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[ continued ]

Griffith: Hi, I’m Kim Griffith with the multifamily area of Freddie Mac. People have said almost everything that I would have said. Here are a couple of other things. We find it hard to do smaller deals, particularly 9% deals. It’s hard to make those deals work from an economic perspective. Also, when you’re doing smaller deals, you’re getting pushed further and further out of our comfort zone into smaller and smaller markets. So you keep worrying about jobs, where they’re going to be, and what happens if the manufacturing plant in that town folds up and leaves. Those are the two big things that we see. Additionally, we’re seeing more pressure on us to be in the preservation business. That is a tough business to be in, and it means a lot of different things to different people. Preservation is going to be a big push for us.

Jana Cohen Blackman, Sonnenschein, Nath & Rosenthal: Jana Blackman from Sonnenschein. I’m chairman of Sonnenschein’s national real estate practice. Most of you have done deals with me at some point or another. Sonnenschein is a 700-member law firm. Of that, we have about 70 real estate lawyers. About $1 billion in tax credit equity comes though our door every year, sometimes more. Our particular side of the table is the investor side, which is how most of you know us.

I agree a lot with some of the things said around the table. I disagree with others. I have a couple of new things to throw into the mix.

I could not agree more with Tony. Deals are being done that should not be done. There is way, way too much money chasing too few deals. The way this industry is meant to work is to have equity provide the checks and balances on the developer. Right now, that is not happening. So forgive me, everybody in the room, but the developers have too much clout. They’re calling way too many of the shots, and the equity investors are caving left and right to get the deals done. Projects will fail as a result. I have been in this business too long. Developers have to be less greedy and back off. Without the checks and balances, the deals will fail. So developers, sorry, you’re not my side of the table, equity is. The checks and balances are no longer in place and that gives me great concern.

Concern number two, which is contrary to my interest but I’m going to throw it out there anyway, is legal fees, expenses, and transactional costs. I love legal fees – those are what pay for my house and the expensive needs of my children. However, what it takes to get these deals done is obscene, particularly when you’re looking at some of the deals that are the most needed. Hope VI, the public-private deals we do: What we pull in for fees to get those deals done is obscene when I think of how that money can be better used. The 2530 process needs to be overhauled, and the process of doing these deals needs to be simplified. I could do more deals and make the same amount of money, and let’s just get it done. The burdensome nature of this is ridiculous. The 2530 peeve of mine has got to go. There has to be a better way to do it.

I agree with Tony; I’m very worried about Fannie Mae. Fannie Mae is the 800-pound gorilla that drives this business. You could theorize that Fannie in trouble is good for this business but, nonetheless, I’m worried about it.

A relatively minor issue is REAC [Real Estate Assessment Center]. I have never seen HUD threaten foreclosure over failed REAC inspections, when debt service is current, to the degree I’m seeing it now. It feels like bullying coming out of Atlanta.

The only other concern that I’ll offer is that I hear everything that was said around this table and the comfort everyone has with this administration. I hope you’re right, but fear you’re wrong, and I hear your concerns about the not-for-profits. I hope we don’t forget about the very poor in this industry who need this housing and the inner-city deals that are the hardest to do. It is a whole lot easier to do deals at 60% of AMI in a nice clean suburb, but there is also a need out there. I would like to think that, in the support that Republicans claim some of this program may have, we don’t forget about the most needy who need roofs over their heads.

Shashaty: Well, thank you. I asked for candor but I wasn’t prepared for that much candor. Absolutely. That was incredible. I’m going to zero in on what Lee Harris and Chris said. What does it take to put the brakes on without having a crash? Several people mentioned soft markets, rising interest rates, rising construction costs, and of course Ernst & Young has pointed out that negative cash flow is increasing even as defaults are staying low. State agencies have responded. In our December issue, you’ll read about how QAPs are raising cost limits and credit award limits, requiring more reserves, and requiring better market studies. Some of them are saying there should be one market analyst per region, and that’s who you go to for your market study.

But as several people pointed out, investment dollars are flowing, and syndicators and investors are doing marginal deals and paying top dollar. How bad is this problem, and what is the trend line, and where is it leading us? With improving apartment markets and rising rents in the conventional market, and declining investor interest, will those market forces solve the problem, or are there systemic problems with the way the program is being run? A lot of times, the market takes care of these things. Why don’t we start on this side and we can jump around. I figured Chris and Lee first and then whoever else wants to get into it.

Tawa: To paraphrase what Tony said, we have been living in a never-never land where the industry and the real estate has never taken a downward hit. Thus, we’ve never felt that pain. Many of us do have significant deals on the watch list and have been holding them together with baling wire and string until that magic 15th year. We have not seen those assets resolve themselves, but I can paint some of those pictures.

Would we benefit from some pain in this industry, and would that bring the discipline to bear? In some ways, our industry has never really had that, with the rise of the multifamily market throughout the past decade, the low interest rates, and the uneconomic terms by which these programs function. The project can have negative cash flow and not default for a variety of reasons that we know about. Not to wish upon myself that downturn as the remedy, but certainly many of the activities that we do are not informed by a perspective on the downside of what exactly can the penalty be. We’ve never really faced that in any large measure in this industry.

Harris: I think that’s part of it. I also think that you have to follow the money back to the source. It starts where Jan is talking about, in the investor market. If the investor market does not care that it’s going to have to shovel money into deals to keep them alive for 15 years, then nothing will change. But we can start by educating investors. It starts where the money starts.

