COVER STORY, JUNE 2004

THE DRAW OF MULTIFAMILY
Lenders and investors continue to succeed with multifamily properties.
Chris Thorn

The eastern and western regions of the U.S. have seen the multifamily market strengthen this year, but the Midwest is continuing to see a depressed market. While this is not good news for multifamily developers, multifamily lenders are enjoying a healthy investment market in the Midwest. Heartland Real Estate Business (HREB) recently spoke with several experts to see how multifamily lenders are faring and what they expect the market to do for the remainder of the year. The experts include John Siff, president of Prairie Realty Advisors; Andrew Fawer, managing director of real estate finance for CIBC World Markets; Barry Axelrod, vice president of Dwinn-Shaffer; Stuart Greenberg, senior vice president with GMAC Commercial Mortgage Company; Charles Krawitz, first vice president of real estate capital markets with LaSalle Bank; and John Davis, executive managing director with Collateral Mortgage Capital.

HREB: In what Midwest markets do you work?

Siff: [Prairie Realty Advisors] primarily operates in Chicago with coverage of Milwaukee/southern Wisconsin, Indianapolis, northwestern Indiana, southwestern Michigan, Rockford and Champaign/Peoria.

Fawer: [CIBC does] deals in Ohio, Indiana, Illinois, Wisconsin, Minnesota, Iowa and Kansas. In fact, not only do we have an office in Chicago, but we have a lot of coverage for the Midwest. We have very strong supportive opinions of the Midwest. It is a good solid market over time. The softness in the multifamily market has abated in a lot markets and is now confined to the Midwest. Those market conditions make every deal different. Who is the sponsor, how much equity is in the deal, what are the trends of that marketplace, and where are we underwriting it? Any market that has experienced softening has flattened out at this point.

Axelrod: [Dwinn-Shaffer] is national. We do a lot in Illinois, Wisconsin, Minnesota, Ohio, Indiana, Iowa, Kansas and Missouri.

Greenberg: [GMAC] works primarily in Illinois, Indiana, Wisconsin, Michigan, Ohio and Iowa.

Krawitz: LaSalle Bank, having its roots in the Midwest, is a well known and reliable source of multifamily financing throughout the region. In recent years, we have parlayed our Midwest success to become a national lender deeply committed to multifamily lending. More than 55 percent of our conduit lending is multifamily. In addition to this, we have a specialty multifamily lending operation known as LaSalle Bank Multifamily Finance Group (MFG) that focuses on small loans ($500,000 to $3 million) sourced exclusively by a dedicated network of residential/commercial correspondents.

Davis: Collateral Mortgage Capital has 13 offices nationwide, including the following Midwest locations: Columbus, Ohio; Indianapolis; Kansas City, Missouri; Milwaukee and Madison, Wisconsin; and Minneapolis.

HREB: What lending/development trends are you seeing in the multifamily markets in which you work? How are these trends affecting the availability of funds for multifamily projects?

Siff: Multifamily is currently the darling of the CMBS investors. Agencies had a record year last year. Fannie Mae closed more than $30 billion and Freddie Mac closed $20 billion in multifamily loans.

Life insurance companies participated on the fringe using long-standing relationships and creative tools, like forward commitments, early funding, float-to-fixed structures and additional collateral pools, to meet the challenges at hand. Life insurance companies have looked at their portfolios and creatively helped good customers restructure performing loans prior to expiry.

Finally, the banks remain vibrant in this area. Generally development deals and acquisition and transition situations are the staple of national banks, and the community-sized lenders are still solid sources of acquisition financing, rehab and long-term loans for the under $3 million relationship loan.

Fawer: CIBC does construction, bridge and permanent lending. We have also done a few ground-up projects and we have seen a lot of redevelopment projects. We are doing more redevelopment loans for older properties. Developers are bringing them up to market standards and there is plenty of capital available for that — both debt and equity. We provide the debt, but we have seen plenty of available capital for good redevelopment projects. There is a market is for good multifamily projects and exiting permanent loans. There also is plenty of capital for acquisition and permanent financing. We are in a market that has been very aggressive.

Axelrod: There is a concern among lenders for the oversupply of condominiums, particularly in larger cities. Apartments are one of the lending institutions’ most desirable products.

