in the nation’s psyche.
“The myth surrounding homeownership routinely being a great long-term investment was exposed,” Bolton says. “A household’s decision to meet their long-term housing needs through renting gained favor coming out of the recession and that continues today. Households are now much more likely to consider how best to meet their housing needs with a broader lens, more actively considering lifestyle needs and their desire for mobility and flexibility.”
The momentum toward rentals did not only occur with residents. It also resonated with investors, who saw that apartments performed extremely well relative to other commercial real estate asset classes, stocks and bonds. In 2007, apartments saw $104.6 billion in investment. In 2017, that number ballooned to $154 billion (with $120 billion traded in the first three quarters of 2018), according to Real Capital Analytics.
“Investors realized that apartments, as opposed to retail, office, stocks, bonds and commodities, satisfied an essential need with consumers,” Mutz says.
The reason: In times of upheaval, people still need someplace to live. “People might cut back on movies, eating out and entertainment,” Mutz says. “They might not buy a car and might not go on a vacation, but they will always need a place to live.”
In some cases, developers from other sectors, such as Houston-based commercial builder Hines, accompanied investors to the rental housing sector.
“There’s been a disruption within other asset classes and some of the groups in those sectors became very active multifamily players,” David Schwartz, CEO, Chairman & Co-Founder, Waterton Associates, says. “The makeup of the players in apartments differs greatly compared to 2008. There is much more capital coming into our space.”
Part of the reason that the makeup is different is a result of REIT privatization and consolidation, which took off after 2012.
Equity Residential and AvalonBay Communities bought Archstone’s assets and MAA purchased Colonial Property Trust and Post Properties. Other companies, such as Associated Estates and, most recently, Forest City and EdR, were taken private by large institutions. On the management side, Greystar’s 2014 purchase of Riverstone Residential created a management colossus, the likes of which hadn’t been seen since Andrew Farkas piloted Insignia Financial Group to the 350,000-unit threshold in the late 90s.
“There has been massive consolidation and there are larger companies now,” Schwartz says.
The crisis also gave long-time players an opportunity to grow. Just before the crisis hit, in March 2008, Bell Partners aligned with DRA Associates to buy 26,000 apartments from UDR.
“While we didn’t buy at the bottom, we weren’t far from it,” Steven Bell, Founder and Chairman of Bell Partners says. “We made a lot of money with that portfolio when we sold it off. In fact, almost anything we purchased in 2008, turned out to be profitable because we could buy it at a good price. There were plenty of things available to purchase. The problem was finding the cash.”
Until 2008, Bell Partners had relied exclusively on wealthy investors for equity, but those investors had been battered by the recession and were reluctant to write more checks. That prompted a change in strategy and Bell began to pursue institutional investors. Now about 80 percent of its capital comes from institutions.
Bell also moved out of other commercial sectors, selling millions of square feet of retail and its senior housing division. Retail companies stopped opening new stores and began to demand lower rents, forcing Bell to accept less-attractive lease terms. In senior housing, people could not sell their homes and move into the company’s independent living facilities.
“We had some terrific success in senior housing and retail,” Bell says. “We hit a lot of doubles and triples repeatedly, but when the recession came, we started having some challenges in filling space. In the good times, we did very, very well in senior housing, retail and apartments. But in bad times, we realized that we needed to focus our attention on the apartment sector.”
Many merchant developers were delivering apartments when the music stopped and were unable to refinance their loans when they expired, forcing them to go back to their banks to ask for loan extensions. That phenomenon was dubbed “Extend and Pretend” at the time.
“The banks would extend your loan by taking all your project operating cash flow and applying that to the loan principal to start paying the balance down,” Fifield says. “The banks were motivated to work with the borrowers. If the regulators made banks start foreclosure or made them write-down a loan, they would be writing it down at say $3 million a year before the bank foreclosed or the borrower paid it off. Those [forced] write-downs were a direct hit to a bank’s earnings, so it could be a disaster for them.”
On the existing apartment side, many deals financed by the CMBS market ended up with special services.
The busted deals and rental market slowdown in 2008 and 2009 forced a number of apartment companies to make major cutbacks, which Bolton says has made them more efficient in the long run. “I suspect that many retained the benefits of their cost savings even after rental rates surpassed their previous peaks,” he says.
