By John Burpee, president, NAI Tampa Bay
Unless you have been living on a mountaintop in Tibet with no cable TV for the last 6 months you already know that the credit markets are on a rollercoaster ride and the Fed is desperately trying to bring order back to the schoolyard. So what does the Fed and Wall Street have to do with the value of apartment properties across the country? Everything. First, every buyer in the market today and every lender behind them is only concerned with actual income not projected rents or future ancillary income from sub-metering or cable contracts. Lenders will only use the current rent rolls for underwriting purposes and place no value on future rent growth projections. Many markets are predicting rent decreases for the next 18 to 24 months so pro-forma growth forecasts carry no weight in the underwriting procedures for today’s loans.
Most lenders have started using internal expense models to validate operating costs relevant to certain markets. A lesson learned from the amount of condo foreclosures, they are now forced to return to rental markets that make no financial sense. An example would be that in coastal states whose insurance rates will average $650 per unit per year annually and as high as $1,000 per unit in some areas that are considered high impact zones. Lenders have also started looking at the impact of increased property taxes on future cash flow and using the projected increase amount in their underwriting procedures. Lenders are now using these models to establish their own expense ratios and comparing them to the actual expense model provided by the borrower. If the borrowers ratios are out of the lenders comfort zone, the lender plugs in their internal expense guidelines and underwrites the loan according to their model.
What buyers have learned is that lenders are setting the values in today’s markets. Gone are the condo converters buying on price per square foot pro-forma’s. Gone is the easy interest only mortgages and loose underwriting. Gone are 30 percent expense ratios and 3 percent cap rates. Here today are the back to basic bankers and buyers that stand ready to do deals but only at terms and prices that make financial sense. Cash Flow is the name of the game today and cap rates are king! Buyers have learned to depend upon lender underwriting as a guideline for submitting purchase offers. Recently an acquisition director for a private equity firm told me that they will no longer enter into negotiations unless they know they have a financing and equity commitment in place before making an initial offer. This way they know if the seller agrees to their offer they have a deal and are able to close. If not, they simply move on to the next property.
Unfortunately, most sellers have adopted a wait and see attitude toward current market conditions that has led to stagnation in the overall multifamily sector. Many believe that current conditions are temporary and prices will recover in the next 18 to 24 months. Most believe their properties are worth 20 percent to 30 percent more than current market conditions are reflecting, and have adopted a “we will wait it out” mentality. What many do not realize is that the last five years of apartment values was an anomaly. The perfect storm of low interest rates, aggressive condo converters, loose underwriting and plenty of Wall Street equity led to unprecedented increased values. Like all storms, this one has past and we are now left with cleaning up the damage and correcting the market. Further, many investors fail to realize that the inflated markets of the last five years will not return overnight and perhaps never again. Buyers and lenders today are much more financially savvy and no longer have easy money to throw around. Buyers are looking under every rock, walking every unit, demanding 3 years certified financial data and when something smells fishing they simply turn, and walk away from the deal. Many markets that experienced double digit increases are now experiencing double digit declines. Many markets that once held the promise of five to seven percent annual rent growth are now struggling to just maintain current rents and occupancies hoping to keep rents stable.
Many investors are experiencing value shock at the worst possible time, when their current loans are resetting and they can no longer find a lender willing to refinance the current outstanding principal amount owed. Many are faced with increased capital calls to reduce the outstanding principal amount of the debt because lenders are reluctant to refinance assets that do not make financial sense at current debt levels and priced above current market conditions. Faced with either coming out of pocket to decrease principal debt or selling at current market conditions has left many investors in a desperate situation. When faced with this scenario most investors choose to brave the market and take the best offer on the table, unfortunately it usually means a loss of equity either way.
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John Burpee is president of NAI Tampa Bay and chairman of NAI Global Multi Family Group.