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Jan. 3, 2013

Investment Forecast

By Philip Shea, Associate Editor

As the dust settles from one of the most contentious elections in recent memory, multifamily professionals are looking ahead to new challenges—ones presented by both politics and market trends. While some are concerned about the level of government involvement in the overall economy, others are hopeful that a new level of bipartisanship can translate into renewed confidence and continued gains for the industry. Joe Greenblatt, CPM and president-elect of the Institute of Real Estate Management (IREM), is less hopeful about the divided government’s ability to work together and believes that new obstacles will continue to arise due to a marked reluctance on the part of elected officials to make tough choices, ones that could ultimately jeopardize their electability.“I expect continued stalemate,” says Greenblatt. “I don’t know that there exists in this government, in its current and future incarnation, the courage to confront the issues. There’s probably more of an inclination to defer dealing with deficits and chip away at the margins.” Greenblatt adds: “You look at the direction that the incumbent administration is going to carry forward—it’s not going to bode well for the economy.”Jim Tobin, senior vice president of government affairs at the National Association of Home Builders (NAHB), believes that the American people made clear they want bipartisanship by re-electing a Democratic president and Republican House of Representatives, and that this coupled with the magnitude of the challenges facing them will motivate lawmakers to finally move on the big issues.“I think on its face it can be called a status quo,” says Tobin. “I am hopeful that, now that we are past the election and the winners have been chosen, everybody will move toward finally addressing the big issues facing the country—whether it’s the macro-economic with job creation or economic growth.”

Scott Meyer, assistant vice president of government affairs at NAHB, agrees that there is room for cooperation and he thinks reform of Fannie Mae and Freddie Mac (i.e. GSE reform) is one issue where the parties are likely to find common ground in the next session of Congress.

“Everybody’s pushing towards reform, but maybe now there’s an opportunity for bipartisan consensus,” says Meyer. “If we can [agree] that there’s going to be some form of a federal backstop, I think we have a real opportunity to make some strides here.”

In terms of how the outcome of the election is likely to affect investments, professionals are taking various factors into consideration. However, none are more daunting than the so-called “fiscal cliff”—a series of drastic budget cuts and tax increases slated to take effect in January unless prevented by a reasonable deficit-reduction agreement between Congress and President Obama.

“If the Draconian effects of the fiscal cliff actually came into effect, I’ve seen forecasts [with] as much as a 4 percent negative growth in GDP, and if that happens, I think all bets are off in terms of investment outlook,” says Gary Tenzer, principal and managing director of George Smith Partners. “Assuming there is a resolution and at least some of the tax cuts are continued… I think that we’ll continue to see growth in the multifamily sector.”

Such growth, however, might be limited in certain areas, as high levels of deliveries over the past year have yet to be absorbed into the market—leading to high vacancies and sub-optimal rents.

“I think there are some markets that are overbuilt or are getting overbuilt, and I think that’s going to put some pressure on rents,” notes Tenzer. “But real estate is all local, so the dynamics of job creation within the locale of the projects will be very important.”

Additionally, while investors are likely to see smaller returns on investments overall in 2013, Tenzer believes that it will still be a strong year for multifamily and high-end properties in particular. While the housing crisis may be over, many are still unable or unwilling to opt for a mortgage, and Class A apartments are becoming increasingly attractive for this segment.

“Either they don’t have the down payment or they don’t have the credit anymore to qualify for mortgages, and they’re probably going to be permanent apartment dwellers,” says Tenzer. “There’s also the cohort of the population that are in their early 20’s who see job mobility as a very important aspect of their career and are probably going to be less likely to commit to a house and a long-term mortgage.”

In terms of what markets may represent the greatest opportunity for investors in the coming year, Tenzer notes a turnaround in some Western markets that were hit hardest by the recession. If handled properly, the chances of a sizeable return are considerable.

“There are certainly cities that have lagged that are coming back, such as Phoenix and Las Vegas, [in which] the values have not climbed as fast in the gateway cities like Los Angeles, San Francisco, New York and Washington,” says Tenzer. “They probably won’t be priced as aggressively as properties in San Francisco, but that doesn’t mean they’re not good investments—you just get into them at a lower basis.”

