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Multifamily Problems Multiply

As property fundamentals deteriorate in the absence of job growth, loan delinquencies begin to spike.

While the pace of monthly job losses is clearly slowing, financial problems for the U.S. apartment industry are growing. The combination of several quarters of declining rents and rising vacancies is creating hardship for an increasing number of owners.

The delinquent upaid balance for multifamily loans held in commercial mortgage-backed securities (CMBS) totaled $8.4 billion in September, a dramatic increase from the low point of $903 million in July 2007, reports Realpoint LLC, a credit rating agency based in Horsham, Pa. Multifamily loans accounted for 26% of all delinquent CMBS loans in September, eclipsed only by retail at 30%.

There is a growing consensus that the U.S. economy is back from the abyss. Total non-farm payroll employment declined an average of 188,000 per month from August through October compared with monthly job losses averaging 357,000 during the prior three months. Gross domestic product rose 3.5% on an annualized basis in the third quarter.

But that's little consolation for landlords seeking to attract and retain renters. “The reality is that until we see some positive job growth numbers over a couple of quarters, it's going to be very difficult for me and anyone in our industry to project any real significant increase in the apartment market,” says Thomas Shelton, president of Western National Property Management, based in Irvine, Calif.

A dominant player on the West Coast, the company manages about 22,000 units in California, including some 12,000 units that it owns. “We're budgeting for continuing deterioration in 2010,” says Shelton.

Specifically, Western National Property Management projects that rent declines among its Southern California properties next year will range between 2% and 3.5%. That's actually a slight improvement from the rent declines of 3% to 4% this year.

Record territory

The U.S. apartment vacancy rate climbed to 7.8% in the third quarter, a rise of 160 basis points year-over-year, reports real estate research firm Reis. That's 230 basis points higher than the third quarter of 2006, when the apartment vacancy rate reached a cyclical low of 5.5%.

The only other time in the history of Reis that the vacancy rate touched 7.8% was in 1986, says Victor Calanog, director of research for New York-based Reis. “Given the inherent seasonality of rental and lease-up patterns, we expect fourth-quarter figures to be even weaker, implying that we may break historical levels by the end of the year.”

Reis forecasts the apartment vacancy rate will peak at 8.3% in 2010. Meanwhile, the outlook on rents is dismal amid a tenant's market. The researcher projects a 3.2% decline in effective rents this year and no rent growth until 2011.

Concessions play a critical role in today's extremely soft market. “The trick is managing the concessions. There is a difference between concessions that you give to new tenants and concessions that you give on renewals,” says Shelton of Western National Property Management.

The company's portfolio-wide occupancy rate is 94.6%, with concessions averaging three weeks on a 12-month lease, says Shelton. “But there are submarkets here in Southern California where we are seeing two to three months free rent on a 12-month lease.”

Supply-side concerns

More than 73,000 new apartment units have come on line nationally through the first three quarters of 2009, reports Reis, and that total is expected to surpass 100,000 by year's end.

“New buildings coming on line over the next four to six quarters will face higher initial vacancy levels,” says Calanog, “and will increase the pressure on leasing managers of existing properties to support current rent and occupancy levels.”

The average capitalization rate — the initial yield based on the purchase price and property cash flows — jumped 40 basis points to 7.4% in the third quarter, even as transaction volume remained relatively weak. About $2 billion in properties changed hands during the quarter.

While some brokers report that the bid-ask gap is tightening between buyers and sellers, the sales volume among properties $5 million or greater remains weak. According to Real Capital Analytics, 664 apartment properties sold for a combined $10.3 billion year-to-date through October. That's far less than the 1,879 properties that sold for a combined $34.7 billion during the same period in 2008.

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