Capital Markets: Look who's coming to dinner

The capital markets have come to play an integral part in the multifamily industry. But Wall Street is still the newest member of the multifamily real estate family. It's the new in-law sitting at the dinner table - dashing, charismatic, a bit domineering, but much less predictable than Grandma or Uncle John.

The tide turned for the capital markets during the second half of 1998. It seemed just as the industry grew accustomed to REITs and the CMBS market dictating many of the terms for the multifamily industry, REIT share prices slumped and spreads on CMBS product widened sufficiently to relegate many players to the sidelines and knock a few out of the game completely. Even Wall Street's Ethan Penner saw the plug pulled from his Capital America, formerly Nomura Securities, after widening spreads resulted in $800 million in losses virtually overnight.

While Wall Street rediscovered that there is indeed risk in capital-market real estate lending, traditional lenders helped fill the void as the conduits licked their wounds and reassessed their strategies. REITs also relinquished their power as multifamily market makers as their share prices continue to underperform and private investors nudge acquisitive REITs to the back of the bid line. Despite the tumult, however, there is comfort for many in the industry in taking a step back. Less one-sided competition for capital and a clearer profile of the inherent risks in the powerful capital markets will benefit participants in the multifamily industry in the future.

Multifamily lending certainly slowed during the crunch in the last quarter of 1998, but the Wall Street conduits seemed to have borne the brunt of the tumult. Borrowers were not completely shut out of the market for capital for long. Following the crisis, regional banks, portfolio lenders - mostly life insurance companies - found they could compete and still secure profitable spreads.

The biggest single-entity story resulting from the disorder of last year was the emergence of Fannie Mae as the dependable alternative to the conduits. The nation's largest private investor in multifamily housing - with over $47 billion in assets - ended the year by financing a record $15.5 billion of multifamily housing by being there for borrowers through the flight of Wall Street capital. "We had no problem in accessing the capital markets when others in the market experienced disruptions due to widening spreads," says Fannie Mae senior vice president of lending and investment Louis W. Hoyes.

One of the main reasons Fannie Mae kept its doors open was its lack of "aggregation risk." Investment banks and other securitizers of real estate loans accumulate large inventories of loans in order to create securities. As these pools have grown larger in recent years, it can take up to six months to achieve the desired bulk. The time preceding securitization, when these loans are warehoused and funded with large credit lines, is exceptionally risky for the investment banks and conduits securing the credit. The risks were played out at the end of 1998 as we saw when spreads widene d and the value of those loans plummet. Fannie Mae DUS securitizations are issued in smaller dollar denominations than the average CMBS securitization, so the chance of FNMA holding the bag on a huge pool of devalued loans is small.

Hoyes is quick to point out, however, that this is not the only reason Fannie Mae was able to remain in the market and set an origination record. "The record production that we achieved last year was not due just to the disruption in the CMBS market. It had a lot to do with the wide range of products that we offer, and our credibility as a lender. The credibility factor has certainly become an issue - will the deal close at the terms agreed to? Fannie Mae has not reneged on any of its commitments." Hoyes also believes Fannie Mae's long-term commitment to the business is a significant reason for its recent success. "The recent dynamics punished, to an extent, the market participants that are not long-term players. Fannie Mae is committed to the long term. We originate loans using quality underwriting criteria and we service our loans for the entire life of the loan."

Then, of course, there is price. Hoyes thinks Fannie Mae pricing compares favorably against conduits and bank lenders. "Our DUS MBS loans are priced at a very cost-effective spread. The borrower's cost on a 10-year, 80% loan with debt-service coverage of 1.25 is around 180-185 basis points above Treasuries. By extending competitive rates to borrowers and offering a wide range of products, from standard loans to affordable housing, fixed rate to variable rate, short term to long term, Hoyes expects another strong year of origination for Fannie Mae. "We have customized our products and streamlined our origination process to better serve the borrower. We expect another healthy year of close to $14 billion of originations during 1999."

Fannie Mae served as a source of capital source for many other lending institutions like ARCS Commercial Mortgage Co., Cohen Financial, and Banc One. Ken Bowen, director of originations for Banc One Capital Funding Corp., reported: "We underwent a surge of originations towards the end of last year, closing $500 million in Fannie Mae DUS loans in December alone. Since a lot of our deals were with Fannie Mae, the loan types were broad - from conventional loans to tax-exempt bond deals."

