A good report from Marcus & Millichap. This came across my desk today and I thought people would find it helpful. - SeanS
Memorandum
To: NMHG Senior Directors and Directors
From: Linwood Thompson
Subject: State of the Major Multi-family Market
Date: February 26, 2008
. These observations are, however, intended to provide a grounded foundation upon which you can build you own personal point of view and, hopefully, be better prepared to provide leadership to your clients.
The Apartment Market in the 2000’s
During the past seven years, the US apartment industry has experienced dramatic change and growth. The most obvious and powerful change has been the significant decrease in cap rates. There are at least five contributing factors to this compression:
1. The low interest rates our industry has enjoyed for the past several years.
2. The emergence of apartments as a preferred investment vehicle and the resulting infusion of capital.
3. The reality that alternative investments (stocks, bonds, commodities) have not provided a compelling enough alternative to slow the flow of capital into the apartment market. (The trend of capital infusion continues.)
4. The awareness of many astute investors as to the impact the maturation of the echo-boomers would have on our industry as they enter their prime “renting†years. (Forward-looking strength of demographics)
5. The increasing acceptance on behalf of sophisticated investors of dynamic analysis and valuation techniques such as discounted cash flow modeling as opposed to the more static cap rate approach of the past.
These factors have been augmented over the past few years with another realization:
6. The current and future balance between the supply and demand of apartments is more reliable and, if anything, supports a conclusion that supply will not be able to meet demand unless rents rise dramatically. The logic behind this is:
a. Development sites are more scarce and expensive
b. Construction costs are higher and more volatile
c. “Nimby-ism†is more prevalent and results in fewer sites being approved, longer approval processes and higher impact fees.
d. The sites where demand is more reliable (close to employment centers and transportation) usually requires “density†and results in further increases in construction costs. (Structured parking, mid / high rise construction techniques, scraping and land preparation, etc.)
These combined factors have led to a dramatic increase in the appetite for apartment investment, a resulting decrease in acceptable (and actual) yields and significant price appreciation. The apartment market is simply more desirable and efficient than it has been in the past and I believe this change is structural (fundamental) and not just cyclical. Apartments are, and will be, more valuable than the historical trend line suggests.
Comments on the Macro Economy
Before discussing the state of the current apartment industry, I believe it would be helpful to make a few comments on the macro economy. There is much current debate as to whether the US economy will: 1) soon enter a period of recession; 2) narrowly escape a recession with a period of slow, but positive, growth; or 3) is, in fact, already in a recession. Much of this discussion provides for interesting debate around the water cooler… but misses the point.
Technically, a recession is defined as two back-to-back quarters of negative growth in Gross Domestic Product (“GDPâ€), a broad measure of the “output†of the US economic engine. The fact is most recent recessions have been of very short duration. Short enough, that by the time the economists could actually declare a “technical recessionâ€, the actual economy had already moved back into a new growth phase. It is not terribly important whether or not we will have a technical recession. What is important is whether or not such a recession would be deep enough and protracted enough to cause serious damage to our industry. Despite all the “concern†about “recessionâ€â€¦ a significant number of economists believe we will avoid a “technical recession†and most others believe any recession we might have would be fairly mild and brief.
In the past, watching our government attempt to control the economy must have looked like your new teenage driver over-steering a car with bad shock absorbers. The “economic†car would be moving down the middle of the lane until it entered a turn. Then, the inexperienced teenage driver lunges the car to the right into “inflationâ€â€¦ then over-steers in the other direction and lunges the car to the left into “recessionâ€. Eventually, “control†is regained until the next curve is encountered.
Over the past few decades the federal government, largely through the work of the Federal Reserve Board (with Chairmen Volker, Greenspan and, now, Bernanke at the controls), has become much more adroit at “steering†the economy without the inefficient and dangerous lunges to the left or right. When GDP growth approaches 4%, interest rates are increased to slow down the economy and move it back to the middle of the road. And, when growth drops below 2%, interest rates are decreased to stimulate the economy and, likewise, move it back to the center. Effectively doing this in a proactive manner involves “reading†the US economy in the context of an increasingly complex global economy and dealing with unforeseen obstacles (like the CMBS meltdown) and sometimes our “economic†car bumps against the “guardrailâ€. However, a high-speed debilitating crash is very unlikely.
