COVER STORY, JUNE 2006

THE RATING GAME
Rising interest rates and a lack of available product have done little to curb investor appetite for multifamily property in the Midwest.
Kevin Jeselnik

The multifamily market in the Midwest is rebounding well after a few years of struggle, improving across the region due to a number of factors. Development activity is still slow, which is helping to reduce vacancies in the existing properties, and higher interest rates have driven potential homebuyers back into the rental pool. All in all, the multifamily market is on an upswing, and Heartland Real Estate Business recently spoke with Susan Branscome, principal in the Cincinnati office of Q10 Triad Capital Advisors; Jim Clifford, executive vice president and chief credit officer of Minneapolis-based Marshall BankFirst Corporation; and Brian Manion, vice president in the Northbrook, Illinois, office of Reilly Mortgage Group, about the biggest trends and factors currently impacting the Midwest.

HREB: What are your thoughts on the current state of the Midwest multifamily market?

Clifford: Overall, we see a steady demand for multifamily product around the Midwest. Redevelopment and conversion of apartments to condos is continuing, and is helping the for-sale and rental segments. In first and second-tier cities, there is continued appetite for living and working downtown. However, due to over-supply and rising interest rates, there are concerns in major markets as to whether adequate absorption will occur.  

Branscome: The current state of the market is very competitive. There is a lot of capital on the market to finance apartments and multifamily, yet there is not as much property to finance. So, the result is low spreads for multifamily, more aggressive underwriting, and more flexibility on the loan structure and document.

Manion: Acquisition financing remains strong, even though rates have risen by approximately 85 basis points since late last year. We see a lot of capital out there; the conduit spreads have increased in comparison to Fannie Mae and Freddie Mac [spreads]. There remains an enormous amount of money chasing deals on both the equity and debt side. So far, things have continued at a furious pace nationally, less so in the Midwest, but there is still good activity, especially in Chicago.

HREB: How does the Midwest stack up to other regions when it comes to the current multifamily market?

Manion: The Midwest markets aren’t as dynamic as the South or the West, and properties don’t trade as often; people in the Midwest tend to hold on to real estate longer than in other markets. We are not seeing as much refinancing or acquisitions in the Midwest when compared to other places in the country.

Cap rates may be higher in the Midwest than they are in other markets, but there is not as large a discrepancy as there used to be. Between a market like Fargo, North Dakota, and Southern California, there used to be 400- or 500-point difference in cap rates. Now, there is maybe a 200 basis point difference.

HREB: How are the interest rates affecting the market?

Branscome: Interest rates have risen approximately 40 basis points in the last several months. When rates go up, loan dollars go down, because loan dollars are driven by debt service coverage ratio. With the rise in interest rates — if long-term rates continue to go up and stay up — cap rates are bound to follow, because the returns on investment will go down, and the price of the properties will naturally go down.

Clifford: For developers, the larger the project and longer the construction period, the more the interest rate means to them. Smaller projects that are completed within 12 to 18 months have less interest rate sensitivity than major, multi-story condo projects. For investors, the same holds true. For the larger projects, they need a higher return on investment to cover their cost of funds. Rising rates mean they could potentially be looking at other asset classes for equal or better returns.

HREB: What potential issues could arise as the cap rates remain low and interest rates rise?

Manion: We haven’t really seen cap rates change at all to this point. In fact, I think in the last 6 months, cap rates have trended down slightly.

I do believe that, at some point, cap rates will have to go up a bit — maybe not in lock-step with interest rates, but they will have to go up.  With fewer condominium converters biding on existing multifamily properties, this should also put upward pressure on cap rates.

If you look at it from a historical perspective, however, cap rates, interest rates and spreads all remain low, at least for the time being.

HREB: How are lenders reacting to this change in their market brought on by the rising interest rates?

Branscome: I think that some of the underwriting has gotten pretty aggressive. I don’t think it’s a problem so long as the fundamentals and the rents continue to go up. Lenders can compete through several different avenues. They can compete on terms, and that is rates and loan dollars, and they can compete on flexibility. There is so much capital and so few deals to finance that suddenly everyone is being flexible.

Manion: We see a lot more financial engineering today. More and more, borrowers are looking to get as many dollars as they can, going down to a 1.10 debt coverage ratio, and in some cases, less.  In order to compete, Lenders continue to become more aggressive, and more deals are getting customized.  A few years ago, we were underwriting at 1.30 debt coverage ratios and then moved down to 1.25.  Now we are talking about 1.15 debt coverage ratios — and if you bring mezzanine financing into the picture, you’re going to be at break even.  It’s becoming more mainstream to do a high-leverage loan, going up the capital stack by putting two or three pieces together that add up to 85 or 90 percent loan-to-value.

