Both sides now

With the subprime challenge before us, it may be time to consider secondary and tertiary markets.

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For the past few years, the focus of the multifamily industry has been riveted upon “high-barrier-to-entry” markets, primarily metro markets in sunshine states such as California, Florida, Nevada and Arizona or cities along the Northeast Corridor such as Boston, New York and Washington, D.C.

With population influxes and limited land availability, high-barrier- to-entry markets enjoyed constrained supplies in the rental pool. National demand for apartments was averaging about 430,000 units per year whereas the delivered supply has been about 200,000 for the past few years. Insatiable demand for rental units has greatly facilitated owners’ and managers’ ability to implement significant rent increases on an annual basis.

With revenue growth outpacing operating costs, property values continued to appreciate at a frenetic pace. As a result, many companies quickly disposed themselves of investments in secondary and tertiary markets in an effort to concentrate their interests in these golden markets. Strong market fundamentals, historically low interest rates and lucrative returns associated with multifamily investments had made equity relatively easy for investors to come by, until recent months that is.

The subprime effect
Fallout from the subprime lending implosion may soon cloud the investment waters in high-barrier-to-entry markets. The multifamily industry and the housing industry are intimately linked and the repercussions from of the subprime meltdown are likely to be the worst in high-barrier-to-entry markets in which property values escalated wildly.

Investors may wish to reexamine their portfolios and rethink their market allocation strategies before the chinks in the armor of these impregnable markets are exposed. As renters and investors alike try to shield themselves from the blows of unscrupulous lending practices in the wake of the subprime mortgage disaster, some might recommend that investors consider retreating back to the secondary and tertiary markets they hastily departed, as these resilient markets are proving to be immune to the repercussions of the subprime lending crisis. Investment mania for multifamily assets in high-barrier-to-entry markets was in many ways reflective of the residential housing bubble forming in those same markets during that time. As housing values continued to escalate and interest rates remained low, lenders were frantic to capitalize on market conditions.

With little regulatory oversight, lenders stretched their lending practices to many prospective “subprime” home buyers who, due to impaired credit histories, short credit histories or large amounts of debt relative to their incomes, made them high risk candidates and excluded them from qualifying as “prime” mortgage borrowers.

Moreover, caught in the frenzy of appreciating property values and the home purchasing craze, many subprime lenders speculated that property values would continue to appreciate (thereby minimizing their exposure) allowing borrowers loan to value ratios of up to 95 percent.

With Fair Isaac Company (FICO) credit scores averaging 605 (borrowers with credit scores below 620 in the FICO system are generally considered as “subprime” borrowers) as opposed to 721 for lower risk “prime” candidates, “subprime” borrowers typically pay on average 3.7 percent more interest on their loans. Preying upon uneducated “subprime” borrowers caught up in the hype of the housing market, mortgage companies were lending to subprime borrowers under terms which the borrowers did not fully understand.

In many cases, these subprime borrowers ended up with adjustable rate mortgages (ARMs). Adjustable rate mortgages’ interest rates are tied to a financial index, such as the London Interbank Offered Rate (LIBOR) or the 12-month Treasury Average Index, with the mortgage interest rate being that of the index plus an additional margin.

As their name implies such rates are adjusted periodically in conjunction with the index. If the index rises, so does the amount of interest paid on a mortgage. In markets where housing values are particularly high, such as high-barrier-to-entry markets, home buyers found it necessary to take out larger mortgages to afford their homes. Larger principle balances result in higher interest payments.

Analysts estimate that resets could boost payments for borrowers by between 30 to 50 percent. As subprime lenders mortgage payments were adjusted, many realized that they could no longer afford their mortgage payments. When this started happening, the housing bubble in these markets burst.

Home values began a downward spiral and because of previously skyrocketing property values, the cost of home-ownership was generally regarded as elusive for most citizens, decreasing market interest; bringing the housing boom to a screeching halt. Subprime borrowers suddenly found themselves unable to afford homes that had dropped in value, leaving them with loans that exceeded the value of their home (negative home equity). Over leveraged and unable to afford their mortgage payments, qualify for refinancing or able to sell their homes many “subprime” homeowners found themselves with no alternative but foreclosure. As a result, billions, if not ultimately trillions of investment dollars are being lost as subprime lenders have begun declaring bankruptcy in record numbers this year.

