It's time to wave the checkered flag in the multifamily sector. It was the first property sector to see recovery and first to see a renewal of construction activity in the fast growing markets of the Sun Belt. Now, it may be the first sector to experience a slowdown in activity. Some of multifamily's hottest markets are beginning to get that overbuilt feeling, places like Dallas, Atlanta, Tampa and Tucson. On the lending side, competition has been so fierce, spreads have come tumbling down.

Emerging Trends in Real Estate 1998 by ERE Yarmouth and Real Estate Research Corp. has also waved the caution flag about multifamily. Last year (1997), Emerging Trends noted an ebbing of investor sentiment for apartments and this year the drop from favor is even more pronounced as the industry expects tepid appreciation and rental growth. In addition, the sector's risk-adjusted return profile has shifted into the "chancier" parts of the spectrum. One concern for investors, a relative supply/demand balance that will be upset by a continuing surge in new construction.

Even multifamily developers and owners are suggesting caution. The MIG Cos.' The Advisor newsletter observed, while national construction levels of multifamily matches well with demand growth, certain submarkets will experience excessive building that will affect near term performance. The Advisor warned, "it is time to pay close attention to local development activity."

Staying healthy This is not to say multifamily faces a collapse like that which hit it and other real estate asset classes just a decade ago. In fact, there are plenty of signs the market is still very healthy. Lenders and investors lean toward multifamily because generally there is less volatility in the markets. Stability has an attraction in and of itself. "There is lots of capital chasing apartment deals," says David Jacob, a managing director and research director at Nomura Securities International. "Particularly because it is the only 'obviously safe' sector remaining after the retail sector's problems beginning in 1995. Apartments are the last haven for dumb money."

"Apartments have stayed pretty steady," says Randy Hawthorne, chairman of the National Multi Housing Council in Washington, D.C., and a senior vice president at Boston Financial. "They continue to be viewed as investment grade property as there is a reasonably good balance of supply and demand."

Going into autumn, multifamily housing starts rose significantly. At a 293,000 units seasonally adjusted rate, starts were up 14% and were at there highest level in seven years. The NMHC's Market Trends newsletter reported "the pipeline of projects under construction has grown in recent months and an increase in apartments coming on line is probable."

With all the construction activity, it would appear that vacancy rates would begin to rise and they have, up 9.4% by autumn. According to Dallas-based M/PF Research, the good news is that the vacancy rate among professionally managed apartments inched downward to 5.2%, near the lowest reading in five years.

Stan Harrelson, president and chief executive officer of Pinnacle Realty Management based in Seattle, can look around his corporate headquarters and see a wealth of opportunity for his company's hometown and the rest of the Pacific Northwest. Pinnacle Realty is national in scope with 86,000 apartment units under management, up from 75,000 at the beginning of 1997. While Harrelson touts Seattle, Portland, San Francisco and San Diego as good markets, he pans the Sun Belt cities of Austin, Atlanta, Dallas, Orlando and Tucson.

"It is not just geographic markets that need to be investigated for construction and lending purposes, but the type of product as well," says Harrelson. "If you look around the country, multifamily has become polarized. Some 60% of it is fueled by tax-credit construction, and the other 40% will be high-end residential. The missing segment is what I consider conventional, non luxury stock."

Boston Financial, an equity investor and property manager for pension funds, has made considerable forays into multifamily having accumulated 40,000 apartment units in 25 states. It, too, is looking at the West Coast as well as the East Coast north of Washington and some of the Rocky Mountain areas like Colorado and Utah. In the Sun Belt, Boston Financial eschews former hot spots like Arizona and Atlanta, but likes San Diego.

"Good markets, in general, create their own problems and you can certainly sell for a very fair price," says Hawthorne. "However, you end up with investment risk. If you are really committed to reinvesting capital back into the same market in the same segment. You may just have to turn those profits back into the cost of acquiring someone else's existing assets."

REITs Except for retail, there are more REITs categorized as multifamily than any other sector. However, it is an unstable category as mergers and acquisitions are rife within the group. Among the names disappearing from stock charts are Columbus Realty Trust, Wellsford Residential Properties and Evans Withycombe Residential. The latter two were acquired by Chicago-based Equity Residential Properties, the biggest and most aggressive multifamily REIT in the business. Equity Residential can now boast being one of the top three capitalized REITs, a distinction it shares with the Simon DeBartolo Group (retail) and sister company Equity Office Properties.

Equity Residential began 1997 with about 76,600 multifamily units and a capitalization of $4 billion. It ended the year with somewhere between 135,000 to 140,000 units and a market capitalization resting between $7.5 billion to $9 billion. The company was able to make such a giant leap forward by not only buying two other multifamily REITs, but at least three other large portfolios. Multifamily REITs were quite active in 1997, making a large number of big portfolio and private company acquisitions. As an example, Walden Residential bought Drever Partners for $675 million and BRE Properties nabbed the West Coast operations of Trammell Crow Residential for $600 million.

Not all REITs grew so aggressively. Some like Essex preferred individual transactions. Through November 1997, Essex Properties acquired $285 million in apartments, plus it had another $100 million that it was closing in the near term and about $1 billion in deals in the pipeline. At the beginning of 1997, apartment REITs had an equity market capitalization of more than $13 billion and controlled properties valued at more than $25 billion. Unfortunately on a stock performance basis, multifamily REITs lagged the market and other REITs in '97.