Bowen believes that there is still a market for borrowers spooked by the crunch last year. "There are some wary borrowers that don't want to get left at the altar again. With Fannie Mae product there is no warehousing risk and the rate isn't locked in until the underwriting is complete. We are expecting to maintain the current level of origination. That would increase our multifamily originations by around 45% over the whole of last year."

The skinny spreads of the summer of 1998 were but a memory by the last quarter, and life insurance companies reasserted themselves in the market for multifamily apartments. Life insurance companies are now able to lend on the higher quality assets with lower loan-to-value ratios, and the CMBS market is, for the most part, sticking to lending for the B and C assets. David Durning, managing director, Central region for Prudential Mortgage Capital Co., explains: "Prior to the market dislocation last year, it was a heavy lending year for life insurance companies as well as for the conduits. Following the dislocation, many life companies that hadn't filled their 1998 allocations continued their high levels of activity through the fourth quarter."

Prudential originates loans for securitization as well as for its own portfolio. With a strong history of private portfolio lending, Prudential Mortgage Capital is now focusing on being a supplier of CMBS for the public markets. "The bumps in the conduit road have not changed our interest in the CMBS or public markets. Actually, we saw the near-term dislocation as an opportunity to expand our market presence," says Durning.

As one would expect from a company providing lending for both the private and public sides of the fence, Prudential Mortgage Capital believes it is important to provide a broad range of products to borrowers. Late last year, Prudential closed a $41 million portfolio loan with a major Midwest apartment owner and manager secured by three apartment complexes. "The borrower received 70% leverage financing, favorable pricing, property release and substitution flexibility, and the ability to add properties to the property pool," says Durning.

Durning also stresses the importance of multifamily. "Lending on multifamily properties will remain a core objective for our originators. We have great familiarity with apartments, and portfolio multifamily loan originations have remained close to 40% of our total production over the past couple years. That would be equal to over $1 billion in new apartment loan commitments last year alone."

With conduit spreads contracting, Durning admitted that it is hard to say for sure what the long lasting impact of the "mini-crunch" will be.

One trend Durning predicts is that portfolio lenders and conduit lenders will look similar in the future. "Over time, we expect the differences between the two types of lending to narrow. For example, portfolio lenders will require more standardization of their loans to make them more liquid and conduit lenders will become more adept in loan servicing."

The near-term effects of last year's dislocation are more obvious. "Lenders are getting back to the basics. They will focus on more straightforward, commodity-type deals. CMBS lenders will also focus on ways to minimize the risks in warehousing loans by going to the market more frequently and partnering."

Two companies that have restructured and returned to the CMBS market are Amresco Capital and The WMF Group Ltd. Amresco's alliance with LaSalle National Bank and Morgan Stanley is an effort to reduce their risk. Steve Beyer, vice president, CMBS Lending Group, Amresco Capital Ltd.'s securitized lending arm, says: "With our new alliances, Amresco doesn't take all of the capital markets risk, so we will not be significantly impacted by another market meltdown. In the new structure we are not liable for the hedge position on the loans or the value of the loans if they are impacted by changing capital markets."

WMF Group is another firm that had to reevaluate its strengths and how much risk it can bear on its own in the CMBS market following the events of last September. After accepting increased credit risks in order to boost profits, only to "get their heads handed to them" when spreads widened, President and CEO Shekar Narasimhan says about the recent partnering with Greenwich Corp., "We understand that there is certainly a role for this product. CMBS will not dry up and go away. But it is virtually impossible to be a totally vertical company. You have to go back to the concept of partnering. We provide the significant amount of geographically diversified closed loans, and Greenwich Corp. hedges the interest rate risk during accumulation."

Narasimhan, who was recently appointed chair of the commercial real estate finance/multifamily board of governors, a structure designed by the Mortgage Bankers Association, cited other areas that WMF will work to improve. "We recognize that there is a huge private market out there. Less than 15% of the industry is public, so we will need focus on the private sector as well. Technology is another area that we will focus on. Linking databases of data and information on market conditions will help improve the quality of our underwriting, as well as improve our efficiency."

