Despite the recent disruption to the capital markets, the outlook for the apartment investment market remains positive. New apartment construction is expected to add just 1% annually to existing stock from 2007 to 2010. Higher construction costs and a more cautious lending environment could restrain construction further.
The summer's events on Wall Street stand as an example of just how quickly the tide can turn. Many conduit lenders have pulled back, but there is still capital available. Banks, life insurers, Freddie Mac and Fannie Mae, which lost market share to conduits in recent years, have stepped up. Properties with seller-backed or assumable debt with interest rates below market are now attractive, placing premiums on prices for these assets.
Conduit spreads widened dramatically from late-July to mid-August and have since narrowed, but remained elevated at 190 to 210 basis points over the 10-year Treasury yield in early October compared with 110 to 125 basis points in mid-July.
While lower interest rates are offsetting wider spreads, interest-only loans are nearly non-existent, and lenders are underwriting based on actual net operating income versus pro forma, or projections of future performance. Lenders have increased debt-service coverage ratios, the amount of cash flow available to meet principal and interest on debt, and reduced loan-to-value requirements from 75%-80% down to 60%-75%.
Quality counts
Property quality, location and performance are driving lenders' decisions. Class-A properties in core markets will continue to command premium prices and favorable financing. When condo converters left the market early last year, institutions and REITs stepped in. Institutional buyers lost many deals to more highly leveraged investors in recent years, but now the higher down payment required gives them an advantage.
Indeed, sellers are placing significant weight on a buyer's ability to obtain financing, putting major investors at an even greater advantage. Smaller private buyers with significant cash in hand are also well positioned to compete today.
In the near term, the return of some condo conversion projects to apartment inventory and the growing shadow-rental market will create more competition for renters. But a decline in the homeownership rate over the next few years is expected to result in 2.3 million households entering the rental pool, hastening absorption of rental supply.
More than 60% of adjustable-rate mortgages slated to reset for the first time in late 2007 or 2008 are subprime. Foreclosure sales are up 90% this year and will rise further as payments become unaffordable for more households.
Risk premiums return
Across major property sectors, the risk premium is rising. Cap rates are forecast to rise 25 to 50 basis points over the next several months, with secondary/tertiary markets and Class-B and Class-C properties expected to be the most affected. Price adjustments following the capital markets shock, which averaged 5% to 10%, were concentrated in the lower tiers. Deal volume has declined but prices are holding firm for top-quality assets and demand from buyers is good.
Healthy apartment market fundamentals are expected to prevent any major pricing correction. Vacancy is in the 5.2% to 5.7% range and rents are rising for Class-A multifamily properties at an average annual rate of 4.6% across the U.S., with the strongest markets reporting annual rate increases of about 8%.
Multifamily development is expected to remain low, and tighter lending standards will restrict the flow of renters to homeownership. Upcoming demographic shifts also bode well for apartment demand, with 70 million echo boomers entering their prime renting years.
Time to sell?
Changing market conditions can create opportunities, making today an ideal time to evaluate current holdings and strategies. With fewer qualified buyers, today's environment provides an excellent opportunity to redeploy accumulated equity into higher-return or higher-quality properties.
Investors waiting until the market stabilizes to sell should consider the risks. Another capital markets disruption, or a deep slowdown in economic growth, could impact values. There is also the risk of higher borrowing costs when a seller is ready to purchase the next property.
Serious sellers are pricing properties based on current net operating incomes (NOIs). Overpriced properties will be overlooked, and extended marketing times can reduce a property's appeal, even after a price reduction.
Will Balthrope is a senior director with Marcus & Millichap and is based in Dallas. He can be contacted at (972) 755-5160, or at [email protected].