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A Test of Resiliency

Two storms are converging on the U.S. apartment industry amid the deepening credit crisis. While developers are forced to scrap projects because financing has dried up, many owners fear that the weak economic climate, with frailty among some of the nation's top financial institutions, steep plunges in the stock market and job losses totaling 760,000 to date in 2008, portend darker days for the industry. But amid these conditions, real estate experts call the apartment market the brightest light on a bleak landscape.

Analysts are bullish on the apartment sector because its fundamentals have outperformed the other major property types. In the second quarter, the national vacancy rate for apartments stood at 6%, while the office vacancy rate was 13%, according to New York real estate research firm Reis. Multifamily effective rents rose 1.1% in the second quarter, while office effective rents grew by only .07%.

But the economic crisis has not spared the apartment industry, and vacancy rates are rising, says Gleb Nechayev, senior economist at Boston-based CBRE Torto Wheaton Research. He predicts that the vacancy rate will increase over the next two years by 50 to 100 basis points.

“One thing is clear, it will show further weakening,” Nechayev says. “We do expect it to weaken for at least another year, or year and a half.”

While total returns for the 14 multifamily REITs fell nearly 21% year-to-date through Oct. 23, according to the National Association of Real Estate Investment Trusts (NAREIT), other sectors fared far worse over the same period.

In the office sector, REIT returns fell 39%, while retail dropped nearly 48%, and industrial, a startling 67%. The problems can be traced to the lack of credit, says Ronald Kuykendall, vice president of NAREIT.

Where were safeguards?

As spring turned to summer, the apartment industry was on track for a solid year. Credit markets had begun to rebound from a deep lending freeze, when the unthinkable happened. The federal government seized control of Fannie Mae and Freddie Mac on Sept. 7.

Then Lehman Brothers filed for Chapter 11 federal bankruptcy protection on Sept. 15, and the Dow Jones Industrial Average dove a record 777 points before Congress approved a $700 billion bailout of damaged mortgage assets held by financial institutions. The alarming sequence of events triggered a renewed credit freeze.

Chicago apartment developer Dan McCaffery is angry and frustrated over the domino effect from the subprime mortgage crisis. “I can't say anything other than that I'm shocked. It's just a damn shame that so many people have been so negatively affected by something so few people had control over. It's too bad that those who had control in government or higher places of finance weren't more on the ball.”

Tremors from Washington and Wall Street have rocked his own offices, says McCaffery, president of McCaffery Interests. “There's a direct correlation. We, and every business, depend on the free flow of capital. Today, credit is evaporating quickly.” Loans have become scarce.

He had the foresight months ago to arrange construction financing at 70% loan-to-value for the $80 million, 26-story Flair Tower in the River North area. McCaffery recently broke ground on the development, which will include 152 luxury apartments that will rent for about $2,500 per month when the tower is completed in 2010.

McCaffery says that if he were to seek a loan today to build the high-end development, he doubts he would get it.

Protecting the golden egg

The consensus among industry experts and many owners is that the takeover of the Federal National Mortgage Association (Fannie Mae) and the Federal Home Mortgage Corp. (Freddie Mac) was necessary to safeguard the enterprises' traditional role of supporting multifamily lending.

Fannie Mae and Freddie Mac, along with the Government National Mortgage Association (Ginnie Mae), held $157 billion in multifamily debt in their portfolios in early 2008 and nearly $143 billion in mortgage-backed securities, according to the Mortgage Bankers Association. The agencies hold more than a third — 35% — of the nation's multifamily mortgage debt.

Apartments represent Fannie and Freddie's healthiest business segment, says Linwood Thompson, senior vice president and director of multihousing at Encino, Calif.-based brokerage Marcus & Millichap.

Foreclosures are low, fees generated for the federal agencies are substantial, and in most markets the fundamentals remain healthy. Indeed, the national occupancy rate registered 94% in the second quarter and effective rents have risen 2% since the start of the year, says Thompson. He expects the vacancy rate to rise to 6.4% by December as the economy weakens.