Greenberg: There is much more competition since lenders have an abundance of funds for all types of products. Some rent concessions and higher vacancy trends are an issue. Spreads are becoming tighter because of the pressure to put out money. Still, there is an oversupply of capital.

Krawitz: As interest rates rise, more and more people are being forced out of single-family homes and back into apartments. During the short run, this is allowing multifamily properties to minimize concessions and rebound ever so slightly in occupancy. The supply side continues to grow at a very slow pace. In addition, job losses plague the Midwest. The recipients of the current economic expansion, thus far, appear to be located on the coasts, and not in the Midwest. This may prove to be a boon for multifamily housing as it is a comparatively inexpensive housing alternative.

On a macro level, the trend is clearly toward homeownership, not away from it. As the Baby Boom generation ages, and wealth expands in the U.S., demographic analysis suggests that people are moving out of apartments and into single-family product. We are confronting a lull in population as embodied by Generation X that has serious implications for multifamily demand. It is not until the Echo Boom comes of age that there will be a wholesale increase in demand for multifamily product.

Davis: There is an abundance of capital in the marketplace, forcing lenders to be very aggressive to win quality business. Lenders are quoting full loans with between 2 and 5 years of interest only, allowing mezzanine debt to take overall leverage well beyond traditional limits, and offering innovative loan structures to meet borrowers’ needs. Examples of structures that have recently been introduced include Freddie Mac’s ‘Float to Fix to Float,’ where a borrower can get up to 2 years of a floating rate, convert to a predetermined fixed rate, and then have the final year of the loan term be a floating rate loan that is open to prepayment. This structure helps borrowers by providing a greater return during the first 2 years, limiting interest rate risk, and then providing for a flexible prepayment at the back end of the loan.

HREB: Is it easy to refinance a multifamily property in today’s lending climate? Why or why not?

Siff: Acquisitions are problematic in Chicago currently because cap rates are so low on prime deals that lenders are finding it difficult to underwrite the values. This puts pressure on the equity and has helped drive the mezzanine market to gap the difference. This translates to higher cost of capital, which makes the deals that much tougher to swallow.

Axelrod: Yes, due to a lot of apartment buildings being converted to condominiums.

Greenberg: Yes, for the most part. Multifamily properties are still a very desirable property for lenders to finance. Borrowers are aware that the rates are the lowest they have been in the past 35 years and have tried to take advantage of this.

Krawitz: Yes, although cash flows remain under pressure, interest rates are near historical lows, making the burden of vacancies and concessions easier to bear. Loans on multifamily properties enjoy low default incidences. Not only does multifamily product benefit from the involvement of Fannie Mae and Freddie Mac in the market, but securitization programs have a seemingly insatiable appetite.

Davis: Funds are readily available, but underwriting is still a challenge in that many markets are still recovering. Properties are experiencing an increase in operating expenses and real estate taxes. Capitalization rates continue to fall.

HREB: What are the optimum occupancy levels for lending on a multifamily project?

Siff: Stabilized occupancy is a function of a specific submarket. A property located in Lincoln Park in Chicago has different metrics than that of a suburban development in Aurora, Illinois. The quick answer is that the optimal occupancy level for everyone associated in a transaction is full.

Fawer: For redevelopment loans, we have gone down on our acceptable levels. With redevelopment loans, we have had deals that were 70 percent to 75 percent leased that had to be redeveloped. On permanent loans, the midpoint is about 85 percent on average. We have gone a little lower than that and we have gone a little higher than that. But, on average, it has been about 85 percent.

Axelrod: Our optimum levels are between 92 percent and 98 percent.

Greenberg: Between 90 percent and 95 percent. Most Midwest markets seem to be stable at this occupancy level.

Krawitz: Although an optimal level of vacancy is below 5 percent, the reality is that, dependent on the particular submarket, vacancy levels typically range from 5 percent to 10 percent.

Davis: The optimum level would be 90 percent and higher, though a borrower can certainly finance a property with occupancy levels lower than 90 percent. Lenders are providing flexibility and the ability to structure a transaction allowing unstabilized properties to be financed.

HREB: How are cap rates faring for multifamily projects in your area?

Siff: Falling interest rates created an interesting paradigm nationally. What might sell in Peoria for a 10 percent cap rate might trade in Chicago for a 6 percent cap rate. This is further impacted by the competition that might exist in certain markets for conversion properties. If interest rates rise, they will impact the cap rates. Currently in Chicago, there are transactions where there is negative leverage. This will not last very long.

