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capital markets outlook 2009

Uncertainty of Execution

APARTMENT FINANCE TODAY • January/February 2009

Multifamily dealmakers see lower values and tougher terms for 2009.

By JERRY ASCIERTO

In the Hot Seat

At press time, Timothy Geithner was expected to easily pass Senate confirmation and become the next Treasury secretary. The former president of the New York Federal Reserve will inherit an economic crisis the likes of which the U.S. hasn’t seen in 80 years.

But many expect Geithner to hit the ground running, as he has worked closely with Henry Paulson and Fed chief Ben Bernanke in the rescue of Bear Stearns and AIG. And his close ties to Paulson and Bernanke represent continuity for the government’s ongoing bailout efforts.

Wall Street reacted positively to the Geithner pick. Word of President-elect Barack Obama’s choice was leaked Nov. 21, a day after the Dow closed at 7,552, its lowest level in more than a decade. The next day, the Dow rallied to close above 8,000.

Geithner has a tough road ahead of him. First and foremost is bringing consistency to the Troubled Assets Relief Program (TARP), a plan that seemed to change by the week in late 2008.

TARP was meant to bring stability to the markets—or at least to put a bottom on the markets’ collapse—but its many iterations have had an adverse effect on market psychology. “The TARP, and its reversal, and the new TARP, is just adding to the volatility and uncertainty of everything,” says Robert White, president of Real Capital Analytics.

Geithner will inherit the mantle at a crucial juncture as the markets await further intervention.

“So many aspects of the economy and of the markets are under the influence or will be influenced by policy decisions,” says Sam Chandan, chief economist at Reis, Inc. “And that introduces an unusual level of uncertainty into the market.”

Still, Geithner’s steady, measured manner and experience will go a long way toward calming the markets. The 47-year-old has already weathered a few storms as a lifelong public servant. He’s worked for five Treasury secretaries and the International Monetary Fund, and he helped to stem financial crises in Mexico, Asia, and Russia for the Clinton administration.

If 2007 was the end of the party, 2009 will be the worst part of the hangover. The subprime mortgage meltdown has spread like wildfire, incinerating the governmentsponsored enterprises (GSEs) and leveling century-old financial institutions that weathered the Great Depression but could not survive 2008.

The government’s seizure of Fannie Mae and Freddie Mac; the bankruptcy of Lehman Brothers; and the failure of AIG, Washington Mutual, Wachovia, Bear Stearns, and Merrill Lynch all foretell of more pain to come in 2009.

“We’re struggling with a financial market that has become much more sophisticated than our ability to monitor it,” says Linwood Thompson, managing director of broker Marcus & Millichap.

This will be a tough year for the multifamily industry. Lenders are expected to lend less and at more conservative terms, equity will be prohibitively costly, and construction financing will be scarce.

The credit crunch that began with the singlefamily housing meltdown reached a fevered pitch in the fall, casting dark clouds over 2009. That paucity of credit had a global domino effect, as job losses mounted throughout the year, foreclosures accelerated, and the decline in housing values trickled up to multifamily properties.

“Every market is suffering signifi- cant declines in investment activity and significant drops in price,” says Robert White, president of market research firm Real Capital Analytics. “The shock has been at such a macro level that most of the underlying trends and fundamentals have been obscured by the capital markets.”

Uncertainty reigns supreme in 2009, but there are some silver linings. The market forces that will make this an ugly year will also present many opportunities for developers (for more information, see While the Iron Is Cold). And the muted construction activity should position the industry for another great run, starting in the second half of 2010.

But how bad will 2009 be, and how will it affect your business?

Liquidity timidity

As one developer puts it, “Get ready for a brave new world of underwriting in 2009.”

The multifamily industry has navigated the credit crunch better than its commercial real estate counterparts thanks to Fannie Mae and Freddie Mac. And though they were placed in conservatorship in September, the GSEs are expected to continue their dominance of the permanent loan market in 2009.

Rates on 10-year deals from the GSEs were being quoted in the 6 percent to 6.5 percent range in early December, and industry experts didn’t expect huge fluctuations in pricing through 2009. Underwriting terms will continue to grow more conservative in 2009, however (for more on the permanent loan outlook, see Agents of Change).

The biggest question in 2009 will be construction financing. The rash of bank failures in 2008 claimed some of the multifamily industry’s largest construction lenders, including Wachovia and Washington Mutual, and more bank failures are expected in 2009. The largest remaining lenders, such as Bank of America, KeyBank, Wells Fargo, and Citi, are expected to whittle down their commercial real estate exposure in 2009 (for more on the construction loan outlook, see Cranes Gather Dust).