A few specifics:
· GDP growth for 2008 is expected to be between 1% and 2%.
· Job growth has slowed but the economy should produce about 1 million jobs this year.
· Unemployment is below 5% and, although it might increase slightly… will remain in the current historically low range.
· Our economy has been amazingly robust and resilient considering it has been challenged by $90+/ barrel oil, the CMBS meltdown and an après-bubble single-family residential housing market.
The real issue is whether current or short-term conditions in the general economy could have a serious enough effect as to undermine the positive underpinnings of the multi-family housing market. I believe the answer is the same… whether we confirm a “technical†recession or not… the general trend of the US apartment market is positive. Period!
The State of the Apartment Industry – 2008
The fundamentals of the apartment industry are solid:
If market fundamentals are solid… why is there so much negative rhetoric in the market and why is velocity decreasing? I believe the answer is that our industry is in a period of “recalibration†not “recessionâ€. While this may be thought of as just a play on words by those in the industry that have a bias towards seeing the glass “half emptyâ€, I believe the distinction can and should be made.
In a typical apartment recession…
· Supply exceeds demand and it is usually accompanied by a “development overhang†that means things will get worse before they get better.
· Occupancies are decreasing
· Rents are either decreasing or significant concessions are widespread…
and yet, this is not what we see in most markets. So are we in an apartment recession… or is something else going on?
A Period of Recalibration
I believe the industry is in a period of “recalibration†meaning the formulas used by the participants in the transaction to measure and allocate resources and reward performance are being re-set. For example:
I use the term “change in attitude†deliberately because I feel there is more “opportunistic†re-pricing taking place than what is truly justified by industry metrics. For example, the delinquency rate for all commercial property in the CMBS pools is still less than ½ of 1% and the multi-family sector is as strong as any competing commercial sector. Point: If you combine the change from interest-only to amortized loans, cap growth rates in underwriting models, increase reversion rates and increase debt coverage ratios… loan-to-value ratios and NOI’s plummet and prices could drop from 10% to 20%. Meanwhile, market fundamentals are currently strong and the supply / demand balance of product appears to favor rent growth and appreciation. Lenders are clearly trying to become somewhat more conservative in their lending practices… but the pendulum has swung too far and will be reversed by market forces.
What Changes Will We Probably Have to Accept
Why Has Transaction Activity Decreased
I believe the biggest challenge we face this year will be lower transaction velocity. We have already entered this environment and it could continue for several months. The reasons for this drop in velocity are laced throughout this document, but, in summary, the reason is a widening gap in the attitudes and expectations of sellers and buyers. The contributing factors to this situation are:
· Is not related to apartment fundamentals (except for a few markets and sub-markets)
· Is being caused by the industry’s attempt to recalibrate the formulas used to measure and allocate resources and reward the various “participants†involved in the process
· Has caused velocity to decrease
· Has had some impact on pricing… with quality assets in primary locations holding relatively firm and deals on the margin feeling the greatest impact.
What The NMHG Believes Will Happen
· Lender spreads will gradually decrease until they reach the 150’s. This trend will be accelerated in better markets and with better product where lenders will be willing to be more competitive.
· Sellers are not going to accept significant price decreases while occupancies are stable to increasing and net rents are increasing. Therefore, velocity will remain below trend until debt and equity providers retreat from the opportunistic portion of their recalibration. (The market will accept a certain amount of adjustment… but the pendulum has swung too far.)
· Because lenders, equity providers and investors have to do deals, the apartment sector remains fundamentally strong and alternative investments are not as attractive, they will moderate their positons in order to create more velocity. (There is more reason for buyers and lenders to “blink†than sellers, given the underlying strength of the market.)
· We are going to experience lower velocity for a period of a few to several months and then the market will enter its next bull run. This transition will be quicker than many are currently predicting.
Memorandum
To: NMHG Senior Directors and Directors
From: Linwood Thompson
Subject: State of the Major Multi-family Market
Date: February 26, 2008
. These observations are, however, intended to provide a grounded foundation upon which you can build you own personal point of view and, hopefully, be better prepared to provide leadership to your clients.