Players in today's capital markets may take different approaches to the marketplace, but most are pursuing multifamily as an integral part of their strategies. Amresco's Beyer believes the outlook for multifamily is good. "Most lenders still believe multifamily loans are the most desirable type of asset and will continue to command the tightest spreads," he says. "We plan to close over $1 billion worth of CMBS loans in 1999 and expect that approximately $350 million of these will be multifamily. Amresco also closed approximately $950 million of loans in its Fannie Mae and Freddie Mac programs last year. In 1999 we expect to close over $1 billion in these programs."

Dan Smith, senior director of the GE Capital Access program, which makes CMBS loans from $3 to $35 million, says the program is reinforcing its commitment to its CMBS business and will double its origination volume to $4 billion in 1999. "We will aggressively pursue multifamily loan business. We tend to focus on B to B- properties, as well as many C properties. It is a very strong property type and accounted for about one third of our 1998 originations."

Multifamily loans are also important for CMBS since they are commonly used to diversify pools. "The historical rule of thumb was that each pool had to have between 25% and 35% multifamily assets, though today this asset mix is getting harder to realize due to FNMA and Freddie Mac pricing being lower than the CMBS originators," says Beyer.

Steve Coyle, director of research at Boston-based research firm Property & Portfolio Research, agrees that the inclusion of apartments in the context of a portfolio is an effective way to reduce risk. "The historic volatility of apartment returns is almost 10% lower than for retail or warehouse assets and 35% less than for office. The apartment market cycle is also substantially different from the office cycle. Apartments take less than a year to build, while offices take 18 months to three years. Thus, apartments correct faster to overbuilding than do office markets. By combining different markets and property types, you can reduce the volatility of the entire portfolio, and this is the real power of constructive portfolio management."

CMBS market is recovering Traditional multifamily lenders have regained ground lost over the years to the CMBS market, but CMBS will continue to play a pivotal role in multifamily finance. Given the severity of the upheaval last year, CMBS is recovering quicker than many observers expected. "Markets are tightening. In recent executions, AAA CMBS spreads have just about returned to pre-August levels and conduit spreads are contracting," notes Durning of Prudential. Amresco's Beyer agrees, "The CMBS market has made a significant come back. Spreads on the AAA bonds have comeback in by 75 basis points from the highs in 1998. Spreads to the borrowers have also come in significantly by approximately 50 basis points."

GE's Smith says, "While spreads are not at the low points seen in early summer of last year, we have seen tremendous spread tightening. Investor appetite for both senior investment grade, as well as subordinate bonds has been very strong. This will mean reduced spreads for borrowers." Spreads on CMBS are expected to contract as investors return to the market.

A recent Goldman, Sachs & Co. report stated that given CMBS-to-corporate bond spreads were sufficiently large to see good value saying, "We recommend that investors take advantage of the attractive spreads in the CMBS market."

In response to renewed investor interest, CMBS issuance has begun to pick up again after grinding to a halt last year. Beyer says, "After attending the Mortgage Bankers Association conference in San Diego, it is apparent that the conduit lenders are again very active in the market, and while Capital America and others were not survivors, there have been new entrants like LaSalle National Bank and UBS."

According to Commercial Mortgage Alert and a survey it recently conducted, second-quarter issuance is expected to decline by 33%. If conduit lenders continue to increase their originations as they have recently, first half securitization volume may be only 20% less than 1998's record volume of $43.4 billion. A swiftly recovering CMBS market may mean fewer wide-open opportunities for whole loan and portfolio lenders, but multifamily borrowers will benefit from a return to normal levels of issuance.

REITs Most industry watchers do not expect another drubbing for multifamily REITs this year, but, for the most part, they are not seeing fireworks on the upside either. Fred Carr Jr., principal at The Penobscot Group, a Boston-based research firm specializing in REITs, forecasts a mixed bag for apartment REITs in 1999. "Performance this year will vary a lot by quality and market tier. Income growth for the higher tier companies will be around inflation plus 1%, and with multiple expansion, the better quality REIT returns should reach the low teens. Many may reach as high as 15%. On the downside, those companies with a combination of passive management and lower tier assets will produce many dismal returns."