In a phrase, cash is king. Since debt providers have grown increasingly stingy, equity has become a more critical piece of the capital stack. But equity providers, especially pension funds, have scaled back their appetites, and return expectations have shot up.

Equity firms raised spreads about 300 to 500 basis points in 2008 and are now charging 20 percent-plus returns. For rescuing troubled developments, that return expectation could be in the 30 percent range. Mezzanine financing is similarly in the 20 percent range (for more on the equity outlook, see Equity Investors Target 50 Percent Higher IRRs).

When the U.S. dollar was trading low early in 2008, a wave of foreign capital was expected to wash over the multifamily industry. And up until September, it was true: Overseas investors including Prudential, PLC, and European pension funds helped fuel U.S. developments.

That dynamic is now in flux, as currencies remain volatile and foreign investors, as well as domestic investors, wait on the sidelines rather than “try to catch a falling knife,” as one dealmaker puts it.

Values bruised

Given the link between the availability of financing and apartment values, it’s no surprise that sales velocity was abysmal in 2008, down at least 50 percent from 2007.

Prices for apartment properties through October 2008 fell approximately 7 percent compared with the same period in 2007, according to Real Capital Analytics.

Values sank lower with each passing month. Sellers were fetching $91,000 per unit in the third quarter of 2008, down from $110,000 per unit in the third quarter of 2007, according to Reis, Inc.

The national cap rate average through October was 6.5 percent, up about 50 basis points from October 2007. Cap rates for Class A properties in primary markets spiked about 35 basis points, and B-class properties in secondary markets have seen cap rates shoot up nearly 75 basis points in 2008. A cap rate, which is a property’s net operating income (NOI) divided by its purchase price, is a measure of return on investment.

“There will be continued pressure on cap rates to go up in the next year, and I’ll bet they push up another 50 basis points in 2009,” says Thompson.

The large amount of debt that reaches maturity in 2009 and 2010 will further impact pricing. Aggressively underwritten loans that need to be refinanced in 2009 may not be able to find capital. And construction loans with overly liberal terms that need to convert to permanent loans also will have trouble finding financing, forcing more sell-offs of distressed assets.

“Increases in the delinquency or default rates, or distressed sales that occur because of imbalances between the demand and supply for capital and credit, will further undermine prices in 2009,” says Sam Chandan, chief economist at Reis, Inc.

In a sense, cap rates are returning to historical norms. The conduit craze that preceded this downturn pushed cap rates down to unsustainable levels, as aggressive rent and NOI growth assumptions overvalued assets.

But for most owners, the pendulum has swung back too far and too quickly for comfort.

“The most remarkable thing about what we’ve been going through is the violence of what it has been, more so than that it has been,” says Jamie Woodwell, vice president of multifamily research for the Mortgage Bankers Association.

Macro ripples

The economy will continue to contract in 2009. After losing nearly 2 million jobs in 2008, another 1.5 million may be lost this year, economists predict. The jobless rate was at 6.7 percent in December 2008, a 15-year high, and Reis forecasts that figure to reach more than 8 percent in 2009.

Job losses negatively impact household formation, which is a key metric in measuring rental demand. One troubling stat for the multifamily industry is how different age groups have been impacted by job losses. “Echo boomers”—20- to 35-yearolds— are facing an unemployment rate of more than 8.5 percent. About 75 percent of that population rents, compared to about 33 percent of the general population that are renters.

Despite the dislocation and stress to the system, the national occupancy rate was nearly 94 percent as of December 2008, and rent growth was about 3 percent in 2008, according to Marcus & Millichap. The firm expects occupancies to dip down in 2009, but only by about 1 percent. The firm also is calling for 1.5 percent rent growth nationally in 2009, led by coastal markets like Seattle, San Francisco, and New York.

The supply and demand of apartments is healthy and might be expected to get healthier as fewer new units are brought online this year. “Our industry has positioned itself well to weather the storm,” says David Cardwell, vice president of capital markets at the National Multi Housing Council. “That doesn’t mean we won’t lose some ships, but we’ll be able to sail through this.”

Since 2000, developers have only added about 1 percent of existing stock each year to the nation’s apartment market. In contrast, developers added 4 percent of existing stock each year in the 1980s. Construction starts for multifamily were down about 30 percent in 2008, and that figure looks to get worse as more developers cancel projects and lay off staff.

The same capital markets forces that will cause so much pain in 2009 will also help position the industry for its next great upturn.

“As we come out of this recession, as the single-family numbers work to the benefit of multifamily, as the echo boomers mature, as immigration continues, we’re going to have even fewer units than we do today,” says Thompson. “The apartment business in 2011 to 2014 is going to be in great shape, and this next run will be one of the better bull runs this industry has ever seen.”

In the meantime, brace yourself.