Risky Business

The psychology of pricing risk premiums in the multifamily space.

The apartment sector is enjoying some of its best times ever, with record-low vacancy rates, record-low cap rates and record-high loan financing volumes. At the same time, and in part because of these domestic and other international trends, some anxiety has crept into the commercial property space. MHN interviewed a number of players, both debt and equity, about their perception of foremost perils in the multifamily space, and how they are expecting to be “paid” for these uncertainties.

William McPadden
Senior Managing Director
N. American Real Estate Finance
John Hancock Financial Services

Apartments offer superior returns compared to office, industrial, retail and hotel asset classes, acknowledges William McPadden, senior managing director, North American Real Estate Finance, at John Hancock Financial Services. However, homeownership may prove to be a risk factor for the sector, says McPadden—Millennials who are tired of renting, or tapped out by aggressive rent increases, could swing towards homebuying.
At some point, Gen Y could ask, “why do I do this?’” says McPadden. “There may be some pent-up demand for home purchasing filtering out of the multifamily space. We see a little of that shift. We will see if it sticks.” Furthermore, possibly encouraging homebuying soon, interest rates remain low, and the government has taken steps to lower borrowing costs.

In addition to the homeownership risks, McPadden notes that apartment value increases may be topping out. Values have been bid to very high levels. Moreover, financing sources, including banks, are desperate to lend, thus further boosting property prices.

In the midst of such perceived heated market conditions, investors and lenders are being very cautious, and that includes John Hancock. “We are underwriting not to the current market, but to long-term sustainable levels of operations,” says McPadden. It is also giving “haircuts” to rent levels in underwriting. “That may hurt us now—we may not win every deal. But that is perfectly okay for us because in years 10 to 15, we want to be paid.” The lender is also reluctant to lend to funds. “They may want out in year five, seven, and if something goes wrong, they may say they have no money.” And it wants equity. “It is nice that a borrower may want a $100 million loan, but we do not want to cash you out now, and be left holding the bag.”

In underwriting, John Hancock considers “long-term, megatrends” over 10- to 15-year periods. The lender is also mindful of interest rate risks—rates may be 3 percent now, but when the loan matures, the interest rate environment may not be as favorable, and cap rates may be higher.

The market can change, rents can increase, and expenses such as increased property taxes can eat into the bottom line, very quickly, notes McPadden. “The homeownership rate is now at a 20-year low. If the tide shifts, you could start to see free rent, concessions, and all of a sudden, a Class A property may be priced like a Class B.”

Hailey Ghalib
Managing Director, Multifamily Development & Portfolio Manager, Multifamily
USAA Real Estate Co.

For USAA Real Estate Co., one of the most prominent concerns in the multifamily space is the new construction that is being delivered into many markets. The company is imposing robust premiums in certain markets, as well as requiring higher returns in, or staying away from, markets that are in danger of being oversupplied.

“The biggest immediate risk in the US multifamily market is the prospect of a supply/demand imbalance as units from new construction are delivered into markets where the demand falls short of absorbing the new product,” explains Hailey Ghalib, managing director, multifamily development & portfolio manager, Multifamily. The new construction, “would put downward pressure on rents and cause an increase in economic vacancy,” explains Ghalib.

“Over the past couple of years, our team at USAA Real Estate C. has been focused on closely examining supply and demand on a submarket basis as well as diligently utilizing fundamental analysis to inform our investment decisions. That has led us to require a higher return threshold in markets with a risk of oversupply and consequently limit our activity in those markets.”

Another potential risk USAA Real Estate Co. is monitoring is the potential increase in interest rates and a corresponding increase in exit cap rates, says Ghalib. “With respect to interest rate risk, USAA RealCo predominately uses fixed-rate debt and has actively utilized hedges to cap interest on any floating rate construction loans in the portfolio.”

USAA Real Estate Co.’s approach to multifamily investments remains highly disciplined, says Ghalib.

“We maintain a healthy spread for development yields over conservative exit cap rate assumptions, invest selectively in value add deals that achieve that target return using disciplined assumptions, and we are only targeting investing in stabilized core product at or below replacement cost.”

Peter Lewis
Chairman & President
Wharton Equity Partners

Peter Lewis, chairman & president of Wharton Equity Partners, agrees that 2015 is a year of increased risks for the multifamily sector.

Areas of concern are the heated apartment investment market, subdued job and wage growth, and falling oil prices. As a result of the perceived perils of the market, Lewis is requiring higher cap rates in some of the markets.

The biggest risk today in the current market is the level of competition for apartment investments and overpricing, says Lewis. “What concerns me is the general exuberance in the market because of the low cost of debt and the continuing flow of equity to the apartment market. Property values are being bid up, and in my opinion, they are being bid up to levels that do not make sense.”

Having seen a few multifamily cycles in 30 years, Lewis approaches the market today with “extreme caution.” The company engages in very diligent underwriting. “We are not seeking to deceive ourselves. We are looking at fundamentals, jobs and supply.” The most important consideration in underwriting is job creation, says Lewis. In that regard, the company is very careful in the oil boom states. It is requiring higher cap rates and forecasting lower rents in those areas.

Lewis is generally building into his models higher interest rates on exits in four to five years’ time, when he expects prevailing interest rates will be higher. These higher expected interest rates drive his requirements for higher caps today. “We want a good spread between the cap rate today and that on exit.” He is generally building in cap rates of 75 to 100 basis points higher for the exits on the back end.

Lewis is also underwriting lower rents into his investments. He expects the blazing apartment rent increase of the past few years to moderate, from 4 to 5 percent growth to 2 to 3 percent growth. Job growth has occurred but not wage increases, notes Lewis. As a result, rent increases are exceeding the ability of renters to pay for them in some markets. At some point, renters will double up again, which will put pressure on owners’ abilities to increase rents.