Carr believes apartment REITs have entered a new stage. "In the big-picture sense, multifamily is flattening. Growth will be derived from same-property growth - time to get back to basics. Those that can manage well will be rewarded with more capital going forward."

Last year's CMBS turmoil was seen by many as the storm with a silver lining for multifamily fundamentals, and in turn for apartment REITs. With Wall Street conduits on the sidelines, development financing would be held in check. Less new supply would improve the supply and demand relationship. "Many market observers have been hoping the public markets would exert discipline to those developing apartments. To an extent it is working," notes Craig Leupold, senior analyst and multifamily specialist for Green Street Advisors, a Newport Beach, Calif.-based REIT research firm. "But many companies are resisting the message and seeking alternative ways to finance new projects."

Despite recent events pointing to a slowing of development, at least on the margins, there is caution with regard to the short-term performance of multifamily REITs. "It's hard to pinpoint the impetus for much improvement in stock prices over the next six months. Development activity has not decreased to the extent many had hoped for given the credit crunch last September, and employment growth is slowing in many markets," says Leupold.

There is also the issue of public markets moving on perceived risk vs. real, fundamental risk. Leupold points out: "We might see some bad press come from one or two of the important markets like Dallas or Houston. Apartment REITs hold around 10% to 15% of their aggregate portfolios in these two areas, and while this is sizable, it shouldn't be devastating if these markets experience weaker fundamentals. However, the perception may be more important than reality, and investors will, perhaps, be more wary about buying into companies with exposure into markets in danger of overbuilding."

According to the National Association of Real Estate Investment Trusts (NAREIT), apartment stocks fell by approximately 8% during 1998. While this is not nearly as bad as the double-digit declines of industrial, office, lodging and healthcare REITs, it was sufficient to reverse a few long-lasting trends.

For years, REITs have had access to some of the most favorably priced capital in the industry. Now relatively cheap capital is available to private multifamily investors, too. Without the distinct advantage of cheaper capital, REITs have increasingly been on the losing side of bidding contests, or perhaps, have not sat down to the table as often.

A survey conducted last year by CB Richard Ellis Inc.'s Multi-Housing Properties Group illustrated the changing of the guard. The survey, covering 50 investment-grade transactions, counted the top three bidders by investor type. Only 20% of the surveyed winning bids were REITs, 20% were life insurance companies and pension fund advisers, while approximately 50% were private investors. Private investors also showed their relatively new power as their total real estate acquisitions topped the REIT industry's by $4 billion in 1998, according to Walnut Creek, Calif.-based Institutional Real Estate Inc.

Leupold says, "I am not sure they are losing on bids as much as they are just not in acquisition mode." That is certainly the case with BRE Properties Inc., which recently eliminated its acquisition staff altogether in order to "streamline" the organization and concentrate on the development of their "Pinnacle" brand of apartment communities.

Not only are many multifamily REITs not acquiring, they are increasingly disposing of property. "Now that access to attractively priced capital is limited, multifamily REITs have focused more heavily on internal growth through improving property operations as opposed to external growth. Disposition activity has increased, and we expect sales to closely mirror or even outpace acquisitions in 1999," says Leupold.

If REIT prices remain at their current level, and if REITs and are unable to raise equity at the entity level by selling common stock, many analysts expect to see an increase in joint venture deals with institutional partners. Leupold adds, "With apartment REITs selling at a discount to their underlying real estate value, it is unlikely they will sell stock to make further purchases. A few will explore the idea of joint venture opportunities."

Multifamily REITs have already begun to joint venture to free up capital for acquisitions and development, retire unsecured debt, or to rebalance their portfolios without losing the benefits of economies of scale in their asset management activities. Leupold says, "Last year Camden Property Trust and Summit Properties both sold portions of their portfolios to joint ventures, and BRE Properties Inc. announced that it will develop many of the properties in its pipeline in joint venture arrangements."