Is the worst behind or ahead?
The National Association of Realtors suggests that as many as 2.5 million homeowners who secured ARMs when interest rates were low are going to see their rates reset this year ($350 billion in loans), resulting in widespread payment shock (severe escalation of mortgage loan interest rate unplanned for by the borrower) and heralding more turbulence in a lending market which many would like to believe has put its worst days behind it.

These woes have affected the capital markets as many lenders pooled, repackaged and resold subprime loans through loan securitization. In pooling loans, the process of securitization reduces risk while increasing liquidity and funding by efficiently allocating risk to the investors most willing to bear it.

Through securitization, the subprime mortgage market has greatly strengthened its links with broader capital markets since the early 1990s. In 2000, the number of proportion of outstanding subprime loans was roughly equivalent to the proportion of prime loans in securitization, at about $100 billion or 42 percent of the $240 billion which was not much less than the 53 percent of conventional prime loans in securitization.

As homeowners began foreclosing, investors who had been enjoying substantial returns in loan interest, suddenly found themselves with portfolios that were hemorrhaging value and sustaining significant losses. In the ensuing panic to mitigate their losses, the market quickly flooded with investors looking to sell their securities.

Unable to sell, investors became stuck holding portfolios that are losing money at alarming rates, some hedge funds losing billions. Moody’s Investors Service reports that subprime bond created during the first half of 2007 are going to delinquent at the fastest rate ever. Similarly, lenders that have held onto their loans, are finding themselves with a liquidity issue, having no more cash to loan.

While the aforementioned high-barrier-to-entry markets will undoubtedly continue to enjoy unabashed success due to simple fundamentals of supply and demand, the ripples of the shock wave from the subprime mortgage crisis initially seem to have caused lending standards to tighten quickly, making equity for investors more costly to come by.

In retaliation to the economic blows suffered by subprime loans, lenders are expecting greater returns (higher interest rates) on loans to reduce their risk exposure and are insisting upon lower loan to value ratios (the amount of the mortgage lien as a percentage of the total property value). This means that investors must provide more of their own equity in order to obtain more expensive financing. Therefore, tightened lending standards could potentially impede investment activity in high-barrier-to-entry markets by all but large real estate investment trusts and institutional investors.

Keeping cap rates low
Moreover, capitalization rates (a property’s income relative to the property’s value expressed as a percentage) or cap rates, have reached historical lows exacerbating the difficulty of investing in high-barrier-to-entry markets through the corresponding high property values.

Marcus and Millichap expects investors’ favorable perception of apartments, both nationally and internationally, will continue to keep cap rates low with perhaps an increase of only 25 to 50 basis points in response to the credit crunch. With cap rates at unfathomable lows, many investors have found it increasingly difficult to achieve desired returns on investments in many major metro markets, as projected cash flows have dwindled in the face of overwhelming debt service.

Under such economic conditions, the viability of investments in a sunshine state or the Northeast Corridor will most likely diminish for all but large institutional investors.

The subprime mortgage debacle will not only impede investments in high-barrier-to-entry markets but it is more than likely to have an adverse effect on the rental markets and the rental pool in those areas as well.

More than a third of all adjustable subprime loans in the U.S. are in California, Nevada, Arizona and Florida. Foreclosures will continue to force homeowners back into the rental pool.

While this may sound enticing to many multifamily investors, these renters will be returning to the market with severely compromised credit histories. Many of them with little or no savings left. One small financial crisis could easily hamper their ability to pay their rents, provided that they are even able to be approved for residency with poor credit ratings.

The shadow market
Worsening matters, many speculators purchased homes in high-barrier- to-entry markets during the housing boom expecting to sell them at a profit in a few years time. With reductions in housing values and a slow down in sales following the subprime meltdown, these owners are left with no other alternative than to rent for the foreseeable future.

These homes along with foreclosed units returning to the market have led to the emergence of the so-called “shadow market.” Jack McCabe, CEO of McCabe Research and Consulting in Deerfield, Florida, was quoted as saying “the shadow market is sizeable and any comment to the contrary is horse puck. We are seeing concessions return to the rental marketplace in Florida, which is a microcosm of everything that will happen in the rest of the country.”