The Apartment Market in the 2000’s
During the past seven years, the US apartment industry has experienced dramatic change and growth. The most obvious and powerful change has been the significant decrease in cap rates. There are at least five contributing factors to this compression:
1. The low interest rates our industry has enjoyed for the past several years.
2. The emergence of apartments as a preferred investment vehicle and the resulting infusion of capital.
3. The reality that alternative investments (stocks, bonds, commodities) have not provided a compelling enough alternative to slow the flow of capital into the apartment market. (The trend of capital infusion continues.)
4. The awareness of many astute investors as to the impact the maturation of the echo-boomers would have on our industry as they enter their prime “renting†years. (Forward-looking strength of demographics)
5. The increasing acceptance on behalf of sophisticated investors of dynamic analysis and valuation techniques such as discounted cash flow modeling as opposed to the more static cap rate approach of the past.
These factors have been augmented over the past few years with another realization:
6. The current and future balance between the supply and demand of apartments is more reliable and, if anything, supports a conclusion that supply will not be able to meet demand unless rents rise dramatically. The logic behind this is:
a. Development sites are more scarce and expensive
b. Construction costs are higher and more volatile
c. “Nimby-ism†is more prevalent and results in fewer sites being approved, longer approval processes and higher impact fees.
d. The sites where demand is more reliable (close to employment centers and transportation) usually requires “density†and results in further increases in construction costs. (Structured parking, mid / high rise construction techniques, scraping and land preparation, etc.)
These combined factors have led to a dramatic increase in the appetite for apartment investment, a resulting decrease in acceptable (and actual) yields and significant price appreciation. The apartment market is simply more desirable and efficient than it has been in the past and I believe this change is structural (fundamental) and not just cyclical. Apartments are, and will be, more valuable than the historical trend line suggests.
Comments on the Macro Economy
Before discussing the state of the current apartment industry, I believe it would be helpful to make a few comments on the macro economy. There is much current debate as to whether the US economy will: 1) soon enter a period of recession; 2) narrowly escape a recession with a period of slow, but positive, growth; or 3) is, in fact, already in a recession. Much of this discussion provides for interesting debate around the water cooler… but misses the point.
Technically, a recession is defined as two back-to-back quarters of negative growth in Gross Domestic Product (“GDPâ€), a broad measure of the “output†of the US economic engine. The fact is most recent recessions have been of very short duration. Short enough, that by the time the economists could actually declare a “technical recessionâ€, the actual economy had already moved back into a new growth phase. It is not terribly important whether or not we will have a technical recession. What is important is whether or not such a recession would be deep enough and protracted enough to cause serious damage to our industry. Despite all the “concern†about “recessionâ€â€¦ a significant number of economists believe we will avoid a “technical recession†and most others believe any recession we might have would be fairly mild and brief.
In the past, watching our government attempt to control the economy must have looked like your new teenage driver over-steering a car with bad shock absorbers. The “economic†car would be moving down the middle of the lane until it entered a turn. Then, the inexperienced teenage driver lunges the car to the right into “inflationâ€â€¦ then over-steers in the other direction and lunges the car to the left into “recessionâ€. Eventually, “control†is regained until the next curve is encountered.
Over the past few decades the federal government, largely through the work of the Federal Reserve Board (with Chairmen Volker, Greenspan and, now, Bernanke at the controls), has become much more adroit at “steering†the economy without the inefficient and dangerous lunges to the left or right. When GDP growth approaches 4%, interest rates are increased to slow down the economy and move it back to the middle of the road. And, when growth drops below 2%, interest rates are decreased to stimulate the economy and, likewise, move it back to the center. Effectively doing this in a proactive manner involves “reading†the US economy in the context of an increasingly complex global economy and dealing with unforeseen obstacles (like the CMBS meltdown) and sometimes our “economic†car bumps against the “guardrailâ€. However, a high-speed debilitating crash is very unlikely.
A few specifics:
· GDP growth for 2008 is expected to be between 1% and 2%.
· Job growth has slowed but the economy should produce about 1 million jobs this year.
· Unemployment is below 5% and, although it might increase slightly… will remain in the current historically low range.
· Our economy has been amazingly robust and resilient considering it has been challenged by $90+/ barrel oil, the CMBS meltdown and an après-bubble single-family residential housing market.