Most public companies came through the downturn in relatively good shape and found room for improvement. Bolton says MAA, which did not reduce or suspend its dividend during the financial crisis, “further solidified its commitment to plan for and consider severe downside risks in its balance sheet management and carefully consider its tolerance for forward funding commitments.”
Camden’s lessons learned include utilizing lower leverage with laddered debt maturities, eliminating complicated off-balance-sheet joint ventures and personal margin loans using stock and lowering development exposure later in the cycle.
“Public companies are operating with much lower leverage,” says Ric Campo, Chairman of the Board and CEO for Camden Property Trust. “Camden had eight times debt to EBITDA in 2008 and now has 4.1 times debt to EBITDA.”
Bolton says these improvements set the public companies up well to weather any financial storms in the future.
“Within the public REIT sector, balance sheets have become much stronger with debt levels and coverage ratios in a much stronger position,” Bolton says. “This financial strength will continue to not only support less volatility in long-term performance for these companies but provide a stronger platform for delivering service and value for both the rental market and the capital markets.”
Public companies are not the only ones that slashed their leverage after the recession.
Waterton, a private company, focuses on a strategy on fixed-rate debt with staggered maturities. “We’re pretty focused on being defensive with the capital structures in our portfolio,” Schwartz says.
Developers, which grew very aggressive during the most recent cycle as they scooped low-leverage, recourse debt, appear to be in much better shape now, though some of that has been driven by the banks with their tighter lending requirements.
“The industry is using lower leverage for developments and acquisitions,” Campo says. “There is also a requirement for increased tangible net worth for any development company that is guarantying construction debt. This has led to even the biggest merchant builders doing fewer projects.”
What Happens Next?
After years of growth, the apartment industry and the economy at large seem due to hit a rough patch in the coming years.
When that happens, developers often get hit the hardest. Conservative underwriting should limit the damage. “I think developers are in very good shape in this cycle and it is unlikely you’re going to see the trouble they had previously,” Schwartz says. “That doesn’t mean there will be no bad deals. With high supply in some markets, looming maturities and high-interest rates, refinancing could become even more challenging for owners of all types of assets.”
When a correction occurs, Bolton predicts a relatively soft landing for the apartment industry as a whole. He says some borrowers who are utilizing short-term debt could get into trouble.
“Although I expect cap rates to widen and rental growth to continue to slow, I don’t see as severe of a crisis over the next few years,” he says. “Balance sheets at all levels seem healthier this time around and there is plentiful liquidity in the system currently.”
It is not just apartment executives who think the sector will weather the next recession. Moody’s Analytics Chief Economist Mark Zandi speaking recently at a conference says the housing and commercial real estate sectors will “navigate gracefully” through the next recession because of relatively low leverage and little supply.
There are trouble spots: Mutz wonders if investors are mis-pricing risk and buying at thinner margins than they should be. He senses that excess liquidity in the financial system is the driving force behind their confidence.
“There will be a recession at some point, and the stock market will correct, but I don’t think it will be as severe as 2008,” Mutz says. “I’m not worried that we are going to see a total collapse, but we are being cautious and mindful that, at some point, this recovery will run out and there will be some sort of correction.”
Over the longer term, Bolton thinks that while today’s enhanced information flow and transparency could at least help mitigate the severity of cycles, the drive for investment returns will require increasing risk tolerance, which ultimately ignites downturns.
“The exact combination of factors that fueled the 2008 financial crisis may not come together again, but there will be others that will come together and very likely fuel another recession, and possibly a financial crisis comparable to 2008, at some point in the future,” Bolton says.
Like Bolton, Campo does not see the factors that triggered the 2008 crisis coming together again anytime soon. But he could see “a major dislocation” given high asset prices worldwide driven by very low-interest rates.
“Until we get back to more normal global interest rates, the ending of The Great Recession will continue to be unwritten,” he says.
And once the ending of The Great Recession is written, Mutz hopes younger executives who may not have been in the business at the time continue to heed its lessons of conservatism in underwriting. “You take up a lot of excessive risks if you have not lived through it,” Mutz says. “The people who lived through it will always be mindful of it. It was scary.”
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