Morgan Walsh is a commercial broker with 20 years experience in investment sales, multifamily and specialty sales, representing buyers and sellers, institutional and private developers in market rate apartment sales, mixed-use residential devepment and the development of affordable housing projects.
Apartment investors model asset returns based on rents, occupancy, expenses and leverage assumptions, and every leveraged acquisition begins with known terms of debt service. But while rents, occupancy and expenses are highly predictable factors based on rental demand, household formation and inflation, the terms of future leverage remain disquietingly uncertain. That uncertainty jeopardizes not only the successful operator who can’t re-finance, but also the buyer with a holding horizon beyond five years, and the owner of a weakly performing asset with substantial debt.
Historically, owners, investors and lenders to the apartment industry valued predictable terms of leverage because it permitted a forecast of investment returns over long maturities, a value especially useful in a commodity apartment market like Reno. The advent of GSE financing added further predictability by guaranteeing the availability of financing. In the current market, financing remains readily available with a steadily mounting list of caveats. Does the loan term fall short of the investor’s holding horizon ? Can the loan be re-underwritten at maturity without a principal reduction ? Will the buyer’s leverage deal support the seller’s future asking price ? How will debt service be handled if the asset value declines ?
Strongly capitalized, sophisticated investors buying stabilized, well-located investments still command leverage offering long maturities, low spreads and little flexibility. The investor who relies on a ready re-finance market, a net revenue stream that can withstand re-underwriting, a rising rental demand, controllable variable expenses, and the availability of new equity if needed is facing unprecedented uncertainty in handling debt service. Some investors respond by changing their acquisition metrics to create a value cushion in return, basis, asset quality and market, or all four. Buy right and you have pricing power, staying power and leverage opportunity. Unlike buyers in the 2003-2006 era, few investors now predicate their acquisitions based on a fixed, short-term exit. But the median apartment buyer with a reasonable return objective still needs to re-finance the loan deal, still needs to manage debt service until robust employment returns and still needs to deal with the buyer’s return objective when the owner goes to market in the future lending market which drives the cap rate for apartment assets.
Leverage uncertainty used to be discounted by owners and investors who held through the financing heyday of rising asset values. Massive deleveraging now shows that uncertainty is present in all of the factors which control credit availability: underwriting, asset strength and performance, personal liability, loan ratios, maturities, and property market performance and forecasts. Buyers in the current market are quantifying that risk by bidding up cap rates aggressively, by treating the computation of net operating income with all the deductions now applied by the loan underwriter, or modeling returns based on modest leverage. What few investors are doing is discounting the availability of GSE financing as we know it, yet FNMA and FHLMC just received an S&P downgrade and the long-term solvency of the agencies is in question.
Apartment investment has always been seen as the safest way to own commercial property. When leverage uncertainty is fully worked into the market demand for apartment property, the asset value needed to deliver that safety may lower prices more significantly than owners and buyers now expect. And in the background of these events is a lending industry refining a nimble, robust machinery for efficiently transferring distressed loan assets from borrowers without re-finance opportunities to large players in the distressed property markets.