SPECIAL FOCUS: CAPITAL MARKETS OUTLOOK 2008

APARTMENT FINANCE TODAY • JANUARY 2008

Apartment Owners Look Ahead

Apartment owners contacted by APARTMENT FINANCE TODAY don’t seem too worried about the availability or cost of capital in the coming year.

Problems in the securitized lending world won’t have a significant impact on the availability of equity and debt for quality properties in good markets, said R. Lee Harris, president and CEO of Cohen-Esrey Real Estate Services in Overland Park, Kan.

“In a more conservative underwriting environment, marginal deals in both weakening and oversupplied markets simply won’t get done, but that’s not a bad thing,” said Samuel “Trip” Stephens, chief investment officer of ZOM, Inc. “So long as the U.S. economy doesn’t slide into recession, capital should still be available for good projects in strong submarkets.”

A marginal increase in debt costs or a slight reduction in loan proceeds won’t cause good deals to fall apart, said Todd Sears, vice president of finance for Herman & Kittle Properties, Inc., in Indianapolis. ”We try to go into our deals with some cushion anyway, so normal fluctuations don’t stop the deal,” he said.

Buyers who have never relied on conduits that lend for securitization face no direct impact from the conduits’ withdrawal from active lending. However, the reduction in debt availability will affect the overall demand for apartment properties, and has driven up the cost of capital from all sources, AFT’s sources said.

Developer Rich Kelly is happy being a Fannie Mae borrower these days but recognizes that a decrease in overall capital availability reduces the number of buyers in the market. “We hear that sellers are having to be a bit more flexible,” he said.

As president of LumaCorp, Inc., a Dallas-based owner and manager of apartments, he sees a silver lining to the home mortgage crisis: The outflow of tenants into homeownership has stopped.

On the all-important question of interest rates and the cost of debt, Harris sees Treasury yields “probably drifting lower during 2008.” “There may generally be decreased demand for apartment loans, which may bring spreads down as well,” he added.

Sears predicted the 10-year Treasury bill will end up back in the mid-4 percent range before 2008 is over. He echoed the feeling of many observers that the rapid decrease in T-bill yields in the fall of 2007 was the result of a shortterm “flight to safety” by investors.

He predicted that spreads will narrow again in the second half of 2008. Sears expects the base rate for construction loans to drop in response to short-term interest rate cuts by the Federal Reserve Board, but he said there is “a lot of turmoil with the London Interbank Offered Rate as an index right now, and we consider what underlying index to use on a case-bycase basis.”

Cap rates have been rising in Midwest markets, Harris said. Deal volume was slowing a bit near the end of the year, he said, but only as compared to “the frenzied pace” he saw earlier in 2007.

Harris does not expect “dramatic” increases in cap rates or slowing of sales because there are “still huge amounts of capital looking for deals.”

Actual cap rates and appraisal cap rates may diverge in 2008, Sears said, as the market will be difficult to read. “Actual cap rates [will] hold [or] decline depending on the level of foreign equity that comes into U.S. real estate given the drop in the dollar,” he said. “The 10-year [Treasury] will have to stay at or below the 4 percent level with spreads getting back to historical levels before the debt side of the equation brings cap rates lower. Appraisal cap rates are going to be difficult to discern, as projected net operating income (NOI) and historical NOI are likely to diverge.”

“With the 10-year [Treasury] hovering in the low 4 percent range, cap rates should stay low for institutional quality assets in the top growth markets,” added Stephens. “Cash buyers will dominate the buy side in 2008, and the so-called ‘wall’ of institutional capital is still there, seeking a home in good real estate. Cap rates in less favorable markets and in the B and C product classes will drift higher.”