By the end of summer 1997, the total volume of capital raised by REITs already surpassed $24 billion. The record amounts of capital raised by the REIT industry have been used to acquire properties, buy large portfolios of properties, take over other REITs or, in some cases, absorb real estate operating companies. "Consolidation is healthy for the multifamily industry. It makes the product more consistent and efficient," says NMHC's Hawthorne.

"We certainly think big is better," says Douglas Crocker II, Equity Residential's CEO and president. "REITs have been telling Wall Street for quite sometime that with size comes economy of scale, synergies, ability to hire more qualified people and a spread of risk over a greater base. More importantly, if you are an institution, there is more liquidity, the ability to get in and out of the stock."

Companies in flux Not all large publicly traded companies are REITs. Insignia Financial Group, a Greenville, S.C.-based company, holds bragging rights to being the biggest owner and manager of apartments. Judging from its activities in 1997, it is not about to give up the title. The firm began the year with 245,000 units and ended with 285,000. Indeed, the easy availability of capital has put too many buyers into the market chasing too few products and forcing prices higher. "There is still a strong demand for multifamily product," says Thomas Shuler, president of Insignia Financial. "However, there is no question that greater available capital at lower rates, mainly capital bought from Wall Street, has to be placed somewhere. The REITs and other entities that have capital need to place it, and they have actually driven up prices on apartments.

Multifamily Capital Markets of Richmond, Va., has also undergone some drastic changes. The company was purchased in 1996 by Resource Mortgage Capital, which subsequently changed its name to Dynex Capital, a debt REIT. The firm now lends on a vast array of real estate with its Dynex Commercial subsidiary doing all the multifamily housing along with other commercial real estate.

"Since 1992 we have been involved in low income housing credit apartments," says Corine Sheridan, vice president at Dynex. "Now we are involved in not only that but also tax-exempt bonds and conventional apartments. We are really covering the spectrum of multifamily housing."

"The low income tax credit is a government program, so you never know how long it is going to last," says Sheridan. "With the firm being purchased by Dynex, it opened up a lot of doors for us. They had the capital to do a lot of other types of real estate lending, so there was no reason for us not to expand."

Another consolidation that rocked the multifamily industry was the acquisition of NHP Inc. of Vienna, Va., the second-largest apartment owner and manager, by Denver-based AIMCO, a publicly traded REIT. What makes this deal so interesting is that NHP bought Washington Mortgage and grew it very rapidly after acquiring it in April 1996. Washington Mortgage serviced $4.4 billion in loans and, at close of 1997, pushed that number up to $9.2 billion.

Washington Mortgage was eventually transformed into The WMF Group and has been spun off as a separate company. "In 1996, Washington Mortgage did more than $1 billion of loans. In 1997 it will report over $2 billion," says Shakir Narasimhan, president and CEO at WMF. "We have grown in origination, in diversification and in servicing. We have grown the whole company."

In Narasimhan's view, WMF has been able to grow so quickly because the origination market, as a whole, has grown so big. "We have not yet put on in 1996 and 1997 as much debt as we got out of the market in 1991 and 1992, so even with rapid growth the market is not crazy yet," says Narasimhan. "The peak of multifamily permanent loans were $40 billion in 1986. By 1990, the numbers had fallen to $24 billion and the market has been coming back slowly ever since. About $30 billion was done in 1993, $34 billion in 1994 and so on."

Trouble in paradise Bank One Capital Funding, based in Columbus, Ohio, did about $300 million in DUS volume in 1996 and 1997. This year it hopes to grow that number to $500 million. Whether it gets there or not may depend on external factors. "The conduit market is a direct competitor of DUS, and 1997 was the first year where DUS production was affected by it," says Mark Beisler, executive vice president and chief operating officer of Banc One Capital. "The problem with DUS is the competition. The conduits came in and really made a hard push. With DUS you can still deliver a rate that is 10 to 20 basis points better for a project, but there is more documentation and underwriting involved which slows the process."

Can lenders still make money? "Yes they can, but what they are doing is streamlining the process to the bare bones," says Beisler. "We are trying to cut costs and deliver the same quality in a faster and more efficient manner. We are still cutting spreads."

"As the competition intensifies, spreads come down. There's no question that the spreads a year ago were probably 100 to 200 basis points higher than what we see right now," says David Queen, chief underwriter with Arbor. "There are still plenty of opportunities out there, but there are more players in the marketplace."

At present, Arbor is still executing more business with its DUS product line than in its capital markets area. Arbor's DUS transactions tend be for higher dollar volume loans. The average size of its DUS loan is above $5 million, while conduit loans are tending more toward the $2.5 million to $3 million range.

Prudential Capital Group is the private debt subsidiary of the Prudential Insurance Co. of America. It provides corporate finance, private loans and mortgage loans. The company's portfolio sits at roughly $15 billion. In 1997, the Newark, N.J.-based company closed somewhere between $2.5 billion and $3 billion of product. Mike Jameson, a Prudential Capital vice president, predicts the firm will do about the same amount of business next year.

"In 1996, Prudential Capital did $840 million, or about 40% of its originations, in the multifamily sector. In 1997, Prudential Capital initiated a conduit program which is being handled through its Prudential Mortgage Capital Co.," says Jameson. "My sense is that 1998 will be a reasonably decent year for loans coming due, and that will mean a very competitive market for existing lenders and everyone else vying for that same business. It's hard to say whether the market will continue to expand as it has done as there is only so much property in the world."