Blackman: I think the investors are starting to say no in terms of bailing-out funds. I have first-hand experience with a handful of funds that are failing or projects that are failing and investors who are saying, “No, I won’t do it.” We’ve dealt with general partner removals to a far greater degree in the last full year than I’ve seen in a very long time. The example is that we had a client come to us who had purchased, through a syndicator, an interest in a couple of projects in a market that has gone notoriously soft. They ultimately triggered a repurchase provision, which they had and sold the projects back to the syndicator. The syndicator was able to flip the projects the same day.

One of our unique pieces of this industry at Sonnenschein is we do an enormous amount of the so-called guaranteed tax credit market, the credit-enhanced market. This is where the investors throw out a lot of money and they don’t have real estate risk, they have credit risk, theoretically of a AAA-rated entity, like NAIG, Morgan Stanley or others. The guaranteed market, I fear, distorts what is happening economically because a lot of those lesser projects get consolidated into the guaranteed funds, get wrapped with the guarantee because the guarantors, for a variety of reasons, feel they’re not at tremendous risk and the risk is mitigated over such a massive volume. There is such a huge cushion built into the business that they are sucking up all of these bad projects, and the investors don’t have the real estate risk. They have credit risk, and the cushion comes from the variances in yield. The guaranteed portfolios are selling now at four-something, and that spread between four-something and the real yield on the project creates a false safety net in this industry. That’s what I’m seeing as a very practical reason of why the economic theories that say this should work are not working.

What I think is going to happen to that, since the yields have come too low, the investors are going to have to pull out of this market because they can’t meet their internal hurdle rates, particularly in the guaranteed market. I think it’s in big jeopardy. If your yield on a deal is 4.8% and you’re internally borrowing to do that, you can’t meet your internal hurdle rate. That’s what happened a few years ago when the guaranteed market plummeted, and that altered the entire economics of this industry. I think that is about to happen; there’s no way it can’t happen.

I also think that the smaller-scale syndicators are going to be driven out of the business in the next year. The spreads are way too low, they’re gone. I think that will be an economic correction. In the unguaranteed market, the yields are going to have to climb a little bit; that is how we will start to see corrections. We are not a normal market: we have Fannie Mae and Freddie Mac with mandates to spend. We have a peculiar division in this industry that creates a false sense of security. I think the correction is going to come purely from business. Yields have gone about as low as we can take, and investors are going to pull out very quickly. It’s going to plummet, and then the corrections will start.

Cunningham: I start with the perspective that the market generally is efficient for tax credits. When you think back to where IRRs were on the equity side when this product was first introduced and compare them to what they are today, either on a guaranteed or unguaranteed basis, the differences are extremely significant. When you think about the traditional arbitrage opportunities on pricing, whether on the equity side or the debt side, those have for the most part disappeared. When you think about the shifting nature of the subsidized financing that has been available, less so as we move on into periods of economic difficulty, that’s another factor that is changing the overall nature of this structure.

What’s the break point at which an investor chooses to walk away from a property? Clearly, it depends on where you are in your overall yield, how low does that go, and what is the viability, which is immediately going into the supply question. Where does that property sit within a market? We’ve talked a lot about whether you’re underwriting at 60% yield or whether you’re underwriting at significantly lower income amounts, AMI thresholds, or somebody referred to it as point chasing. That’s is the long-term viability that we as an industry have to look to.

… When we talk about the continuation of the administration and stemming the growth of the affordable housing properties, that is the arbitrage opportunity that everybody will be looking at. Where do you take the risks on Sec. 8, as opposed to financing something with the expectation that that program, in some sense, is not going away? How do you look at the inventory that has been built with HUD? You reach a point where sustainability and net present value is less than zero. I think we have to go down on a deal-by-deal and asset-by-asset basis where those decisions are going to be made in a negative manner. We are seeing that on a limited basis, so I’m not overly worried about the viability, particularly because I know how large the gap continues to be. People are in this business because there is a profit to be made at the end of the day, and the question is exploiting those opportunities on the upside and the downside. That is the challenge we face.

Finch: I’m not so sure I buy into that. … I see a bubble coming. … I don’t think it’s going to be a gradual decline. It will be stop and then a shakeout! After that shakeout, we should get back to a reasonable rate of return. But I don’t see it until something big pops, and I think that it will be soon.

Griffith: I want to clarify that the Freddie Mac mandate on the regulatory side is in the debt area, not the equity area. We are the second biggest investor in the tax credit equity market. We don’t buy guaranteed funds because of yield. We do look all the way through the properties to decide what to buy. We only buy in multi-investor funds. We’re trying on that investor side to have some modicum of discipline. We’re trying to get a yield that works for us. That’s why we stayed away from guaranteed funds and that’s why we underwrite on the equity side.

Shashaty: Can you address the forecast a little bit? Is there going to be a dramatic decline in investor interest or will there be a gradual correction?

Foster: I’m sitting here as a developer. Maybe I’m just naïve, but there aren’t very many defaults. Maybe the world is about to explode, but I don’t really see it. MMA and Ronne have underwritten projects of mine, and I think that you’ve been fairly conservative and responsible in terms of how you’ve underwritten the projects. I’m not seeing a whole lot of troubled projects out there. The problem does not start with the developer. It starts with the seller of the land or the property wanting the highest price. Then somebody has to buy it and somebody has to buy the credits. It backs all the way up to the very beginning of the line. If you want to stop it early, the agencies have got to be the ones to enforce some kind of responsible underwriting. I think the agencies are being more responsible in requiring tougher standards in market studies, and so forth. When the agency says this is how the deal will be underwritten, I know I can say to the seller that there is hard evidence of why the price needs to be where it is. 

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