The real issue is whether current or short-term conditions in the general economy could have a serious enough effect as to undermine the positive underpinnings of the multi-family housing market. I believe the answer is the same… whether we confirm a “technical†recession or not… the general trend of the US apartment market is positive. Period!
The State of the Apartment Industry – 2008
The fundamentals of the apartment industry are solid:
- The national occupancy rate is 94% and is predicted to hold steady for the year.
- The industry will deliver just over 100,000 market rate apartment units to the market. This represents 1% of our existing stock. In comparison, the industry delivered an average of 4% of existing stock to the market each year throughout the 1980’s.
- Effective rent growth will slow this year to 3% to 3.5% for a national average but still remains quite positive.
- The national “homeownership†rate that moved from 64% to almost 70% over the past several years is reversing for every age group of the population.
If market fundamentals are solid… why is there so much negative rhetoric in the market and why is velocity decreasing? I believe the answer is that our industry is in a period of “recalibration†not “recessionâ€. While this may be thought of as just a play on words by those in the industry that have a bias towards seeing the glass “half emptyâ€, I believe the distinction can and should be made.
In a typical apartment recession…
· Supply exceeds demand and it is usually accompanied by a “development overhang†that means things will get worse before they get better.
· Occupancies are decreasing
· Rents are either decreasing or significant concessions are widespread…
and yet, this is not what we see in most markets. So are we in an apartment recession… or is something else going on?
A Period of Recalibration
I believe the industry is in a period of “recalibration†meaning the formulas used by the participants in the transaction to measure and allocate resources and reward performance are being re-set. For example:
- Lender Spreads: Lenders are recalibrating the spreads they charge for providing access to debt. In mid-2004, lender spreads were about 150 basis points (“bpsâ€) and fell almost overnight to 100 bps. The main catalyst for this rapid decline was the hyper-activity caused by condo-mania. Once one over-eager lender dropped their spreads to gain market share in the condo sector… the entire industry followed. (Some made the decision not to follow… but they were non-competitive and out of the market.) Since the CMBS bubble burst in mid-2007, lenders like FannieMae and FreddieMac have been willing to fill the gap… but at a price. It is interesting they originally responded to the CMBS gap with spreads in the 140 to 160 range. However, as 10-year treasuries fell (so they could still provide market-rate financing at higher spreads) and it became clear that demand was brisk they have raised their spreads to the 180 to 200 range. I believe some of this “recalibration†is “justified†(100 bps was too small of a spread and could not be sustained) and some of this recalibration is “opportunistic†(200 bps is too large of a spread and will not be sustainable when the market returns to a more competitive environment.)
- Lender Underwriting Standards: Due to “perceived increased riskâ€, lenders are also re-calibrating the formulas they will accept in the under-writing process. Examples of this are:
- The change in attitude toward interest-only loans on the front-end of an amortization period. (Banned for “eternity†last August but already back in the market.)
- The change in attitude toward growth rates in financial models. (Banned last fall but already a fact of life in numerous markets like the Bay Area where rents are expected to increase by 8% this year.)
- The change in attitude about reversion cap rates. (This is the most elusive area to rebut but market forces should keep reversion cap rates in the 75 bps to 100 bps range of the initial cap rate.)
- The change in attitude about debt coverage ratios. (DCR’s that led to 90% loans could be argued as “too aggressiveâ€. However, DCR’s that lead to 65% loans are clearly too restrictive. This industry has demonstrated historically that a healthy balance can be maintained with loan-to-value ratios in the 75% to 80% range.
- The change in attitude about loan-to-value ratios. (See above paragraph)
I use the term “change in attitude†deliberately because I feel there is more “opportunistic†re-pricing taking place than what is truly justified by industry metrics. For example, the delinquency rate for all commercial property in the CMBS pools is still less than ½ of 1% and the multi-family sector is as strong as any competing commercial sector. Point: If you combine the change from interest-only to amortized loans, cap growth rates in underwriting models, increase reversion rates and increase debt coverage ratios… loan-to-value ratios and NOI’s plummet and prices could drop from 10% to 20%. Meanwhile, market fundamentals are currently strong and the supply / demand balance of product appears to favor rent growth and appreciation. Lenders are clearly trying to become somewhat more conservative in their lending practices… but the pendulum has swung too far and will be reversed by market forces.
