James M. Manzi, CFA, senior director, Structured Finance Research, at Standard & Poor’s Rating Services, talked to Keat Foong, executive editor, MHN, exploring the ratings agency’s take on a range of subjects of interest to the multi-housing industry. Manzi reveals why S&P thinks we may not be on the brink of meaningful improvements, whether in CMBS delinquencies, home prices, the economy or the agency’s ratings of U.S., Fannie and Freddie debt.
Does S&P see a “double dip” for the U.S. economy? Why or why not?
We once expected a half-speed recovery, but that view now seems overly optimistic. Investment markets remain exceptionally volatile, and the risk of policy mistakes—both here and abroad—is high.
A major injection of fiscal stimulus is a political nonstarter, and the private sector isn’t ready to pick up the slack. We expect real GDP to rise 1.6 percent in 2011, which is almost half the 3 percent rate of 2010. For 2012 and 2013, we expect just 1.9 percent and 2.2 percent growth. None of this seems enough to make a dent in the unemployment rate, which will likely remain above 8 percent through 2013. We’re keeping the risk of a double-dip recession at 35 percent, but with every market sell-off, the risk of a recession becomes more real.
As a result of a slowdown in the U.S. economy this year, will we see a decrease in occupancy levels and negative rent growth for apartments, or will we see merely a leveling off in these metrics?
A modest construction pipeline, favorable demographic trends, a weak housing market and the de-bundling of households have all contributed to recent strength in the apartment sector. As of July 2011, CB Richard Ellis Econometric Advisors reported broad-based year-over-year vacancy declines and increases in effective rents. While the firm warns of a potential “uneven” recovery going forward regarding specific markets, locations and asset qualities, it projects that national effective rents will continue to rise and vacancies will fall over the next three years. In our view, this should generally be positive for CMBS credit, though the recovery may not be as beneficial for the Class B and C properties, which could constrain improvement in the multifamily CMBS delinquency rate.
When is the single-family market forecasted to recover?
Housing remains the biggest drag on the economy. Starts and sales have stabilized after plummeting earlier this year, which brought starts only slightly above the all-time low of April 2009. The spring rebound indicates that the decline stemmed from weather and the changes in regulations (including tax rebates) in several states, which took effect in January and caused a spike in late 2009. But even allowing for the weather, the housing market is weaker than we expected, and we have lowered our projections of sales and starts, expecting only 600,000 housing starts this year and an additional 670,000 in 2012.
In July, the supply of unsold inventory for existing homes rose to about 9.5 months from 9.2 months in June, but held at 6.6 months for new homes. Both are much better than the double-digit reading a few months ago, though both figures are still above the six-month historical average. This excludes homes in the process of, or likely to be in, foreclosure, which at least doubles that supply. Standard & Poor’s Structured Finance Research Group estimates that it could take a few more years to clear the supply of distressed homes on the national market.
The current average home price is below its historical average relative to income, and interest rates are near record-lows. However, high unemployment, tightening credit standards and a lack of savings means that fewer households can qualify to buy a home. At the same time, the glut of houses in the process of, or likely to be in, foreclosure is depressing prices even further. We expect them to continue to drop another 5 percent through spring 2012, slipping below the April 2009 trough in the S&P Case-Shiller index.
Even though prices are likely to drop again, we believe housing sales and starts will improve this year. We expect 600,000 total starts in 2011, up 3.4 percent from 2010, but still dismal compared with 1.6 million starts needed to keep up with demographics and the 2005 peak of 2.1 million. This likely will be the fourth consecutive year that starts have been fewer than 1 million, the first time since World War II.
S&P just reported that Fannie and Freddie now dominate the CMBS market. What are the implications?
Class A properties are typically luxury units, fewer than 10 years old, and usually occupied by white-collar workers. Class A properties are considered to be at the higher quality end of the apartment spectrum. These assets may also tend to be located in stronger markets (eg., high income levels and cost of housing) that support demand for these properties. They’re also the apartment types that Freddie Mac and Fannie Mae generally bid on aggressively.
Class B properties are generally 10-25 years old and usually have a middle-class tenant base of both white- and blue-collar workers. Class C properties are generally 30-40 years old and generally have blue-collar and low-to-moderate income tenants. In legacy CMBS, conduit lenders typically sought to finance B and C Class apartments as they were able to offer borrowers more favorable terms.
It’s our view that the performance of Class B and C properties will likely constrain any meaningful improvement in the multifamily delinquency rate. This is because potential homeowners have settled into Class A units while they wait for the single-family housing market to turn around. We anticipate that this trend will continue until signs of home price stability become evident.
In general, it’s also our belief that Class B and C owners will continue to experience operating cash flow stress due to thin debt service coverage
levels and rental concessions that are still available in these classes. This practice can put additional pressure on a borrower’s ability to make their loan payments. Increasing employment for the 20-34 year-old cohort should, however, provide some support for these apartment classes.
We believe that until the weak housing markets that we identified strengthen, rents stabilize among Class B and C apartments and troubled rental conversion projects get worked out, any meaningful decline in the multifamily delinquency rate may take a while to materialize. Differences will vary by market, however, particularly for those weaker areas where concentrations of foreclosure-displaced homeowners stimulate demand for rental units.
S&P downgraded the debt credit ratings for the GSEs. What will it take for their credit ratings to be upgraded?
First, it is important to note that Standard & Poor’s does not have an issuer credit rating on Fannie Mae and Freddie Mac, as they were placed into conservatorship in September 2008. However, Standard & Poor’s does have ratings on their senior debt, subordinated debt and preferred stock issues. We recently lowered our ratings on the senior debt issues from Fannie Mae and Freddie Mac to “AA+/Negative” from “AAA/Watch Neg,” following a downgrade of the U.S., in accordance with our government-related entity criteria. Our “A” subordinated debt rating and our “C” rating on the preferred stock of these entities remain unchanged. We don’t believe either entity has experienced a material deterioration in its ability to fund operations in the market as a result of the downgrade or any of the subsequent market turmoil. However, we could further lower the senior debt ratings if the U.S. rating were downgraded again, which is why the outlook is negative, consistent with the outlook on the U.S. government. Given where the ratings are currently on the subordinated debt and the preferred stock, we are unlikely to move them if the U.S. were to be downgraded again.
Does S&P think it is desirable to eliminate the GSEs and reduce the role the government plays in housing finance?
We do not make policy recommendations. However, any reformation process would likely take several years because the government isn’t likely to pull out of the housing finance business until it’s confident the housing market has strengthened enough to withstand an overhaul.
Did you see any signs of deteriorating underwriting standards of CRE loans being made today under CMBS 2.0?
We published two commentaries on these issues in 2011, one in February and another in May. One topic that we highlighted in both articles was potentially aggressive valuations/appraisals, especially in hotel and office loans in primary markets. The appraisals appear to be building in upside in rents and occupancy to arrive at a value for the properties in question, instead of using in-place rents and tenancy at the time of closing.
Using metrics such as Standard & Poor’s stressed loan-to-value (LTV) and debt service coverage (DSC) ratios, we also indicated our opinion that, on average, CMBS 2.0 underwriting most closely resembled pools issued between 2002-2004. While these metrics moved in a more aggressive direction in 2011 when compared with 2010 vintage deals, they had not yet reached levels seen in the boom years of 2006-2007.