The prognosis for the shadow market’s lifespan seems excellent, given the following: the National Association of Realtors announced in early October that its index of signed purchased agreements fell 6.5 percent to its lowest level on record; homes sales in August 2007 were down 22 percent from the prior year; more than 10 percent of the signed contracts in August fell through because buyers could not secure financing; and USA Today reported in September that only 2.7 percent of people plan to make a home purchase in the next six months. All the aforementioned indicators point to continued stagnation of current economic conditions.

The prime
While the Federal Reserve cut the federal funds rate (the interest rate that banks charge each other to borrow funds) and the discount rate (the interest rate at which the central bank charges other banks for loans) in September by a half point, there is some skepticism as to whether or not this will ease lending conditions for the multifamily investment industry or subprime homeowners.

Banks are often expected to lower prime lending rates in response to a reduction in the federal funds rate. However a reduction in the federal funds rate will not necessarily remediate the current situation. Since the half point reduction in the federal funds rate, 10-year Treasury rates have increased, not decreased.

The 10-year Treasury was at 4.66 percent at the end of September as opposed to 4.30 percent earlier in the month. The 10-year Treasury is one of the indexes commonly used for commercial mortgages and would indicate that the reductions in the federal funds rate have not made equity any easier to come by.

While President Bush and Congress scramble to introduce legislation that would allow companies Fannie Mae and Freddie Mac refinance more at-risk loans, many analysts believe it will make no difference as many of the loans were made with such loose standards.

The “subprime” mortgage meltdown is going to be most pronounced in the same high-barrier-to-entry markets where housing prices ballooned at unimaginable rates along with multifamily property values. Many multifamily investors whose portfolios are in these markets will struggle in the aftermath of the mortgage crisis.

Indeed, many have already begun to do so. The Apartment Finance Today Index, which tracks the financial performance of the stock prices of some of the largest multifamily companies (many of whose portfolio’s are now concentrated in high-barrier-to-entry markets), registered its lowest reading since April 2004 in August, losing 17.91 percent of its value within two month’s time.

While high-barrier-to-entry markets continue to wrestle with the repercussions of the subprime mortgage debacle and investors interested in those markets continue to find it increasing hard to find affordable equity for investment purposes, a rosier picture can be painted for many secondary or tertiary markets, such as Rochester, N.Y., and the investors that are interested in them.

Secondary or tertiary markets have demonstrated better immunity to the subprime epidemic than some high-barrier-to-entry markets. Many of the market conditions that precipitated the meltdown of the subprime lending industry, primarily rapid and unsustainable appreciation of property values, were non-existent in secondary and tertiary markets.

While a couple of years ago many homeowners in markets such as Rochester might have been lamenting the fact that housing values were appreciating only modestly in comparison to the astronomical gains made in many high-barrier-to-entry markets; today they are happy to note that while home values in many parts of the country continue to depreciate, their homes continue to gain modestly in value.

The safe zones
In 2004, the median home sales price in the United States was $225,000 whereas in Rochester it was only $115,000. Today the median home price is $125,000. While an 8.6 percent appreciation over three years may not sound very impressive, it is certainly preferable to helplessly watching home values erode and finding one’s self with negative home equity.

Yale University professor, Robert Shiller presented a paper to the Federal Reserve in September in which he stated that it was entirely possible that 50 percent declines in home prices could occur in some places in the not too distant future. In fact, the national median home price is poised for its first annual decline since the Great Depression.

However, such will not be the case in many, secondary and tertiary markets where housing values were not artificially inflated. With housing prices that were well below the national averages, homes were more affordable. As such, borrowers accumulated less debt when they purchased homes and have been able to continue to meet their financial obligations in the aftermath of the subprime debacle.

As speculators were not rushing to purchase homes in secondary and tertiary markets, the threat of an emerging shadow market does not exist to entice renters away from multifamily properties; while the much publicized subprime crisis has deterred them from considering home purchases (as have tightened lending standards). Therefore, the same quality renters that were residing in apartments have continued to reside in apartments, improving retention rates.

McCabe Consulting and Research reported that occupancy levels in South Florida are hovering at 92 and 93 percent, which was a drop of 4 to 7 percent from the third and fourth quarters of 2006. If one believes CEO Jack McCabe’s assertion that Florida’s marketplace is a microcosm indicative of the rest of the country, particularly the high-barrier-to-entry markets, then one can conclude the same is in store for many similar high-barrier-to-entry markets.

