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Where Have All the Good Deals gone?

By Mike Kelly President
Caldera Asset Management, Denver
mkelly@calderaassetmanagement.com

As the year 2009 comes to an end, an interesting phenomenon is occurring in the apartment transaction world. There is virtually no institutional product available in the market. Over the past couple of weeks, we have done extensive research with a large percentage of the institutional brokers across the country. Due to our long standing relationships, Caldera was able to have an open and frank conversations about assets in the market; the depth and closing ability of current buyers; and the properties being pitched which will make up the sales pipeline over the next 60 to 120 days. Historically, apartment transaction markets are in the closing phase for year-end deals and gearing up for the bevy of product which is generally announced prior to the National Multi-Housing Council (‘NMHC”) Conference.

Few Highlights:

•	Currently, there are very few institutional quality assets in the market. Across the country, there appears to be fewer than 20 institutional quality assets that are actively being marketed or are under agreement.
•	In 4Q 2009, sellers have been quick to pull assets off the market even after the completion of the marketing periods.
•	There are very few institutional quality assets currently being pitched by brokers. Most of the properties entering the market in early 2010 will be low quality Commercial Mortgage Backed Security (“CMBS”) servicer related assets.
•	The most active buyers of institutional transactions are private REITs, a few public REITs, 1031 exchange buyers (selling retail / buying apartments), and a few pension fund advisors. Although sellers are getting multiple offers, most of them are from buyers who are simply trying to gauge the current market dynamics and pricing. Ultimately, the private REITs are effectively driving pricing in most markets.
•	The animal spirit among transaction professionals is back; most have sat on the sidelines for 12 to 18 months. Apartments are the best relative game in town.
•	Fannie & Freddie are getting more aggressive on funding, terms and underwriting as they are reportedly below their anticipated 2009 funding amounts.
•	Virtually all REITs, institutional owners and large management companies anticipate rent rolls to be flat in 2010. However, that does not appear to be having a material impact on pricing.

Is the 25 to 75 bps cap rate compression over the past 120 days a trend or a lack of supply driven bubble?

Construction Deals

Every apartment professional knows that there has been a number of new units delivered since 2006 which were never sold to long term owners. The FDIC has made it easier for the banks not to force the issue with their November 2009 announcement that “prudent underwriting” trumps overleveraged assets. However, the flexibility of loan reviews will end at some point and these assets will need to be cleared in the market. Development equity rarely becomes a property’s long term equity due to large new dollars needed to “right size” the assets (in process of replacing construction debt with long term debt) as well as different yield expectations.

Note:
We estimate that 20-25% of these assets were built by either REITs or longer term investors. Based upon that assumption, approximately 200,000 units will need to clear the market as development equity transitions into a long term equity. Most construction loans will use their extensions thus this major flow will not hit until 2011-2013.

CMBS Overhang

Based on conversations with brokers, the loan servicers appear to be moving from only getting “opinions of values” to actually listing assets with the intent of selling the properties soon after they obtain them. We see this as a positive development as the overhang of assets entering the queue is staggering and the market needs new ownership for many of these overleveraged assets.

Most of the assets currently in the CMBS pipeline are B- to C grade assets which took the first hit in this economy with decreasing rent rolls and occupancies. With rent rolls impaired below 90%, thus limiting the ability to obtain agency financing, the new breed of buyers either acquire with all cash or obtain lower loan-to-value (“LTV”) recourses from a local bank. This need for more equity, will severely limit the absolute number of transactions that clear each market.

So what does 2010 look like?

Nobody has the crystal ball. The anticipated events proved to be extremely elusive in 2009. However, based upon our experience and research, we anticipate the following:

Barbell Market

Most of the transactions in 2010 are anticipated to occur at the two extreme ends of asset quality, vintage and location. This will happen either at the high end with newer and higher quality assets, or the B- to C grade assets at the lower end where the price per unit and yields are attractive to smaller local buyers. Currently, there is little incentive for buyers in the middle. With the uncertainty of the direction of rent rolls and occupancies, it makes the typical value add transaction extremely difficult. Furthermore, those buyers will not be able to obtain the LTV's needed to drive returns.

First Mover Advantage

Many assets are currently overleveraged:

•	A large percentage of high quality assets were bought or developed in the past 4 years. Therefore, any sale will probably not deliver significant amounts of equity after the high debt levels are paid off.
•	Even though cap rates have compressed in the past 120 days, there is a limit to how low they can continue to go down. The agencies are the only lenders and their spreads are 210 to 230 basis points (“bps”) over the 10 Year Treasury; resulting in 5.30 to 5.75% range pricing. Interest only periods are short, if at all, and there is no mezzanine debt available to enhance yields. With the current uncertainties of rent growth, buyers are generally not willing to underwrite large amounts of negative arbitrage like they were in 2007.
•	Interest rates going forward are anybody’s guess. The apartment industry needs the economy to recover and add jobs. However, conventional wisdom suggests that when the economy recovers, interest rates also rise in tandem. Although agencies usually reduce spreads when interest rates rise, Overall, the total cost to the borrower still goes up.

We believe the owners who make the first move and are able to sell will be the ultimate winners. There are a lot of assets in the system, especially development and value-add products, which need to have their equity replaced, or recycled with longer term equity. Although extensions help, they do not solve the problem. Currently, pricing is relatively strong, but may be driven by a lack of products in the market. However, when the inevitable supply that has been held back comes to the market, buyers will have many options to invest their equity. Although, more capital will be raised in 2010 and 2011 to absorb some of this supply, there will simply not be enough for core and long term investments.

About the Author
Mike Kelly is the president and co-founder of Caldera Asset Management, a turnaround consulting and restructuring services firm specializing in multifamily assets. Caldera’s team has experience working with lenders, equity investors, lawyers and other consultants to solve complex problems associated with distressed multifamily assets including turnaround, refinancing, stabilization, restructuring, dispositions and property management. For more about Caldera, please visit www.calderaassetmanagement.com.