By Bill Shippen
Apartment Realty Advisors, Atlanta
shippen@arausa.com

From 2006 through most of 2008, ‘Value-Add ’ was the buzz word that brought investors flocking into the market. Equity and debt were cheap and plentiful. Everyone believed that we were on the verge of a huge run up on rents. An investor just had to swap some hardware, add an accent wall, and justify his low cap rate with an aggressive pro forma. Unfortunately, the rents never materialized and cap rates have rocketed up 40% to 60% in the past 6 months alone. Furthermore, with a deteriorating economy, this upward trajectory in cap rates has yet to reach its zenith.

While Apartment Realty Advisors (“ARA”) has completed over 129 transactions ($1.7 billion) this year, we have been spending more time assisting lenders understand the changing value of their loan portfolios. These valuations differ from our typical “snapshots” prepared for traditional sellers because lenders want to see three different scenarios for each property. First, the value we would obtain if we were to market the property immediately. Second, a midterm value if the lender were to take control of the property and make some minor changes. Third, a long term valuation that would take into consideration major changes to the property market in particular and the investment market in general. These three valuations help determine lenders’ course of action with the borrower and his property.

There were very few Real Estate Owned (“REO”) transactions in the first half of 2009. The transactions that occurred were on properties that were truly lost causes. These deals were typically in poor locations, had significant management/ownership issues, and invariably had terrible economic standing. These deals were the ones on which the lenders felt that there were no short, medium, or long term values that could be created. Therefore, an immediate sale was deemed appropriate.

The next wave of REO properties will be assets which are functioning communities but are simply overleveraged for today’s market. These will be the classic “Value-Add” deals mentioned above. The original investor comes in and does renovation, but cannot move rents. The properties generate net operating incomes (“NOI”) but it falls well below the debt service level. Typically, the lenders remove current borrower and place a receiver into the property. Once new management has been established, the property will be “tuned up” a bit with minor maintenance and tenant profile adjustments. These deals will get good investor interest as they will support agency financing (just not at the current loan balance) and will be easily transacted. The caveat here is that the only viable investors for below investment grade properties are usually the private groups. Eventually, these groups will be limited by the supply of available equity.

The final wave of deals we expect to see from lenders will be the classic term default. Rather than paying down their existing unpaid principal balances (“UPBs”) to meet current debt service coverage ratios (“DCR’s”), owners will simply walk away from their properties when their notes are due. The large wave of these defaults will begin to appear late in 2010 and will continue for several more years. This figure will be compounded by the number of extensions, which will expire during the same period, that are being granted today. Again, these properties will be performing but will probably not underwrite to their loan balances. Additionally, appraisers will have several years of REO sales data to look at for their underwriting. This will undoubtedly put downward pressure on pricing and lender underwriting.

The sheer amount of deleveraging that the market needs is both obvious and monumental. The question appears to be in the timing of the REO disposition. With cap rates rising quickly and rent rolls continuing to slide down, with no short to medium term relief on the horizon, we believe that the “first mover” will fare better than those who take a wait-and-see-attitude. Lenders who find themselves with short and medium term problem properties need to educate themselves and move quickly to resolve them before appraisers have a lot of historical sales and the capable buyers reach their own capacity.