Fawer: We have seen cap rates fall quite a bit in the last 12 months overall (not just in the Midwest). I have not seen any cap rates go up. They are certainly going down, and the pace at which they go down depends on the market. In Chicago, they go down a lot more, and again, there is a lot more condominium development or more conversion in Chicago than in Des Moines. So, there are different prices being paid for that. We have certainly seen cap rates fall across the board.

Axelrod: In the Chicago area and throughout the Midwest, we’re seeing cap rates as low as 4 percent; but generally cap rates are between 6 percent and 7 percent.

Greenberg: [Cap rates of] 6.75 percent to 8.5 percent are supportable in most markets that have stabilized. Depending on the specific deal, it could be lower or it might be higher than this range. It depends on the overall desirability of the situation.

Krawitz: Cap rates are at historical lows, but have bottomed out as interest rates appear to be on the rise. In addition, the stock market is no longer being perceived as highly volatile. This stability has induced many investors to return to the market. In comparison, real estate’s allure as a safe haven has comparatively declined. That said, real estate has enjoyed a broadening of appeal due to its tangibility in the face of corporate malfeasance and the punitive tendencies of the stock market in the face of bad news.

HREB: What are the average vacancy rates and lease rates for multifamily properties in your area? How does this affect a loan?

Siff: On a long-term basis in Chicago, vacancy rates have ranged from 3 percent to 8 percent and rents have increased steadily during the past 10 years, now ranging from $1 per square foot to $2.10 per square foot. With interest rates at historically rock bottom levels, homeownership has been very attractive. We continue to see pressure from that segment impacting vacancy rates as well as rents. Another factor impacting the metrics of multifamily is real estate taxes. In Chicago, the Northside reassessment has substantially impacted the returns of established owners.

Fawer: We take a look at vacancy as the economic vacancy, which includes concessions. So, we have seen it range from 8 percent to a high of 25 percent (economic). We identify trends and we look at the fundamentals of the marketplace. What is driving the demand generators in that marketplace? If we see a market that had an economic vacancy of the T-12 higher than the T-3, then we see the trend improving. If we see in conjunction with that, the available product coming on line and the end of the development pipeline slowing to nil, then we know there will be positive absorption. If we see more and more companies moving into the market, we know that there will be more jobs created. Making sure jobs are being created in these marketplaces is one of the challenges for the multifamily market right now.

Axelrod: The higher class properties tend to have higher vacancies than the Class B, C and D types because [B, C and D] tenants are less likely to buy a home or condominium.

Greenberg: Vacancies range from 5 percent to 10 percent. Rentals can range from 50 cents per square foot in the suburbs or second tier cities to $2 per square foot in the Chicago downtown area. It depends on the market area. The more stable the area and thus rental rates, the easier it is to process the loan with a lender and provide the borrower with what he is requesting.

Krawitz: Properties with loans in the range of $500,000 to $3 million have not suffered vacancy issues to the extent that larger, Class A projects have. Typically, occupancies have ranged between 90 percent to 95 percent on transactions of this size. On the larger deals, the effects of low-interest-rate-induced homeownership have been the most pronounced, causing occupancies to slip into the 80 percent to 85 percent range across the Midwest.

Davis: Higher vacancy ratios are being experienced in most markets. Also, we are seeing some concessions, which make underwriting a challenge. The historically low interest rates combined with an abundance of capital and the fact that multifamily is a preferred property type for most lenders, provides borrowers the ability to meet their financing needs.

HREB: What kinds of loans are multifamily borrowers asking for? Why these?

Siff: With interest rates still in the 5s, the owners are simply just trying to get their properties in a position to tap into today’s rates. We have been approached to secure forward commitments, interest rate caps and long-term loans from the sources of capital. The hottest products out there currently are the low floater DMBS (discount mortgage-backed securities) product offered by Fannie Mae and float-to-fixed product offered by the life companies. The life insurance companies will find a way to get the prime deals using creative means to gap occupancy shortcomings or construction completion issues.