In fact, Camden sold 19 apartment communities totaling 5,119 units for $248 million to a joint venture company where it owns a 20% interest with a pension fund represented by Schroeder Real Estate Associates. Summit Properties sold five properties consisting of 1,443 apartment homes for $90 million in December 1998. In the resulting joint venture structure, Summit retained 25% ownership and will continue to manage the North Carolina and Florida properties for a fee.

There seems to be agreement that certain joint ventures between institutional partners and REITs can be positive. Leupold says, "There are many trade-offs, many positives and negatives, for REITs doing joint venture deals. In many instances, joint ventures make sense, but we have yet to see evidence that the market rewards this type of activity. The downside for the REIT is that these deals add a layer of complexity to the company and management gives up control of the asset. Many REITs also engage in joint venture activity as a way to leverage returns and keep debt off of their balance sheets."

With multifamily REITs effectively shut off from accessing capital from the equity markets, many feel they must take on debt to implement their strategies. There have been concerns regarding the multifamily REITs' aggregate debt levels. Frederick Carr says, "The multifamily sector REITs have not been a good case to look at for investors being happy with more debt. Malls and office REITs can be at a higher level. This is not really the case for apartments. The market is much less tolerant for multifamily."

There is evidence of multifamily REITs becoming more highly leveraged. According to Green Street Advisors, the average multifamily leverage remained between 40% and 42% during the last three years. At the end of 1998, the average reached 43% and has now reached the 50% mark.

"Clearly leverage in the apartment REITs has risen significantly over the last few years. Many are reaching debt levels of 50%. This leads many to enter joint ventures to put debt off the balance sheet."

Despite trepidation by a few concerning multifamily REITs' debt level, debt players are, for the most part, looking forward to doing business with REITs. Fannie Mae has extended more than $1 billion in medium-term credit facilities at relatively low leverage to REITs during the last year. GE Capital Real Estate is also busy looking at REIT business.

Narasimhan of WMF Group says, "Lending to REITs represents a growing trend for us. When the equity markets dried up for the REITs last year we did a lot of lending. As a company, we have lent at least $1 billion to REITs. We see an opportunity to provide them with financing and flexibility when they are having trouble accessing the equity markets."

Another trend that is expected to reverse course is the frenzied consolidation experienced in the past. Carr believes that the consolidation trend has become overblown. "There is still great pressure for many of these companies to be taken over, but most of the logical candidates remaining are less desirable." Leupold agrees that consolidation will not reach the volume of the past, though he expects to see a few deals. "On the whole, REIT teams are decidedly less aggressive now due to their lower share prices. They are just more cautious and that should result in less activity."

The recent privatization of the Irvine Apartment Communities by Donald Bren's Irvine Co. in February and sluggish performance of REITs has prompted the debate whether there may be many REITs reassessing their public REIT status. Leupold and Green Street Advisors do not see this as a significant trend. "I certainly don't see an exodus. There may be many out there that will re-evaluate their status as a public REIT and choose to switch to a private REIT structure. But, that is still a difficult transaction for most companies."

Leupold explains, "In order to go private, there must be a substantial gap between the share price and the underlying real estate value. Public shareholders require a premium in order to sell their shares. Coupled with the costs of the transactions the existing gap between share price and real estate value will be too small. Also, given the increased size of many apartment REITs, any equity source would have to be fairly bullish on apartment fundamentals and put together a significant financing package. In the case of Irvine Apartment Communities, all of these factors were present, but they are less likely to be present for most other multifamily REITs."

The recent upheaval in multifamily capital markets had many unpleasant short-term effects for investors and Wall Street conduits, but many agree it may be beneficial in the longer term. Wall Street may have relinquished its total dominance of the commercial lending industry for the time being (it was responsible for 70% of all commercial real estate lending at one point last year), but the slap in the face it received when spreads tightened provided insight into risks that few considered, and fewer priced. Most important, though, is that capital is back. The underwriting is tighter and many of the lenders are more conservative, but multifamily borrowers will have access to capital. Multifamily REIT performance has also languished, putting formerly ravenous purchasers on the sidelines for lack of cheap capital and forcing them to concentrate on the management of their current holdings. This capital market correction may be the first crucial step in steering clear of a major overbuilding stage for multifamily product. It also gives the rest of those sitting around the multifamily table a better idea of who the newest member of the family is.

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