By Ron Skelton Vie President
Caldera Asset Management, Denver
skelton@calderallc.com

There are a few factors that directly impact the transaction flow for apartments.

Interest Rates:
Earlier in March, the Federal Reserve confirmed that they will end its purchase programs of mortgage backed securities (MBS). The original goal of the Fed was to stop the freefall in housing and restore some stability. Broadly, it has succeeded at least in the short run. At the beginning of 2009, the Fed held virtually zero MBS on its balance sheet. But, at the end, this program will hold approximately $1.2 trillion. This purchase program has also driven down the cost of funding for real estate, including apartments. So, what will happen to rates and the related deal flows when the program ceases?

Many analysts predict that the spreads will increase as investors who are not currently purchasing MBS will expect higher returns for the additional risk. The Survey of Professional Forecasters predicts the 10 year bond to end in 2010 at 4.10%. Meanwhile, others predict that the move will, in fact, reduce lending available for future transactions; thus further reducing the ability to complete transactions. Still, some argue that the program never had a direct effect on keeping rates lower. The truth is that we are in an unchartered territory. It is anyone’s guess who is correct or what will happen in the immediate future. Common logic suggests that interest rates will rise after the Federal Reserve stops buying, and this will directly affect transactions unless spreads fall and the all-in rate stays the same. Fundamentals in virtually all markets will not offset the increase in cost to borrowers. If interest rates fall, then we may be in a worse situation as it could be indicative of a continued soft economy that will reduce, or delay, any anticipated rent increases.

The general consensus tends to be that interest rates will rise starting in 2010. The following chart is based on a survey of leading economic analyst within the industry. From Q2 2010 through Q2 2011, the survey suggests an expected increase of 50 basis points with yield at 4.48% in Q1 2011. Both the median forecast and average forecast will increase with an expected yield of 4.40% and 4.47%, respectively.

Debt Markets:
In today’s market, the only lenders in town are Fannie Mae and Freddie Mac. Similar to the residential housing market, the government agencies are effectively providing about 90% of all new loan originations. The spreads have been pretty consistent throughout the quarter at about 220 bps over the 10 yr bond. Both agencies have increased the allowed LTV (approx. 80%) within their basic underwriting (with slightly less for new acquisitions). We anticipate the agencies to continue their lending volume throughout 2010.

There has also been a lot of talk about the CMBS market returns. We do not see that affecting the apartment market anytime soon. The CMBS originators have a much more fertile hunting ground in fully leased office, retail and industrial rather than trying to compete with the agencies.

Availability of Products and Capital Flow:
The common wisdom in the market is that massive amounts of capital are chasing deals. However, some would say that there are only a few deals in each market; thus, the capital available is basically chasing the same few deals. We continue to see strong activity on the high-end of the market. Newer properties with urban locations are getting priced at hyper aggressive rates. There is some logic to this as buyers believe that any rebound will start at the higher-end product.

Most of the money raised to date is either at the high end or the fully distressed variety. Surprisingly, there have been only a few public REITs or pension fund acquisitions in the first quarter. If large EQR purchases are removed, the number can be counted on two hands.

Buyers are looking at in-place yields on NOI. They are generally placing long term fixed rate agency debt and playing for an expanding cash-on-cash return with a strong potential residual. Cap rates have been compressing on institutional urban properties, where debt is available. However, lower quality properties have been less attractive because of their inability to be financed. There is a belief that the newer urban locations will be the first to regain top line rent growth; thus creating higher yields at a faster pace. Lower quality properties (B- / C-) will continue to struggle as renters continually find opportunities to move (foreclosures, roommates, market concessions, etc.). This places pressure on occupancy, and combined with increasing capital requirements, places pressure on potential growth. Banks, including agency debt, are not willing to lend unless properties maintain stabilized occupancy and have sufficient debt service coverage. These properties typically require all-cash buyers, and few investors have stepped up to clear transactions.

The real test to determine the depth of capital flows will occur this summer/fall when a large amount of recently developed suburban assets hit the market as the construction loan extensions expire. If cap rates continue to show their aggressiveness with a larger supply of “commodity” assets available, then the market will potentially recover.

Two Things to Consider:

Fundamentals:
We have spoken to our contacts in the property management business across the country. It appears that rent rolls are starting to stabilize, but it is difficult to confirm whether this is a normal spring time bounce or an impact of real economic growth. Rents in many markets have become so low that a floor has been reached and there is nowhere to go but up. Leasing traffic has increased, however as one owner stated “we love the increased traffic flows; however the number of notices has significantly increased as well.”

Over the past year, the ability of owners to raise rents has been non-existent, and many owners have focused on keeping units occupied to reduce the turnover costs associated with signing new leases. This spring, owners may take the opportunity to actually push rents up. We are encouraged that the rental freefall has stopped in most markets.

Conclusion:
We believe the availability of product will increase significantly during the second half of the year. There is simply too much product at all quality levels that need to find new owners. As evident in a recent transaction in Phoenix, as soon as a quality, suburban, commodity product obtained a highly aggressive cap (reported at 5.5%); it got the existing owners off the fence. Within three weeks of the transaction, four suburban assets hit the market. The large amount of equity, waiting on the sidelines, will need to be put to work. As the supply increases, the demand levels should adjust and cap rates will potentially respond. However, if the supply starts to outweigh the demand, cap rates will rise, placing more pressure on valuations. If interest rates climb at the same time, without significant economic improvement, cash flows will be affected and equity will continue to stay on the sidelines. Investors will return to the market when there is a consensus that the markets have hit the bottom. However, identifying the bottom is a very difficult thing to predict. With an increase in product, hitting the market and interest rates returning to a normal level, investors, and banks will underwrite with more certainty. And that increase in certainty will also bring an increase in transactions.

About the Author
Ron Skelton is vice president at 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.