Fawer: Some borrowers have been wanting less than 10 years since they think that there might be some upside and don’t want to stick around in 10 years. Others want 10-plus years because they see these rates never coming around again, and want to lock them in for the long term. We also have the ability to do fixed-rate loans with earnout. If someone wants to lock in rates to see more upside, we can do a fixed-rate loan and earn them additional dollars.

Axelrod: Most borrowers want to lock up a fixed rate of 7 to 10 years. With current spreads as low as 90 basis points during the 10-year Treasuries, today’s rates end up in the 4.75 percent to 5.75 percent [range]. Fixed as opposed to floating are most desirable. In addition, the availability of non-recourse loans is very high for fixed-rate loans.

Krawitz: Refinances are typical as borrowers try to lock in historically low interest rates. With the national election looming, the general feeling is that the Bush administration is doing everything in its power to keep rates low, thus encouraging economic activity. Offsetting this is a Federal Reserve that has taken a tenacious stance against inflation. Realizing this, real estate investors have been rushing in droves to refinance their properties while the going is good. In addition, transactional activity appears to be on the upswing as select markets have firmed.

Davis: Borrowers are frequently seeking loans with an initial interest-only period in order to maximize their initial returns. They also seek to combine fixed-rate terms with some prepayment flexibility.

HREB: What markets are you bullish to lend in?

Siff: We are bullish in all cities committed to being or becoming 24-hour cities like Chicago, Milwaukee and Indianapolis. Demand from empty-nesters and young professionals continues to drive demand for urban living. Suburban markets will continue to underperform until interest rates rise 200 to 300 basis points to balance the cost-to-own-versus-rent matrix.

Krawitz: LaSalle is bullish on all markets in the Midwest. We rely on our mortgage banking clients to fully explain the property in question and the underlying market dynamics. We do not red line markets due to higher concessions or declining rental rates. Instead, we proactively endeavor to understand what drives each and every deal. Fundamental to this is understanding “why do people want to live here?” Get us comfortable with this and we are well on our way to yes.

Davis: Real estate is a preferred asset class for most investors and multifamily leads that list. Most markets remain strong investment targets for lenders.

HREB: What are some large projects that have been financed recently?

Siff: [Prairie Realty Advisors] recently closed the following transactions in Chicago: American Heritage portfolio, a 16-property portfolio consisting of 1,100 units located throughout the north side of Chicago; 3200 N. Sheridan Road, a 196-unit pre-war building with a historical landmark designation; and 399 West Fullerton Avenue, a 32-unit co-op overlooking Lincoln Park.

Axelrod: [Dwinn-Shaffer] financed the 202-unit Westwood Pines in Columbus, Indiana, for $11.84 million. The property is owned by Oakbrook, Ill.-based GCA Properties.

Greenberg: [GMAC has financed] Park Evanston Apartments ($53 million) in Evanston, Illinois; Old Orchard Apartments ($16.2 million) in Grand Rapids, Michigan; and George Town Apartments ($9 million) in South Bend, Indiana.

Krawitz: [LaSalle] financed the Cornell Street Apartments in the Hyde Park neighborhood of Chicago. The 70,000-square-foot property has apartments above street-front retail.

We financed the purchase of this property under a floating-to-fixed rate arrangement earlier in the year. The property suffered from poor management and had vacancies well in excess of market levels. Within 3 months, the buyer was able to fully lease the property without offering concessions and roll into a permanent fixed-rate, non-recourse mortgage. The mortgage broker, Baird & Warner, was able to get us comfortable with the borrower’s capabilities as a property owner and manager by illustrating specific past performance on several like transactions.

Davis: Collateral Mortgage Capital funded Nantucket Phase I Apartments in January through its Fannie Mae DUS (Delegated Underwriting and Servicing) loan product. Collateral is one of Fannie Mae’s 26 DUS lenders nationwide.

Nantucket Phase I Apartments is a 298-unit multifamily community located in northern Cincinnati. The $22.5 million first mortgage loan was used to take out the construction loan for the property.

HREB: Overall, how would you rate the financing climate for multifamily properties in the Midwest?

Siff: This year, the market will remain extremely competitive and strong. Any expansion of employment in a market will drive demand for multifamily products.

Greenberg: Because of low interest rates, borrowers can easily find competitive rates and an abundance of capital. Currently sellers have no problem in selling their projects at or near the price they require. It is a positive time for multifamily financing in the Midwest with various opportunities available.

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