The Upstate NY market
Compare this to average occupancies in Rochester, N.Y.: The Cabot Group, a real estate firm headquartered in Rochester has witnessed an increase in occupancy levels from an average occupancy of 90 percent in 2005 to an average occupancy year-to-date of 94.8 percent in 2007. Needless to say, rent increases generally mirror occupancy trends and while concessions are making their way back into the Florida markets, they have all but disappeared in Upstate NY.

While some companies, like Home Properties, also headquartered in Rochester, chose to divest themselves of all their assets in the Upstate market (and other secondary or tertiary markets such as Detroit) and reinvest in high-barrier-to-entry markets as competition for properties in the high-barrier-to-entry markets came to a boil; other investors such as Morgan Management, another Rochester firm, have focused their attention on secondary and tertiary markets, quickly acquiring properties in the wake of Home Properties departure.

Instead of paying upwards of $150K per unit to acquire investment properties, many smart investors recognized the opportunity to add properties to their investment portfolios at half or a fraction of the cost in markets where competition was not quite as stiff.

Multifamily properties in Rochester typically range in value from $30,000 to $70,000. Investors have been quickly rewarded as property values are appreciating modestly while cap rates are favorable for investment in comparison to many other markets.

It is here that many multifamily assets are being acquired at cap rates in the 7 to 8 percent range. Investors who do not have the financial resources of large institutional investors are able to acquire multifamily assets that would be beyond their means in the high-barrier-to-entry markets.

Investment properties of a couple hundred units can be had for the same price as a property just a fraction its size elsewhere. In such circumstances, the investor is additionally rewarded by enjoying better economies of scale.

Companies that have chosen to keep balanced portfolios by not forsaking investments in secondary and tertiary markets in lieu of placing all their interests along the coasts or Sun Belt may be proven to have made very strategic decisions in the long run.

While demands for apartments in high-barrier-to-entry markets will continue to draw the eyes of many, it seems counter intuitive that the American populace will continue to migrate indefinitely toward these markets. The cost of living in many areas is becoming prohibitive and routines of daily life laborious.

In many high-barrier-to-entry markets, rent and/or mortgage payments continue to eat up greater percentages of the median income, in many cases, precipitously higher than the advised 28 percent margin advised for the housing expense-to-income ratio typically used by the mortgage industry.

Factor this with elongated commute times and rapidly dwindling natural resources such as water in many areas and it could easily lead one to conclude that secondary or tertiary markets have a good likelihood of becoming the desired markets of the near future. After all, renters in the high-barrier-to-entry markets will not be able to sustain large rent increases on an annual basis indefinitely as rent increases drastically outpace the growth of their personal incomes.

Leanne Lachman, president of Lachman Associates LLC has conjectured that current wage and immigration trends will create the strongest demand for B and C quality apartments.

In secondary and tertiary markets, B and C quality apartments constructed in the late 60s and early 70s often comprise the greatest percentage of the market share. With affordable housing, low cost of living, short commutes, abundant recreational opportunities, the Rochesters of today may be the San Diegos of tomorrow.

Expansion Management magazine recently ranked the Rochester region as number one for overall quality of life among metros with populations of 1 million or more, and a “5-Star Business Opportunity Metro,” considering it a premier place for companies to do business in the U.S. This rating was also endorsed by Inc. magazine.

The effect of the subprime collapse may be felt more keenly by multifamily investors in the high-barrier markets versus those in the secondary or tertiary markets. Time may prove investors in secondary and tertiary markets had great insight as sub-markets gain national media recognition for their quality of life and low cost of living. These markets may also catch the eye of investors quick to discern good market fundamentals, and the secondary and tertiary markets’ resilience to the current subprime quagmire.

Therefore, perhaps a word of caution is merited to those investors and multihousing executives who have expounded the virtues of high-to- barrier-entry markets to their possible detriment. You may want to take pause and reconsider the virtues and long term prospects of secondary and tertiary markets, for they may one day soon be a more promising deal.

Author: Jordan Debes is director of the multifamily management division of The Cabot Group in Rochester, N.Y.