HREB: How are the borrowers reacting?

Branscome: We see borrowers feeling pressure to lock rates based on the feeling that the rapid rise in interest rates will continue. The borrowers are feeling pressure to go ahead and lock interest rates in today, even for loans that are not yet expiring. They want to fix their interest rates now, not knowing where the rates are going to be in 6 months. So, they go ahead and pay the pre-payment penalty and lock the rate in now because it could be a point higher or 50 basis points higher a year from now.

Clifford: Borrowers continue to increase the use of mezzanine debt in their financing structures as this capital — from REITs, hedge funds, etc. — becomes more available to smaller developers. End financing for stabilized and credit tenant-based projects is also plentiful, and is being provided by an ever-increasing array of providers including conduits, insurance companies and REITs.

HREB: Is lending activity still weighted more heavily on acquisition/investment financing as opposed to construction/permanent financing?

Clifford: Our firm has primarily focused on development and construction lending for the last several years. So, our perspective is skewed in that direction. Overall, we see a balance, where those that have acquired sites (in the last 6 to 12 months) are now going forward with appropriate pre-sales and reservations. And we still see an abundance of acquisition lending in urban areas of the Midwest. Both sectors are heavily driven by demographics, economic prosperity and consumer confidence. Our feeling is that even a modest rise in rates will not quench demand if markets meet these tests.

HREB: What lending institutions are most popular right now with potential borrowers?

Branscome: A few years ago, when short-term bank rates were so much lower, banks were our biggest competitions, and borrowers were staying at the banks to benefit from lower short-term interest rates, lower LIBOR and a lower prime rate. That was our competition in the permanent market. Now, with the inverse flat yield for short-term rates and long-term rates, there is no compulsion on the part of borrowers to stay with the banks. They’d rather fix the rate long term if they are going to finance it.

Manion: Banks are still very popular, especially in the Midwest where fewer Borrowers are concerned with some portion of recourse.  However, Fannie Mae, Freddie Mac and Conduits still offer the best overall non-recourse terms in the Multifamily industry. 

Branscome: In the last 2 to 3 years, there have been times when Fannie Mae and Freddie Mac have dominated the multifamily market, with their pricing being so low. What we’re seeing is conduits and life companies coming into the fold and offering just as competitive terms and some more so in terms of interest rate and loan amount.

HREB: How are the Midwest apartment markets faring?

Branscome: The apartment market is strong [in Cincinnati]. Every quarter, it continues to improve in terms of vacancy in every segment because of the lack of new construction. The condo market has been white-hot downtown. A lot of older office buildings that are functionally obsolete have been converted to condos, and there is a real demand for condos downtown and across the river in northern Kentucky.

HREB: How is the condo conversion market affecting the multifamily market?

Manion: The condo conversion trend is having a positive impact on the occupancy rates of apartments. I think Chicago is 96 or 97 percent occupied today, which is about 10 points higher than it was 2 years ago.  With so many apartment units being taken off-line over the past few years it has definitely solidified the apartment sector across the country.

HREB: How would you describe the development activity in the Midwest? How is it affecting the multifamily market fundamentals?

Branscome: Development activity is pretty slow for a couple of reasons. Construction costs are way up, because Hurricane Katrina and the construction going on in the Gulf Coast region has raised material prices.

Also, the income coming from apartment properties, compared to how much it costs to construct them, isn’t justifying the construction of new units. Only about 95,000 new units are being constructed in the country.

But, the lack of new construction has helped the market. Vacancies have continued to drop, and for the first time in probably the last year, I have heard borrowers and owners getting rental increases.

HREB: What do you think we will see in the Midwest multifamily market for the rest of the year?

Clifford: It all depends on the economy and the Federal Reserve’s reaction to the economy’s strength or weakness. We believe the Fed is close to its target rate, and we may see a pause in tightening. However, continued strength in job creation, rising oil prices and inflation concerns could mean continued rate hikes throughout 2006. The rate curve continues to be flat with relatively small premiums for longer-term credit structures, which, if sustained, will favor real estate development markets. And, the regulatory environment is presenting itself as a potentially negative factor in the real estate lending industry.

Manion: I think it is firing on all cylinders at this point. Even in markets that have historically not attracted as much capital and had higher vacancy rates, lenders are working aggressively to capture that business.  Historically, interest rates, spreads, and cap rates are still low, and if that continues, the multifamily market will perform well.

Branscome: I think we’ll continue to see interest rates increase. The loan amounts will be lower, as they are driven by debt service coverage ratio.

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