But as owners brace for new head-winds, Thompson believes they need not worry that federal officials will scuttle the multifamily lending program. “I'm not concerned that [Freddie and Fannie] are going to slow down multifamily lending, because it happens to be the goose that's laying the golden egg.”

Negative impact of job losses

With each passing month this year, the employment market has shown further signs of deterioration. “We've lost 760,000 jobs through September of this year — this is certainly negative for the apartment industry,” says Mark Obrinsky, chief economist for the Washington-based National Multi Housing Council. The job losses could push up vacancy rates in 2009, he says.

Despite mounting pressures, the apartment industry remains the healthiest sector, according to the recently released “Emerging Trends” report authored by PricewaterhouseCoopers and the Urban Land Institute. The consensus of 600 investors and industry experts is that 2009 will be the worst year for commercial real estate in nearly two decades.

Other sectors lack the advantage that the multifamily sector has enjoyed for years — the availability of financing backed by the U.S. government through Fannie and Freddie. Demographic trends also bolster the long-term health of the apartment sector.

Between 2006 and 2010, about 800,000 new renters, many of them young “echo boomers” and tens of thousands of immigrants, are expected to become tenants of the country's 17.4 million apartment units, assuring healthy rental income.

Construction nosedives

Apartment development is likely to be reduced substantially over the next year, a positive trend for owners of existing properties because it will put a lid on new supply and help prop up demand.

That could bolster the chances for rent increases, though in many markets there is little discussion of rent hikes at a time when many tenants are struggling to keep their jobs and landlords are trying to maintain high occupancy rates.

Construction starts, projected to drop 25% this year, are forecast to dive another 25% next year. And deal-making has plunged by 50% from two years ago, as apartment buyers demand pricing discounts and sellers refuse to budge. This is likely to continue in 2009.

Property values also are expected to soften. Over the past 12 months, the value of Class-A property in primary markets may already have dropped by 5% to 6%, observes Thompson of Marcus & Millichap.

“The values in the Class-C properties in tertiary markets at the other extreme may have deteriorated 20%,” while Class-B properties in middle markets may have depreciated 10% to 12%.

Thompson phrases the estimates cautiously, since buyers and lenders assert that a 15% to 25% drop in value has occurred, but most owners aren't willing to accept lower prices, so few deals are occurring.

NMHC's Obrinsky also has seen a shift in valuations. “I think we are seeing some generalized retrenching of prices, retreating from the levels we saw a couple years ago.” Buyers are factoring the more expensive cost of credit into their offers, he adds.

REITs roll with the punches

Chicago-based Equity Residential ranks first by market capitalization among the top 14 apartment REITs, with $20 billion in equity market capitalization, according to NAREIT. Equity Residential owns, operates or is developing 160,000 apartments in 25 states.

True bellwethers, the REITs have lost ground in 2008. Equity Residential shares closed at $31.50 on Oct. 23, down from a 52-week high of $49 per share.

Last year, Archstone-Smith, then the country's largest publicly traded apartment REIT, was acquired by a partnership of Tishman Speyer Properties and Lehman Brothers in a $22.2 billion deal.

But buying Archstone, with its 86,000 units, put Lehman Brothers $2.2 billion in debt and left it with properties it could not unload, as credit tightened. The financial advisor for the mega-deal was Wall Street's then-venerable Morgan Stanley.

REITs own less than 5% of the nation's stock of traditional apartment properties of five or more units, but they are powerful players and their portfolios usually feature a minimum of 100 or 250 units.

While the REITs hold only a small percentage of all apartment units, they own some of the most coveted properties, such as Camden Property Trust's 894-unit Camden Vanderbilt in Houston, where apartments rent for an average of $1,339, or Post Properties' Gateway Place, in Charlotte, N.C. Many of the REIT properties are Class-A multifamily buildings located in primary markets.

Tales from the trenches

Not only is the mosaic of multifamily credit markets and property values changing, so are buyers. Kitty Wallace, senior vice president with brokerage Sperry Van Ness in Los Angeles, has sold more than $922 million in commercial properties, and is currently marketing the 49-unit, garden-style Coronel Apartments in Santa Barbara, priced at $15 million.