With respect to fresh policies pertaining to taxes and revenue, it’s clear that both rates and deductions will be on the table. While President Obama has emphasized raising the top income tax rate from 35 to 39.6 percent, Greenblatt is also weary of the administration’s expressed support for other methods of raising revenue—ones that could have a significant impact on the housing industry.

“If we’re talking housing, there’s great concern about the mortgage interest deduction, and that mirrors concern on the commercial side about all of the things that have been at issue in recent years,” notes Greenblatt. “Those would include the Buffett Rule, the capital gains issues, the carried interest issue—a host of things that are going to have a potential chilling effect on the economy.”

The “Buffett Rule,” first proposed by President Obama in 2011, would impose a minimum 30 percent tax rate on those making more than $1 million per year, whether through earned income or capital gains. The president would also like to begin taxing carried interest as ordinary income instead of capital gains—which has a much lower rate of 15 percent.

Tobin believes that the president’s second-term cabinet picks will be a strong indicator of his reform priorities. In particular, Tobin thinks Obama’s choice for Treasury Secretary will allude to where the administration wants to focus its energy.

“It’s widely speculated that Tim Geithner will leave his post at Treasury,” says Tobin. “Who takes over is obviously the parlor game here in D.C. now. There’s Jack Lew, who’s currently the Chief of Staff and former OMB director. Erskine Bowles is mentioned [as well]. Jack Lew is more of a budget guy; Erskine Bowles is more of a tax-reform, entitlement-reform guy who was the chairman of the Simpson-Bowles commission. They will signal whether Fannie and Freddie are high on their list or whether it’s a real run at tax reform.”

According to Tobin, there is a significant need for reform of Fannie and Freddie. While the government-sponsored enterprises (GSEs) “seem to be getting healthier,” there is still too much government control—and “we need to see the private sector move in. The way to do that is to tackle a comprehensive GSE bill.”

Tenzer agrees that the two secondary mortgage market giants need to be reorganized and emphasizes that while most of the impact will likely be felt by single-family, the multifamily sector would be able to weather any potential reduction in capital traditionally provided through the GSEs.

“Fannie and Freddie may get restructured in the next year or two, [and] they certainly need to do that,” says Tenzer. “What that’s going to do to the availability of capital for multifamily—I don’t know. To the extent that Fannie and Freddie pull back from financing multifamily, CMBS I think is ready to pick up the slack. There is very high demand for CMBS securitization.”

Tenzer notes that, up until now, CMBS has simply been unable to compete with Fannie and Freddie due to the latter’s higher credit rating and lower cost to capital. A 25 to 50 basis point difference in interest rates has bolstered the GSEs’ place in the market, yet a withdrawal of government support could quickly change this, and Tenzer thinks the “CMBS market will be there to pick up the slack.”

Apart from the issue of GSE reform, another major shakeup in the country’s regulatory environment, affecting all major businesses, is scheduled to take effect in about a year’s time. The Patient Protection and Affordable Care Act (i.e. “Obamacare”), which was signed into law in March 2010, will see most of its major provisions implemented in January 2014.

Greenblatt is especially wary of the looming health care overhaul, mandating all businesses with over 50 employees to provide health insurance or pay a tax penalty, which could result in decreased investment volumes for major real estate companies.

“I think that the opposition to Obamacare has been largely philosophical, but I think as we approach the realization of a very specific hike in taxes, there’s going to be an effect,” says Greenblatt. “We can anticipate that it’s not going to enhance the economic climate, it’s not going to increase spending and it’s going to put an onus on those individuals that otherwise would be investing in real estate.”

Tobin believes that the decision companies face with regard to employer-sponsored insurance will ultimately come down to a cost-benefit analysis—weighing the expense of the insurance versus paying the fine and thus incentivizing employees to seek out insurance through state-sponsored exchanges. However, from his perspective, the ultimate effect the policy will have on the average price of health care truly remains to be seen.

“It’s really going to be a business decision for individual companies,” says Tobin. “As far as a broad effect, it depends which side of the aisle you’re on—some people say it’s going to raise premiums, some say it’s going to lower premiums. For us, it will be business decisions for our member companies.”

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