- Equity Yields After watching lenders “recalibrate†their under-writing metrics under the fog of the CMBS crisis, many equity providers are also announcing their own changes in an effort to better match “risk†and “yieldâ€. For example: a certain equity source might have been willing to accept a 12% to 13% leveraged yield on a given quality of asset in a primary market. However, based on increased “perceived†risk, the investor has increased their yield requirement on the same asset and location mix to a range of 14% to 15%. The desired effect is to be able to purchase quality assets at higher yields. (This also means the price for the seller just dropped)
- Short-term Equity Plays in the Financial Markets Another fact of today’s market is that many of the most sophisticated and flexible equity sources (investment banks as opposed to pension funds) have realized the CMBS melt down has created a short term, but potentially highly profitable alternative to a one-off apartment investment at a 12% to 15% yield. Many of these groups have turned their short term attention to high yield plays in the financial markets and rather than saying they are out of the apartment market… have simply increased their hurdle rates to the point where operators cannot make the numbers work. By the way, using this strategy, these equity providers can reduce their targeted yields in a future e-mail and immediately be back in business when the short-term opportunity in the financial markets fades away. However, if you are not aware of the ulterior motive, this can be interpreted as a fundamental change in their attitude towards the multi-family market… which it is not.
What Changes Will We Probably Have to Accept
- Lender spreads will probably revert to a normalized range in the 150’s, not stay where they are or revert to the 100’s.
- The interest-only portions of loans will probably settle in the 2 to 3 years range in select markets and not revert back to the 10-year variety.
- Exit caps rate will edge back to the 100 bps range except for the best of markets.
- Cap rates will revert to more normal spreads between quality classes and market size (primary vs. tertiary markets) As a result, cap rates for less desirable assets and locations will move higher. (Probably 100 bps)
- Loan-to-values (for the private client sector) will stabilize in the 75% to 80% range. (Institutions will continue to use less leverage)
- The valuation process during the proposal phase and the value-driving process during the marketing phase are going to have to be supported with better research and market information. Lenders, investors and operators will stretch but will require the “story†to be well-grounded.
Why Has Transaction Activity Decreased
I believe the biggest challenge we face this year will be lower transaction velocity. We have already entered this environment and it could continue for several months. The reasons for this drop in velocity are laced throughout this document, but, in summary, the reason is a widening gap in the attitudes and expectations of sellers and buyers. The contributing factors to this situation are:
- The justifiable “recalibration†of certain metrics from the unsustainable levels created through several years of an increasingly strong and competitive market. (Lender spreads, underwriting standards, interest-only terms, yields, etc. have all been “compressed†and it is rational for lenders and investors to expect some level of moderation.)
- The CMBS meltdown and the resulting absence of rationally priced conduit financing.
- A general concern about the relationship between “risk†and “yield†and an attempt by equity providers and lenders to moderate the balance.
- Overstated concerns about the state of the US economy
- The natural tendency of people looking for justifiable “relief†to opportunistically “over-reachâ€
· Is not related to apartment fundamentals (except for a few markets and sub-markets)
· Is being caused by the industry’s attempt to recalibrate the formulas used to measure and allocate resources and reward the various “participants†involved in the process
· Has caused velocity to decrease
· Has had some impact on pricing… with quality assets in primary locations holding relatively firm and deals on the margin feeling the greatest impact.
What The NMHG Believes Will Happen
· Lender spreads will gradually decrease until they reach the 150’s. This trend will be accelerated in better markets and with better product where lenders will be willing to be more competitive.
· Sellers are not going to accept significant price decreases while occupancies are stable to increasing and net rents are increasing. Therefore, velocity will remain below trend until debt and equity providers retreat from the opportunistic portion of their recalibration. (The market will accept a certain amount of adjustment… but the pendulum has swung too far.)
· Because lenders, equity providers and investors have to do deals, the apartment sector remains fundamentally strong and alternative investments are not as attractive, they will moderate their positons in order to create more velocity. (There is more reason for buyers and lenders to “blink†than sellers, given the underlying strength of the market.)
· We are going to experience lower velocity for a period of a few to several months and then the market will enter its next bull run. This transition will be quicker than many are currently predicting.
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