Funds and REITs once were her best buyers, she says. But suddenly, REITs are no longer buying, and 80% of her buyers are new.

Not so long ago, the properties she represented were grouped in $200 million portfolios, when dazzling sums chased deals. Today, properties are packaged in smaller financing bites.

Wallace recalls a turning point last year, when she put together a $180 million project for one buyer. “The buyer was removing all his contingencies when the [CMBS] crisis came and the deal came tumbling down.” The property returned to market with the price tag marked down from $180 million to $140 million.

These days, deals over $50 million are hard to finance, and even smaller sales encounter credit problems. Recently, three such deals were nearly scuttled, but squeaked by after eleventh-hour renegotiating with banks.

Gone are low down payments and high leverage. During the boom, one buyer financed a $200 million deal with just $3 million of his own money, plus a trust deed, mezzanine debt and equity, Wallace recalls. Today, that investor could buy a $6 million apartment complex. “That's what he should purchase. Not a $180 million apartment complex,” Wallace says.

Is this a good or bad time to invest? “If you're a short-term investor thinking you want to hit a home run, it's too soon to buy,” cautions Thompson. But it's a good time for a long-term investor, he says.

For Chicago developer McCaffery, this is no time for growth. “Who gets to have a job tomorrow? I'm very concerned — even at our own company and other people's companies — that there isn't a horrible depression or massive recession. You just have to be prudent about what you do. We're not going out and ordering jets. We're not ordering big boats, or doing buildings on spec. We're not going out and expanding,” says McCaffery.

As for obtaining credit in the future, McCaffery has confidence in his own banker. “We're with a very solid group of people. At least they appear to be solid. If they aren't, I wouldn't know where to go to find more solid people.”

Denise Kalette is Senior Associate Editor

Apartment investment sours in Phoenix, Florida markets

Not long ago, Phoenix was a hotbed of multifamily activity, as buyers streamed in from Southern California in pursuit of mega-deals. But since peaking in 2005, the number of closed apartment sales locally has declined by a stunning 80%, and the metro area's apartment vacancy rate stands at about 12%.

The most frequent deals — Class “B” and “C” communities with 100 to 300 units built in the 1980s — have been hardest hit by the slowdown, says Bill Hahn, managing director for broker Sperry Van Ness in Phoenix. “That was our bread-and-butter deal within our company, and that is the market where it is most difficult to finance acquisitions right now.”

Phoenix ranks among the nation's worst-performing apartment markets, says Gleb Nechayev, senior economist of Boston-based CBRE Torto Wheaton Research. It is fifth worst in terms of year-over-year revenue growth, a calculation of rent multiplied by occupancy, which in the case of the Valley of the Sun yields a 3.2% decline. The best-performing market by that measure is San Francisco, with 8.8% revenue growth year-over-year.

Developers are building more apartment complexes in San Francisco, including Trinity Properties' 1,900 apartments at Trinity Plaza on Market Street, and Alexandria, Va.-based REIT AvalonBay's 250 planned units on King Street.

A number of Florida cities rank high on Torto Wheaton's “worst” list, starting with Jacksonville, Fla. with a 5% decline in revenue growth, followed by West Palm Beach with a 3.9% decline.

Florida's economy remains relatively weak. As was the case in Phoenix, speculators in the Sunshine State drove up apartment vacancies with ill-timed buys of condos and second homes. Many were converted to rentals, and now compete with apartments for tenants.

Financing for large, 200- to 300-unit deals is scarce in Phoenix, but loans are available for 20 to 50 units priced from $1 million to $3 million, according to Hahn. “Small community banks will make apartment loans, and we've seen a comeback in seller financing.”

A recent trend is the arrival of Canadian buyers to purchase 20 or so condo units unsold from projects of about 200 units. “There aren't many individual condo buyers right now. We're seeing discounts of 30% to 40% on some of these bulk sales,” Hahn says.

Investors who bought early made money. Those who completed projects after mid-2006 probably missed out, he adds. “Some projects out there have sold 10% of inventory, and if they have 90% left they're pretty much doomed.”
Denise Kalette

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