Strong Market Challenges

Multifamily remains the best-financed commercial real estate sector, but expect hurdles in acquisition/rehab financing.

The investor chase after multifamily product is creating pressures for affordable housing developers. Nonprofits are finding that financing cannot be obtained quickly enough, especially in the hot primary markets. According to Thomas Deyo, deputy director for real estate, community stabilization, and green strategies at NeighborWorks America, these developers are “struggling to compete with a lot of capital resources driving towards the rental markets.” Coupled with the drop in subsidies for affordable housing, he says, it is becoming very difficult for affordable housing developers to be competitive in accessing properties.

NeighborWorks America represents a national network of 235 non-profit community development corporations serving more than 4,500 developments. Deyo says that of the 7,000 to 10,000 units developed by NeighborWorks’ members, about one-third, or 2,500 units, are acquisitions and/or rehabilitations. Most developments fall in the smaller 20- to 50-unit multifamily category, because these groups tend to work in rebuilding in small communities. Multifamily property acquisitions by these groups are on average Class B and Class C properties financed by the standard affordable housing tools such as the Low Income Housing Tax Credit program, FHA-insured mortgages, HOME funds and local subsidies, says Deyo.

“The challenges they are facing in many markets is that the markets are very active. Rents are increasing, there are many players, and cap rates are falling,” adds Deyo. “It is difficult for them to acquire the properties, fit in the rehabilitation work and still provide the housing at affordable rents.”

It would help if financing could be quickly deployed, but many market-rate developers in the intense multifamily markets today are making all-cash purchases. The competition for acquisitions is, of course, most keen in the coastal urban markets, says Deyo.

As a potential solution, some community developers are attempting to first acquire the properties as operating entities and then amass the rehabilitation financing 12 months down the road, says Deyo. NeighborWorks Capital and Community Housing Capital are two Community Development Financial Institutions (CDFIs) that make development loans to NeighborWorks’ member organizations. These organizations provide NeighborWorks members with short-term bridge financing for rehabilitation as a precursor to the properties’ securing permanent loans.

NeighborWorks Capital and Community Housing Capital are investigating the possibility of providing “more flexible financing that can be brought in at the front end,” reports Deyo. “That is where the groups are most in need, especially for Class B and Class C properties. They need more available and ready cash,” he says.

Among market-rate developers, the issue with multifamily acquisitions financing today, whether the financing be from the GSEs, life insurance companies or banks, seems to be that permanent loan lenders are not allotting enough dollars for rehabilitation and renovations. The result could be that some multifamily properties may be under-capitalized and may require significant capital calls in future, or the rents may not be maximized.

David Snyder, chairman of Continental Realty Advisors (CRA), says that in their capital assessments, lenders are focusing on the need for low-cost cosmetic improvements and that there is a dearth of attention to the structural or infrastructural capital needs of building systems. “Lenders are very willing to finance acquisitions and mild cosmetic renovations, and many times, developers are doing just that. But no one is paying attention to the underlying systems of each property that need replacement. That needs to be included in the valuation of these properties as well, but everyone seems to sweep [these renovation needs] under the rug and hope that [all the building systems will] still work.”

CRA is active in acquiring and renovating properties in the Midwest, in markets such as Kansas, Indianapolis, Louisville, Cincinnati; in Texas markets such as Dallas, Houston, Austin; in Southwest markets such as Phoenix, Albuquerque and Denver; and in the Southeast, including Nashville, Orlando, Tampa and Atlanta. The company projects it will acquire about 5,000 units in 2012 and another 5,000 units next year.

Snyder says that renovation budgets performed by CRA show capital needs that are in excess of lenders’ underwriting. “Some older properties are approaching 30 to 40 years old, and the lenders would say only $300,000 to $500,000 in total renovations are needed, whereas we see [the capital needs to be] $4 million. That is a discrepancy that should not even happen,” he says. Snyder cites an example of a $44 million property CRA had purchased about 1½ years ago on which the lender offered a $17 million loan, or 38 percent LTV, which is “really ridiculous.” CRA sunk in cash to perform the deep renovations it determined were necessary—and the company will exit the property this year for about $60 million, he said.

Snyder believes the underestimation of capital improvements is especially evident on properties located in the Midwest and Southeast. Yet in the Midwest, many older multifamily properties built in the 1970s or 1980s are precisely the ones that are located in key downtown and employment centers. “Lenders need to update their criteria” to allow higher rehabilitation loan amounts in these markets, he says.

Peter Lewis, founder of Wharton Equity Partners LLC, also thinks that one of the key issues in apartment acquisition senior debt financing today lies in the amount of money determined by lenders to be necessary to fund needed renovations. “Renovations capital is harder to find still. Agencies are not that liberal in providing tons of capital to fix up properties,” says Lewis. “We have often found that lenders under-reserve.”

Lewis’s beef, however, is that there is not enough reserves funding set aside for cosmetic, rather than capital, improvements in the common areas and for amenities and streetscapes. In Lewis’s view, lenders often overlook the “more esoteric” cosmetic requirements such as entrance lighting, new signage and flowers, which could greatly impact leaseup or rental rates. “If you want to reposition the asset, you have to think all the way through the process,” he says.

Wharton Equity Partners makes value-add investments as both an investor and developer, says Lewis. The company has a portfolio of about 1,500 units in Florida, the Midwest and the Southeast. It recently acquired nearly 1,500 units in value-add opportunities, and it is in discussions to acquire another 2,000 units in Florida, says Lewis. The company targets value-add properties in secondary markets and stays away from what he sees to be the overpriced primary markets.

Developers can seek short-term bridge financing to fund renovations that are not covered by reserves set aside under the senior debt. However, many types of loans, such as those provided by Fannie Mae and Freddie Mac, carry prohibitions on junior debt. But, supplemental loans provided by the GSEs can offer a solution: If the value of the property increases after the renovation, a supplemental loan provided by the agencies can be added to the original loan, Lewis notes.

Another solution for funding rehabs is presented by preferred equity. “Preferred equity can give you extra money needed to pay for the renovation, and it can be structured in a manner that does not violate the covenant with Fannie and Freddie,” says Lewis. However, the issue with private equity is that it is senior to the developer’s equity and costly.

In practice, renovations are often funded by developers’ own equity, says Lewis. “This is not an issue. There is plenty of equity around. The problem is because multifamily is so sought after, [the underfunding] bids up the values.” Bidders for properties begin to cut back on the reserves funding and as a result can pay more aggressively for the properties, thus driving up property prices.